China’s Contradictory Third-Quarter Economic Growth

China’s third-quarter GDP growth report is chock full of contradictions. Though the 7.8% year-on-year growth rate was only the second in the past 10 quarters to represent a pick up in the pace of growth from the previous quarter, that was largely because of investment spending. A slowing of the growth in factory output and retail sales, along with September’s exports fall suggests there is little sustainable momentum to the economy’s recovery. With inflation hitting a seven month high, policymakers are more likely than not to rein in the credit growth that has accompanied the investment spending, a further potential brake on growth.

More broadly, the economy has to be switched away from its reliance on investment spending and exports to generate growth and towards domestic consumption. That implies a long-term slowing of growth. Yet government spending accounted for an estimated quarter of all infrastructure spending in the first nine months of this year, against a more typical 15-20%. As this Bystander has noted before, for all the good intentions over rebalancing, the old habits of goosing the economy when growth slows are dying hard.

The third-quarter number may serve to boost the annual GDP average so it clears the official annual targets. Growth for the first nine months of this year is 7.7%, against a full-year target of 7.5%. Yet its latest quarterly rise does not necessarily signal that the economy is moving in the right direction for the long term.

Wen’s Words Buck Up China’s Slowing Economy

Avuncular Uncle Wen is always the man to send to uplift spirits and spread reassurance when natural disaster strikes or times are trying. This week, China’s prime minister has been dispatched to his home turf, the economy, which has just reported its seventh consecutive quarter of slowing year-on-year GDP growth at 7.4% in the third quarter. And he is at his most upbeat. He says the slowdown has stabilized, and the official target of 7.5% annual growth for the full year will be achieved.

When it was first announced in March that target seemed a ridiculous low-ball of a number, one that would be easily exceeded so that the outgoing leadership could hand over to their successors on a high note, at least as far as the economy went, and particularly in comparison with the ailing developed economies. But the managed slowdown in domestic investment, aka deflating the property bubble and stopping the local government debt bomb from exploding, has been exacerbated by the drop in demand from China’s export markets, and especially from its largest, crisis-wracked Europe. Policymakers have had to walk a fine line between stimulating the economy sufficiently to prevent growth slipping irrecoverably below the official target and reigniting the inflation they struggled so long to bring down. At the same time, they had to avoid inadvertently lighting any fuses close to the banks’ loan books.

Yet Wen is all public cheer: “Exports have gradually recovered, consumption has grown steadily, price inflation has clearly receded, the job market has been very good,” he said in a statement published just ahead of the announcement of the third-quarter GDP number. There are monthly numbers to back him up. Exports rose 9.9% year-on-year in September, while inflation dipped to 1.9%, well down from last year’s peak of 6.5%. Retail sales were up 14.2%. This Bystander is always wary that one month’s number is no guarantee of the performance of the next one, though we don’t doubt that the 7.5% growth target for the year will be met, by hook or by crook. But Wen looks likely to over-deliver by as little as it is now clear he under-promised.

Wen also pointed out in his statement that the government “had taken new steps towards structural transformation.” As to whether he has pushed the economy fast enough down the road to rebalancing and far enough so his successors won’t turn back, we’ll leave for another day.

Another Cut Forecast Of China’s Economic Growth

The World Bank and the OECD have already cut their growth forecasts for China for this year. Now comes the IMF. In its latest World Economic Outlook it says its expects China’s growth to be 7.8% this year, down from the 8% it expected in July (see chart, right). That would be the weakest growth in more than a decade.

The IMF does see growth picking up to 8.2% next year, though it had previously expected 8.4%. Achieving any pick-up will probably depend more on what policy makers in Europe and the U.S. do than those in Beijing. If the euro zone crisis worsens and the U.S. falls off its fiscal cliff, matching this year’s growth will be a challenge in itself.  “The balance of risks to the near-term growth outlook is tilted to the downside,” the Fund says.

Beijing is being cautious in its policy response to the slowdown, providing moderate monetary and fiscal stimulus. The massive spending spree after the 2008 global financial crisis still hasn’t played itself out. Another round of extensive bank-financed infrastructure spending is just too risky for still strained bank balance sheets. Nor is investment-driven growth sustainable if Beijing is serious about rebalancing the economy towards more domestic demand.

