Monday, January 19, 2004

My friend Matt asked me about the Bradsher piece in NYT that states that China has a bubble economy now. Below is my view, followed by the article:

On the Bradsher piece, I am going to play Fred Hu for one moment. First of all, what is happening now (say money supply expansion) as a percentage of the total economy is not a big deal relative to the problem in the early 90s. So, the over expansion of money today is something that China has dealt with at least three times in the past. First, this means they know how to deal with it. Second, I don’t think the supply side of inflationary pressure is as great as it was in the early 90s. Thus, I highly doubt that inflation would reach even 15% (it reached 25+ % in the early 90s). I think China now faces a series of smaller bubbles in various sector rather than one giant bubble that threatens the economy. Things are overheated in real-estate (again real-estate investment as % of GDP has fallen since the early 90s), and there is a supply shortage in some areas, but I don’t think it is a serious problem yet. On the flip side, even the bursting of several mid-size bubbles can threaten the credibility of banking reform. Currently, the Big Four are toting to foreign investors that NPLs from new loans is very low, in the 2% range. However, much of this rides on the current economic expansion. I am sure that NPL will go up if the bubble bursts in the real-estate or stock market. It might not go up by 20-30% like in the early 90s, but a 5-10% jump will greatly undermine investor confidence in these IPOs.

3,003 words
18 January 2004
The New York Times
Late Edition - Final
(c) 2004 New York Times Company

DONGGUAN, China -- THE prospectus for China Green Holdings Ltd. looks a little like a seed catalog. Color photographs show the corn, cabbage, pickled plums and other vegetables that the company exports, mostly to Japan. There is even a helpful list of the growing times for broccoli, cauliflower and sweet peas; it is tucked between tables showing that the company earned $14.1 million on sales of $31.2 million in its last fiscal year.

Though China Green's business literally involves small potatoes -- cubed and shipped in plastic bags -- its initial public offering in Hong Kong was anything but. Retail investors put in bids to buy more than 1,600 times as many shares as were available for sale, making it the most oversubscribed I.P.O. ever in Hong Kong. The stock jumped 58 percent last Tuesday, its first day of trading.

Japan had its bubble in the late 1980's, when the Imperial Palace grounds in Tokyo became worth more than all the land in California. Thailand and Indonesia had their bubbles in the mid-1990's, when speculators and multinationals poured money into what seemed like a Southeast Asian miracle. The United States had its Internet and telecommunications bubble in the late 1990's, when stock prices looked as if they could rise indefinitely and unemployment kept hitting new lows.

Each of those bubbles ended badly, with millions of families losing their savings and many losing their jobs.

As 2004 begins, China's economy looks as invincible as the Japanese, Southeast Asian and American economies of those earlier times. But recent excesses -- from a frenzy of factory construction to speculative inflows of cash to soaring growth in bank loans -- suggest that China may be in a bubble now, especially on the investment side of the economy.

Bubbles can last years before they pop, but they seldom deflate painlessly when they do. Nobody knows how harmful a sharp economic slowdown would be to China, a country undergoing huge social changes, like the migration of peasants to the cities. The Communist Party rests its legitimacy on delivering consistent annual increases in prosperity.

The Chinese government is showing concern. In the last few weeks, the central bank has tried to dissuade banks from reckless lending while the government has bailed out two of the largest ones, to prepare them for possible hard times as well as planned stock sales. The State Council, China's cabinet, has warned that it will discourage further construction of new factories in industries like aluminum and steel, whose capacity has grown swiftly in the last three years.

Because China is now so important to the global economy and to global political stability, the possibility of economic trouble is starting to draw serious attention among economists and China specialists.

Huge billboards in Guangdong Province commemorate Deng Xiaoping's decision a quarter-century ago to allow capitalism to gain a foothold in a few cities here in southeastern China. Practically ever since, China's astounding economic growth has provoked warnings that the boom may not be sustainable. Year after year, China has proved the worriers wrong, although there have been a few missteps along the way, most notably when inflation surged temporarily and foreign exchange reserves withered in the early 1990's.

But even by Chinese standards, things have been moving at a blistering pace of late. Official statistics, which the government tends to smooth so as not to indicate big booms or busts, show that the economy expanded 8.5 percent last year, despite the fact that growth came to a virtual halt during the second quarter because of an outbreak of SARS. According to independent economists, however, the Chinese economy actually expanded at an annual pace of 11 percent to 13 percent through the second half of last year.

Strains are already showing. Blackouts have become a problem in a majority of China's provinces, as families with new air-conditioners and refrigerators compete with new factories for electricity. Auto sales soared 75 percent last year, as prices in a market protected from imports until 2001 drifted down toward global levels. Still, automakers are planning huge factory expansions in the hope that such growth will continue.

Most economists specializing in China now predict that sometime this year, growth will have to slow, at least for the investment side of the economy -- the building of new factories, for example. That could prove painful. The United States economy suffered severe weakness on the investment side in 2001 and 2002, when the market for telecommunications equipment became glutted. The upshot was tens of thousands of lost jobs in that industry, not to mention steep drops in the stock portfolios of millions of Americans.

