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China 2011: risks are from liquidity not liability

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In Brief

A year ago, I made five predictions for the Chinese economy in 2010 in an article prepared for this Forum: 1) the renminbi will probably begin to appreciate against the dollar; 2) job market pressures may rise again even as the economy recovers; 3) housing prices would probably begin to weaken; 4) structural imbalances were likely to deteriorate further; and 5) the government would likely introduce another stimulus package.

Now that the year 2010 has retreated into the rear vision mirror, we can confirm that predictions (1), (3) and (4) actually occurred, but prediction (2) didn’t materialize.

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The government did not announce a new stimulus package in 2010, but in mid-year the State Council and the PBOC re-confirmed the need to continue expansionary monetary policy, reversing its earlier decision to return to a neutral policy stance. So I might get some marks for prediction 5).

Predictions 3) and 5) were based on the expectation that the stimulus package would run out of steam before the end of the year. If the private sector could not step in to fill the gap, then either the job market would weaken or the government would be forced to stimulate growth again. What actually happened was that exports picked up much faster and private sector spending was stronger than I expected.

What caught international investors’ attention at the beginning of the year was, of course, the call by a number of prominent investors and economists that the China bubble would burst. Jim Chanos, founder of the New York-based Kynikos Associates, predicted a slump after excessive property investments in China. Kenneth Rogoff, a Harvard Professor and former Chief Economist of the IMF, predicted that a debt-fueled boom in China could trigger a regional recession within a decade. Later, James Rickards, former General Counsel of hedge fund Long-Term Capital Management warned that China was in the midst of ‘the greatest bubble in history‘. He argued that PBOC’s balance sheet resembled that of a hedge fund buying dollars and short-selling renminbi.

Chanos, Rogoff and Rikards were certainly right to warn against rapid growth of both liabilities and bubbles. These risks could potentially lead to disastrous consequences, which were already evidenced by the experience of Japan in 1989, East Asia in 1997 and the U.S. in 2007. But were investors to translate such warnings into investment strategies for 2010, they would have lost lots of money.

The fundamental difference between China in 2010 and Japan in 1989 or the U.S. in 2007 lies in the balance sheet position. Before the meltdown in Japan after 1989 and in the U.S. after 2007 the balance sheets for the government, companies, banks and households were already in very bad shape – they all had very high leverage ratios or debt burdens. It only needed a modest change in either policies or prices, or both, to trigger a major meltdown.

China’s current circumstances are very different. China bears worry about fiscal sustainability, especially given the reckless spending habits af local governments. This is cause of concern, not a an immediate trigger of crisis. Even if we count unfunded pension funds, local government borrowing and potential non-performing loans, total public liability is still only around 50 per cent of GDP. Over the past years, fiscal deficits widened to about 2 per cent of GDP. But fiscal revenues have been growing by around 20 per cent per annum for more than 15 years. Although the growth rate slowed to 9 per cent in 2009, it rebounded to 21 per cent in 2010.

Given the massive credit expansion over the past two years, the quality of banking assets is likely to deteriorate going forward. Yet, a banking crisis remains highly unlikely in the conceivable future. This is because the average non-performing loan ratios of the Chinese banks are still relatively low, at below 5 per cent in most banks. More importantly, the government is likely to assume responsibilities for new non-performing loans in the coming year. One scenario is for the government to transfer non-performing assets to asset management companies, as it did in 1999. The corporate balance sheet is also quite healthy. During the last ten years, corporate income as a share of national income increased steadily. Despite the adverse effects of the financial crisis, growth of industrial profits accelerated throughout 2010 and reached over 20 per cent during the second half of the year.

The property bubble is the most important evidence supporting the case of the China bears. Property markets have obviously shown signs of a bubble, judged by usual indicators such as the price/income ratio, rental yields and the vacancy ratio. But normally, collapse of housing bubbles is triggered by either sudden slowing of income growth or the dramatic tightening of monetary policy. These can happen faster if households have already become overly leveraged. But this is not yet the case in China. Mortgage loans account for about 12 per cent of total outstanding loans. This is equivalent to 24 per cent of GDP, only a little over household income in one year.

All these factors suggest that, while the risks may be on the rise in China, a collapse or bursting of the bubble or crisis are unlikely in the near future. And the fundamental factors supporting macroeconomic and market stability are continued strong economic growth and very healthy balance sheets for the government, companies, banks and households. The risks for the Chinese economy in 2011 are unlikely to come from the liability side.

Liquidity, however, has become a bigger challenge for the Chinese policymakers and investors. The Fed’s QE II is already asserting pressures on China, through a sudden jump in inflows of ‘hot money’. Whatever the Fed’s motivation, QE II is likely to continue in 2011 and is likely to further complicate China’s economic situation.

China’s own monetary policy direction is even more complicated. From the end of 2008, PBOC maintained very loose monetary policy, as evidenced by RMB9.6 trillion in new loans in 2009 and possibly RMB7.8 trillion in 2010. PBOC will probably set the new loan target at RMB7.2 trillion in 2011, lower than the actual numbers in the previous two years but still 50 per cent more than PBOC’s original target for 2009. Credit expansion was useful in supporting growth. The downside is that loose monetary policy created inflationary pressure. In 2009, we saw waves of price increases first in the stock market and then in the housing market. Entering 2010, the government tried hard to crack down on property prices. Economists are generally skeptical about effectiveness of those restrictionary measures. But at least housing prices stopped going up.