How Near To The Bottom?

The long-awaited sign that China’s economic slowdown has finally bottomed out, or just another step towards that trough? HSBC’s Flash China manufacturing purchasing managers’ index (PMI) stabilised in September, ticking up to 47.8 from its nine-month low in August of 47.6. There was also a broad steadying across the sub-indexes, though the one that measures output fell to its lowest level in 10 months.

The numbers are still on the contraction side of the 50 mark that separates contraction from expansion. The overall index shows that new business remains sluggish and the running down of inventories is taking longer than might have been expected. Stimulus measures – tax and interest rate cuts, expanded bank lending and liquidity injections and a green light for bringing forward $150 billion in infrastructure investment — may be taking effect, but gradually.

Inflation showed signs of reviving in August, after hitting a 30-month low in July. Policy makers will be wary of taking further stimulative measures unless they absolutely have to. HSBC’s Flash PMI lets them hold fire for another month.

Squeaking By With 7.5% GDP Growth

It doesn’t seem that the Hu-Wen leadership will get to handover to their successors an economy that has put slowing growth behind it. The hit the global economy has taken from the eurocrisis has hurt China’s vast manufacturing industry harder and longer than expected. It now looks as if the slowdown in growth will last well into the third quarter, possibly beyond.

Both the official and the unofficial HSBC purchasing managers’ indices for August were bad news in that regard. The official index fell below the 50 mark dividing expansion from contraction for the first time since last November. HSBC’s version, which reflects more small and medium sized firms than the official index and already below 50, hit its lowest point since March 2009.

Talk of further policy measures to boost growth has intensified. Two interest rate cuts and central bank injections of liquidity via large-scale reverse repos have not had the hoped-for impact. As central bankers in the U.S. and Europe have found, it is not the price or availability of money that is the drag on recovery, it is lack of demand.

China’s policymakers remain wary of aggressive easing and stimulus via infrastructure spending for fear of rekindling inflation and the property bubble that they worked so hard to reduce. The debt overhang from the last round of stimulus, after the 2008 global financial crisis, casts a dark and deeply concerning cloud over policymakers.

This Bystander still thinks they will remain cautious about further easing, hoping that they will be able to get though the year with better than the 7.5% GDP growth that was set as the annual target, all be it by the skin of their teeth. That they were intending to pass on a plumper cushion of growth while setting expectations the longer term structural slowing of the economy will be conveniently forgotten for the moment.

World Bank Sees Scope For Soft Landing For China’s Economy

The World Bank has raised its forecast for growth in China this year to 9.1%. In March the bank had forecast 9.0% GDP growth. But it sees growth slowing next year to 8.4% against the background of a slowing global economy. That will also put the brakes on regional growth already hit by the flooding in Thailand that has disrupted manufacturing supply chains.

In its semi-annual regional economic outlook, the bank highlights the Chinese economy’s vulnerabilities to the debt crisis in Europe and the heavy endebtedness of local governments at home, which it says may be exacerbated by the central government’s success so far in dampening the property bubble. “Policymakers will need to walk a fine line guarding against the short-term risks to growth and the lingering vulnerabilities associated with a still buoyant, if not overheated, economy,” the bank says. It also notes that the moderation in inflation gives policymakers scope to manage a soft landing by loosening their monetary tightening.

The bank also says that the slowdown in global growth provides an opportunity for governments to refocus on reforms that will boost growth in the medium- and long-term, including investment to increase productivity and move toward higher value-added production, a task it calls “urgent” for China’s coastal manufacturers. In a clear nod to Beijing, it also says that where investment levels are already high, increasing the quality and efficiency of these investments should be the first priority alongside rebalancing growth towards domestic consumption. To drive ahead the structural changes in China’s economy, the bank repeats its calls for Beijing to focus on completing the transition to a market-based economy and strengthen the national innovation system. The China-specific part of the outlook is here.