But consumer spending is now strengthening in China, while household savings rates are high. China, like the United States, is likely to rely on consumers to prevent any coming slowdown from becoming too severe. ''We look for a hard landing in investment, a soft landing in overall economic growth and no landing in consumption,'' said Tao Dong, an economist in Hong Kong with Credit Suisse First Boston.

The risks to China, and indirectly to the world, fall into four broad areas. Those categories follow, starting with the most likely, a cyclical bust in the investment sector, and ending with what appears the least likely but also the most serious: political turmoil or some other loss of social stability.

Business-Cycle Risk

A quarter-century ago, Dongguan, in the Pearl River delta region of southern China, was an impoverished farming village where residents struggled to survive on limited rice rations. Today, its 14,000 foreign-controlled factories make it the world's largest single site for the production of microwave ovens, and it is a huge producer of everything from computer cables to furniture and computer displays.. The roads are jammed with freight trucks carrying boxes of components to assembly lines and the finished goods to ports in Hong Kong and Shenzhen.

Dongguan has formidable advantages as a place to do business, as Frank Jaeger, a German businessman, can attest. Eight years ago, he started a five-employee operation making computer cables here. He now has 1,000 employees, and is still expanding. And small wonder: factory floor space, built by municipal government contractors for businesses willing to locate here, costs 10 cents a square foot to rent each month excluding the installation of pipes and wiring, compared with $1 to $1.50 a square foot in some American factory towns and as much as $2.50 in Germany, Mr. Jaeger said.

Wages are also low, thanks to a constant flow of semiskilled migrant workers from even poorer provinces in China's interior. Mr. Jaeger's company, TCA Ltd., offers base pay of $60 a month, and an additional $40 a month in overtime and free room and board in adjacent dormitories, where the workers sleep six or eight to a room.

While the wages may sound low to Westerners, even with free room and board, they are high by local standards, holding down turnover and training costs. The workers, mostly young women who stay one to three years and then return to their home provinces to start small businesses or families, wear green and yellow company-issued windbreakers and sit in chairs at long metal tables under fluorescent lights, clipping wires, filing plastic and installing copper disks to make reliable electrical connections.

Other domestic and foreign businesses have noticed the same attractions, too. In fact, so many factories have been built that in industry after industry, from washing machines to cellphones, production capacity far exceeds domestic demand. Exports have not entirely absorbed the difference, so prices have plunged.

Business executives and economists often complain that factories are built with little attention to whether similar plants are being constructed elsewhere, or to how low prices will fall if all of them start churning out the same products at the same time.

Many former farmers in Dongguan have profited from land deals. Instead of putting the money in bank deposits paying negligible regulated interest rates or risking it in mainland China's tiny and fraud-riddled stock exchanges, they invest it in factories in their hometown.

''In China, overcapacity is not an issue that stops a businessman, because they always think they can do better,'' Mr. Jaeger said.

Domestic and foreign investors alike share that approach. Executives from multinational corporations see China as such an important market that they have little choice but to continue investing, in the pursuit of ever-greater slices of the market. ''Good companies, be they local or be they global, can increase their market share,'' said Pekka Ala-Pietila, the president of the Nokia Corporation, the cellphone maker.

The problem arises when too many companies make the same calculation and invest too much. Nearly half of China's economic growth is investment-related spending, an extraordinary figure that reflects public spending on highways and dams, as well as private-sector projects. Calculations by Smith Barney show that Japan in the 1980's, Southeast Asia in the mid-1990's and the United States in the late 1990's each had a few years of investment spending well above historical averages. In each case, overcapacity accumulated in many industries and, eventually, a bubble popped.

China has developed a special disadvantage, in that its economy has become so ravenous for commodities that it is pushing up global prices for products like oil, for which China has become the second-largest market, after the United States. With very low wages and real estate costs, factory managers find that materials are their biggest cost by far, and a sudden jump in their cost can leave businesses with no competitive edge.

The People's Bank of China, the central bank, has reported an acceleration in wholesale price inflation this winter. The big question is how quickly this will feed into consumer price inflation, which could antagonize politically important urban residents. If consumer prices start rising significantly, the central bank will come under growing pressure to let interest rates climb, which could make more factories less competitive as loans become more costly.

China still has some advantages that, at least in the short term, may forestall a plunge in investment. One is a banking sector willing to lend heavily to even the most indebted companies, provided that they have political connections. But in postponing the final reckoning in the current business cycle, China may be making an eventual bust even worse.

Protectionism Risk

China Green exports three-quarters of its fresh vegetables, and the prospectus for its I.P.O. warns that it relies heavily on sales to several Japanese companies. If there were a prospectus for China's economy, it would need to warn of a high dependence on sales to America.

China exported $125 billion worth of goods to the United States in the first 10 months of last year and imported just $22 billion. The resulting trade surplus equaled an extraordinary 9 percent of China's entire economic output during this period.

Rapid growth and a persistent imbalance in China's trade with the United States have turned Chinese exports into obvious targets during an American election year. In the last few months, United States trade officials have begun to take the legal steps needed to impose steep tariffs on Chinese products as varied as color televisions, furniture and bras.