Then prices of beans, garlic, apples, cotton, sugar and other commodities started to skyrocket one after another. Government officials were extremely busy running around inspecting inventories and punishing speculators. Surprisingly, the government was very reluctant to take aggressive monetary policy measures. With abundant liquidity and negative real deposit rates, waves of price increases continued to rotate around different products. By the end of 2010, the growth in the consumer price index (CPI) was already above 5 per cent year-on-year or above 12 per cent month-on-month annualized.

There were probably two reasons for the government’s reluctance to tighten monetary policies. One, it is still more worried about growth than inflation. And, two, it is somehow convinced that recent price increases were a reflection of structural adjustment, not overall inflation. The problem, that argument suggested, did not require monetary policy action.

So how will the Chinese economy do in 2011? There shouldn’t be much uncertainty about GDP growth reaching 8.5 to 9.5 percent. Export growth should remain solid. Whether or not the trade surplus will widen rapidly again depends on China’s import policy. Any widening of China’s external account imbalance, or lack of progress in rebalancing, could lead to significant international pressure on Chinese exchange rate policy.

Unless the PBOC changes its current policy approach, inflationary pressure is likely to rise further, at least during the first half of the year. The CPI may reach a cyclical high of 10 per cent, but rapid acceleration of inflation should eventually change the policymakers’ stance, since they are also worried about the political consequences of high inflation. We may see high inflation during the first half of the year and then aggressive policy tightening in the second half of the year, including rate hikes, currency appreciation and tightening liquidity. Those measures should exert some downward pressures on inflation, asset prices and economic growth.

One big uncertainty surrounds the trend in housing prices. In 2010, the government adopted two rounds of tightening policies in April and October. As a result, housing prices did not go up. But they probably did not go down, either. There will be a strong tendency towards increasing housing prices as soon as the government shows any sign of loosening its controls. The government has already confirmed that it will continue to crack down on housing prices in 2011. Some experts predict significant decline of housing prices. The analysis here suggests otherwise. A more likely outcome is continued stabilisation, not collapse, of housing prices in 2011.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

This is part of a special feature: 2010 in review and the year ahead.

3 responses to “China 2011: risks are from liquidity not liability”

  1. I would tend to agree more with Jim Chanos on the real estate issue.

    1. Homes are not ‘currency’. They are for living. Why would anyone hold on to them? This is like the rotting sardines story where the trader says “These are not eating sardines, they are trading sardines” (Seth Klarman: Margin of Safety)

    2. An investment by its definition should throw up income. A non-rented house is not an investment but speculation.

    To me, the real estate market in China looks like it is following the ‘Greater Fool’ theory for now. Once prices as much as stabilize, the investors will want to exit – en masse. Thats when the music stops (refer to BAC’s ex-chairman)

  2. Well, I share Chanos’ concern about the real estate bubble and its likely consequence. My only difference from him is that I don’t see the bubble bursting imminently. Balance sheets and urbanization are the two drivers of the bubble, if any, and they are likely to sustain it for a while. I don’t know when the bubble will burst. But it doesn’t look like a 2011 scenario to me.
    Yiping Huang

  3. A few minor points.
    Firstly, in terms of housing prices in China, it is interesting to note that the Chinese government has been talking down the prices and attempting to get them down significantly.
    While a government engineered fall in housing prices is good news for buyers, it is not that good for house owners. Whether the approach is politically viable or sound in the longer term is yet to be seen.
    The government had the responsibility of keeping housing prices in check in the first place. It failed to do that and now it is forcing them down and directly creating losers and winners because of its past policy failures. Isn’t that interesting?
    What the government should do is to manage the bubble over time, rather than to burst it suddenly.
    Secondly, in terms of liquidity, it has been reported that the Chinese authorities are either considering or have already allowed the direct deposit of foreign currencies overseas by Chinese exporters, that would reduce the pressure for the authorities to deal with them, lowering liquidity and increasing the degree of the limited monetary autonomy.
    The authorities should consider allowing most Chinese to buy foreign currencies and consume or invest overseas that would further reduce the autonomous pressure on liquidity of future trade or current account surpluses.
    In terms of the hot money, it is interesting that Chinese stock markets have performed poorly relative to others, including the US. Where has that money flown to or what has it bought?
    There is also report that the IMF is considering to relax its stance on control of international capital flows that may make it easier for authorities to deal with international ‘hot money’.
    Thirdly, in terms of inflation and the Chinese authorities’ monetary policy approach, what is the target or are the targets? Clearly public concern is the CPI because it affects their lives, whether it is due to structural or not. While there is a point to dealing with unhealthy speculative activities if appropriate policy tools are available, the government’s administrative measures are a step in a backward direction.
    The reluctance to using interest rates as the main tool of monetary policies is a poor approach given that it robs from those who have deposits that earn interest.

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