Forget February’s Trade Figures

China’s trade deficit for February is an anomaly caused by the New Year holiday. This set of trade figures is even more meaningless for interpretation of a trend than a single month’s numbers usually are. If one looks at the trade figures for January and February combined, exports were up 21.3% and imports 36% on the same period a year earlier, compared with 17.9% and 25.6% in December. Rising commodity prices are inflating the export number, but the arc of the trend is for a gradually diminishing surplus on a rising volume of trade.

 

A China Banking Crisis: Possible But Not Likely

The prediction that China faces a 60% risk of a banking crisis by mid-2013, made by Fitch Ratings senior director Richard Fox in an interview with Bloomberg, falls into that category of eye-popping but not inconceivable.  Fox’s number comes from a risk model designed by the credit-ratings agency to predict banks’ vulnerability to systemic stress in the face of sustained rapid credit growth, rising property prices and an appreciating real exchange rate.

China has ticked at least two of those boxes for a long while, and indeed, Fitch’s model put China into the most at-risk category last June, though seemingly not many noticed at the time.  The model is not infallible. It raised a red flag about Ireland and Iceland ahead of their crises but not Spain’s. Countries can also retreat from the at-most-risk zone. Brazil, France, Denmark and New Zealand are recent examples. We think China is likely to join them.

Likely though not certain. A bursting property bubble and the local government debt bomb going off (and the two are so closely linked that the one would likely trigger the other) are the banking system’s greatest vulnerabilities. Policymakers are tackling both, though neither are susceptible to a quick fix. As the raft of piecemeal measures over the past 18 months to cool property markets, soak up excess liquidity in the economy, get local government finances and governance on a tighter rein and shore up banks’ capital reserves attest, it is painstaking work.

Given the scale of China’s lending binge over the past couple of years, it is inevitable that the banks will end up with some odorous piles of bad debt on their books. The question, of course, is whether they are mountains or molehills. The rapid pumping up of capital reserve ratios and the bank-by-bank way they are being required suggests the regulators have some fix on their magnitude and which are most threatening. It is the unexpected, though, that blindsides even the best layers of plans.

Prudent macroeconomic policy is the best way of avoiding a banking meltdown anywhere. As we have noted, the shift in policy Beijing is now trying to pull off to minimize what it sees as politically threatening social disparities caused by full-pelt economic growth gives the economic planners additional priorities that will complicate prudent macroeconomic management. Further, some of the tools at Chinese policymakers’ disposal are still rudimentary, one reason that the new five-year plan makes much of the need to continue financial reform. Yet they do have one big advantage in managing a potential banking crisis: administrative guidance over both the dominant banks, which are state-owned, and their big customers, similarly state-owned. That guidance is not always followed to the letter, but if a systemic crisis loomed both banks and state-owned enterprises would soon find guidance coming with arm-twisting.

Beijing has already bailed-out the big banks once from their bad loans in the past decade, and it could do so again if necessary. It could also, we should say, would also, spread the stress of a developing banking crisis to avoid it causing a systemic failure. We still don’t think it is likely that it will have to absent that black swan, and the more progress there is on structural reform of the financial sector, the longer the odds get, but it is not impossible that it might.

Footnote: Economist Michael Pettis makes the point about the political protection of China’s banking system much more elegantly in a post on why the yuan won’t become a reserve currency any time soon (a point on which this Bystander also agrees):

It is worth pointing out that the Chinese banking system is one of the least efficient in the world when it comes to assessing risk and allocating capital, and would be bankrupt without repressed interest rates and the implicit (and sometimes explicit) socialization of credit risk.  Beijing accepts this because of the tradeoff that gives it banking stability.

Beijing greatly values this stability, even at the expense of capital misallocation, and is in no hurry to give it up by opening up the financial markets and, what’s more, for political reasons I think local governments will resist ferociously any further corporate governance reform.  Remember that the phrase “corporate governance reform” in the banking context is just another way of saying that credit decisions will be made on the basis of economic considerations, and not on the basis of government preference.  That particular reform will be politically contentious.