To avoid a full-scale trade war, Beijing has followed Japan's example in sending official buying missions to the United States. Shopping for everything from soybeans to communications equipment, they have agreed in the last two months to buy $11 billion worth of goods, by Beijing's calculations. Some of these deals might have happened anyway, like the one to import General Motors auto parts for assembly into finished cars here.

So far, American trade restrictions have covered a tiny percentage of Chinese shipments to the United States. But any significant broadening could slow the Chinese economy in a hurry, and with it the economies of many Asian neighbors that increasingly send components to China for final assembly and reshipment to the United States.

Financial Risk

Lists of potential causes of a Chinese economic derailment tend to start, and sometime end, with a banking crisis. By plying borrowers with ever more loans, following lending criteria that credit ratings agencies contend are laced with corruption and political influence, Chinese banks have wound up with extremely high proportions -- as much as 45 percent -- of nonperforming loans.

The banks rapidly stepped up their pace of fresh loans last year. Exporters, foreign investors and speculators were depositing large sums of dollars. The central bank then exchanged the dollars for China's currency, known as the yuan or renminbi, at a fixed exchange rate, so as to keep the holders of those dollars from bidding up the yuan's value. The banks lent heavily from their expanding deposits, with loans rising 21.4 percent last year.

''The world economy is being kept afloat by the aggressive expansion of the U.S. budget deficit and Chinese loan growth,'' said Ajay Kapur, the chief Asian equity strategist at Smith Barney. ''Any reversal in these two trends has pretty serious outcomes for the rest of the world.''

Most Chinese savers have few alternatives to the state-owned banks as places to park their cash, and the banks appear to have informal but total government guarantees of deposits. As a result, they have not experienced significant losses of depositors, although that could change as ever more businesses engage in trade deals that can be used to transfer money to safer banks overseas if hard times ever return to China. Lately, concern has gone beyond the stability of the banks themselves to the economic effects of all the extra money sloshing through the banking system.

Chinese officials have said they would try to sterilize the effects of their purchases of dollars, by selling bonds to the public for yuan that the central bank then cancels or destroys. If the central bank actually sold extra bonds as fast as it bought dollars for yuan, it could theoretically leave domestic banks with no more cash on hand than they had before, and prevent the risks of faster loan growth, a rising money supply and, eventually, inflation.

But financial experts say the central bank is no longer able to sterilize the effects of its currency activities. The problem is that the Ministry of Finance, a separate agency in charge of budget policy, has limited the interest rate that the government can pay on bonds, so as to hold down the cost of servicing China's national debt. With inflation starting to rise, the bonds have become less attractive and the central bank has been struggling to sell enough new bonds each month just to pay off old bonds falling due.

The central bank has been able to soak up little if any of the billions of extra yuan it has been pumping into the economy lately to buy up dollars, said Liang Hong, a Goldman Sachs economist. At the same time, flows of ''hot money'' -- short-term investments being moved into China from overseas through a variety of channels despite China's capital controls -- appear to have accelerated.

''I'm really worried about their losing control of the money supply,'' Ms. Liang said.

Political Risk

To the West, the hallmark of the last quarter-century in China has been rapid economic growth. But for hundreds of millions of Chinese, it has meant something else: a respite from the wars and the domestic strife that had dogged the country for more than a century before, from the Taiping Rebellion of the 1850's to the Cultural Revolution in the late 1960's and early 1970's.

In the years immediately after the Tiananmen Square killings in 1989, China became relatively placid, perhaps in part from fear. But that calm seems to be fading now.

President Hu Jintao has gingerly tried to restrict some police powers -- like the ability to detain people without proper identity documents -- and is seeking slightly greater openness in Chinese society. Human-rights groups report a growing number of protests in China, mainly workers and retirees seeking unpaid salaries and benefits. At the same time, many on the mainland are acutely aware of the huge marches organized over the last seven months by democracy activists in Hong Kong, now an autonomous region of China.

Whether any of these forces become significant enough to rattle China's stability is anybody's guess. Peaceful change toward a more democratic system may still be possible, especially if it is fairly gradual.

But if the economy slows sharply, political instability could follow. That would be a serious problem, and not just for China, but also for the rest of the world.

Photo: Workers at a TCA assembly plant in Dongguan, China, earn base pay of $60 a month to build electrical parts. (Photo by Grischa Ruschendorf for The New York Times)(pg. 9)

Drawing (Illustration by The New York Times)(pg. 1)

Chart: ''Big Spenders''

Countries in the middle of economic booms tend to show above-average spurts in investment spending. The surges are often followed by sharp slumps as businesses seek efficient uses for all the new offices, factories and equipment they have accumulated. The Japanese economy in the late 1980's, Southeast Asian economies in the mid-1990's and the American economy during the Internet and telecommunications boom of the late 90's each had a surge in investment spending, followed by a bust. Will China's economy suffer the same fate?

Graphs track capital expenditures (percentage difference from the average capital expenditures as a percentage of gross domestic product) for China, United States*, Japan, and Southeast Asia from 1980 to 2003.

*Equipment and software spending only

(Source by Ajay Kapur [Smith Barney])(pg. 9)

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