Wen’s Glass Half-Empty

The China a timorous world sees is so different from the one a timorous China sees. Prime Minister Wen Jiabao’s annual government work report to the National People’s Congress laid out a raft of serious problems threatening the country’s stability as it gets ever nearer to the transition to the next generation of leaders: inflation, a wealth gap, over-reliance on investment rather than domestic consumption for economic growth, paucity of technical innovation,a polluted environmental, shortfalls in education and healthcare, inadequate food safety and official corruption.

Fortunately, there is a five-year plan for that.

 

The Two Instabilities

As the 11th National Committee of the Chinese People’s Political Consultative Conference, the country’s top political advisory body, meets in Beijing to ratify a new five-year plan to rebalance the economy and to tackle inflation and rising property prices, two comments from western China illustrate the Morton’s fork China’s economic policymakers find themselves somewhat uncomfortably stuck by.

The first occurred at a recent meeting of regional managers from one of the large state-owned banks. A manager from Xinjiang, we are told, complained that credit quotas imposed by the banking regulators were constantly tightening in the cause of the national fight against inflation, making his bank’s branches unable to meet the local demand for loans, demand that was rising because of the development priority now been accorded to the region by Beijing.

The central bank is repeatedly dabbing up as much of the excess liquidity in the economy as it can through interest-rate hikes, higher capital reserves requirements on banks and administrative measures such as new-loan quotas. The goal is to dampen inflation and to let down the asset bubbles inflated by the lending spree triggered by the post-global-financial-crisis stimulus.

Yet it is precisely through fixed-asset investment that the government has been able to deliver the constant economic growth that the Party sees as essential to legitimize its monopoly on power. The second comment, from Xinjiang regional chairman Nur Bakeri just this week, spells out how raising living standards through economic development is key to maintaining social stability. “Development is our top priority and stability is our greatest responsibility. Without development, there would be no stability and vice versa,” he said.

Such local political pressures lie behind not just the continued pace of new bank lending this year, but also the discovery in February by the banks’ regulator, China Banking Regulatory Commission (CBRC), that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the fear that China’s banks are sitting on a potential dung heap of bad loans. The rules require banks to meet tougher credit and risk standards with new loans. As far as the banks are concerned it is a case of old habits die hard. For years and years and years, China’s growth has been fueled by fixed asset investment financed through government-directed bank lending. Flash the cash and the devil take the hindmost.

Beijing had to bail out the big banks once to cleanse their loan books. After a couple of years of stimulus fueled record lending, it worries it may have to do so again. The recent turn to the capital markets by the big four state-owned banks has been in part to replenish threadbare capital cushions.

The CBRC has recently read the riot act to the banks for their continued lax lending. More detailed — for which read, stricter — regulations on things like capital adequacy and leverage ratios are likely to be announced later this month or early next, once the horse trading between the regulators, the industry and the myriad of official agencies with an oar to shove in to in these particular waters, has been completed. These will bring China broadly in line with international standards, and in some cases be much tougher.

They won’t completely mitigate the regulators’ darkest fears about bad loans. The CBRC is still acutely concerned about banks’ lending to the captive investment vehicles of local governments intended to get round restrictions on direct capital raising from banks. Banks had lent at least $1.2 trillion this way to local governments as of June 30th, with 23% not backed by cash flows. The CBRC’s new rules in February were particularly tough in this regard, as they were for real-estate lending. As we noted earlier, regulators have reportedly told banks to recalculate their capital levels using higher risk weightings for their loans to local governments via captive investment vehicles. It will be a nervous-making wait for the results. As the finance ministry noted in its budget report, “local governments face debt risks that cannot be overlooked”.

How much the Party can risk slowing down the economy  to minimize the risk of a hard landing if bubbles go pop and yet still keep real living standards rising is the calculation that now has to be made in Beijing. Late last month Prime Minister Wen Jiabao set an expectation that annual growth rates will slow. He said the government would target 7% annual GDP growth for 2011-15, though it wasn’t so long ago that growth of 8% a year was said necessary to generate sufficient jobs to absorb new workers coming onto the labor market and thus ensure social stability. Diverting GDP growth into social services and income-tax cuts to offset the effects of inflation is now seen as a greater guarantor of stability than providing jobs, it appears, to a government that is seemingly increasingly if unnecessarily rattled as it enters a period of economic, political and foreign-policy transition.