Wednesday, April 21, 2004
China's Hard Landing
By JOE STUDWELL
April 20, 2004
For the past six months the global-investment community has sung what is -- even by industry standards -- an improbable song. That booming China, currently yielding foreign companies their best returns since economic reforms began more than 20 years ago -- is headed for a soft landing. That a country where bank lending has increased by 40% in the past 24 months and fixed investment by much more is going to casually ease down a couple of gears without paying a price for its frenzy of state-driven investment.
Last week's economic data for the first quarter of 2004 put a bit of a damper on that proposition. Gross domestic product surged 9.7% in January-March, from the figure for the same period last year. Fixed investment increased by a jaw-dropping 43%, maintaining a share of GDP that is comfortably in excess of that recorded in other Asian countries such as Thailand before they were hit by the 1997-98 financial crisis. And outstanding bank loans steamed ahead by 21% over the same period last year. They now comprise 140% of GDP, an unprecedented share for a developing economy. For March alone, industrial production growth set an all time record of 19.4%.
Perhaps the soft-landing spinmeisters will now concede that the possibility of a hard landing has increased somewhat. But their analysis remains at best flawed, and at worst disingenuous. For historical experience shows that communist China does not do soft landings any more than subtle diplomacy or get-to-know-you meetings with political dissidents.
Since China began its economic reforms in 1978 there have been four violent economic cycles -- each dictated by government macro policy. That is one reason why it has been so difficult to make money by investing in China's domestic economy (as opposed to the export economy or opportunistic trading): just when companies put their cash on the ground, the economy tends to drop off a precipice. The peaks of the three previous cycles were 1978, 1984 and 1992. And now, 2004 may prove to be the peak of the fourth.
The gap between peaks and troughs has been enormous, even though this was partially disguised throughout the 1990s by the vagaries of China's statistical regime. A Soviet-based data reporting system understated growth in peak periods and overstated it in troughs.
Back in 1978, growth rocketed to 12% as Deng Xiaoping initiated China's economic reforms with a long-cherished wish list of industrialization projects. By 1981, it had crashed to 5% because China was unable to pay for them. But by 1984, investment fever was back with growth of over 15%, before it dropped like a brick to close to 0% in post-Tiananmen 1990.
In 1992, Deng reissued calls for fast development and that year saw another growth peak -- officially 14.2% and probably higher. Then former Premier Zhu Rongji hit the brakes in 1994. The economy slowed to a 1998 growth nadir that almost all China economists now agree was at most 3% -- and quite possibly less. Different means of calculating China's GDP (using consumption instead of socialist expenditure-based methodology) and looking at the performance of proxies for growth -- such as freight, air travel and power -- gave the lie to officially reported figure of 7.8% growth that year.
The same techniques show that growth in the latest peak has been faster than reported. After 1998, the government panicked over the implications of the Asian financial crisis and again began to pump up the economy with investment steroids. Official growth in 2003 was 9.1% but there is compelling evidence that real growth was closer to 11%.
The four growth cycles of the reform era, plotted on a graph, look like a child's cartoon rendering of a mountain landscape. Even Time Warner's Road Runner would be unnerved by the gradients.
The main reason why China does not do soft landings is because the Communist Party leadership controls the country's financial system, and small groups of people make much cruder judgments about money than are made by markets. China's capital controls mean that every legal avenue citizens have to save -- buying (state) bonds, buying stocks (of state companies) or making deposits in (state) banks -- puts their money, albeit indirectly, in the hands of politicians.
Those politicians always find excuses to maintain excessive levels of investment. And when that investment leads to overheating, there is nothing -- in the absence of effective market mechanisms -- they can do short of hitting the brakes with both feet.
Before this occurs, however, there is a ritual of rhetoric to be performed. At the height of the last investment frenzy in July 1993, Mr. Zhu issued a 16-point plan to curb excessive credit and thundered that inspection teams were being sent to the provinces to shut down speculative projects. Speculators nodded their assent and carried on speculating. Only at the end of the year did different factions in government concede credit was out of control and slash the growth of fixed investment in 1994 by more than 75%, compared with 1993.
Today the wailing and gnashing of teeth phase is well under way. All the leadership's recent assertions that the banking system has been commercialized and now makes its own decisions haven't stopped Premier Wen Jiabao from railing against sectors of the economy that are "overinvested," saying they must not be lent more money. Central bankers promise that increases in the proportion of deposits banks must keep on reserve with the central bank will tame reckless lending. But they miss the point. Because of state ownership and capital controls banks are awash with deposits. Making them park a bit more money with the central bank is neither here nor there.
Instead, banking is driven by the government's demand that financial institutions commercialize in a non-commercial, even anti-commercial, environment. They have no control over their interest rates and face no serious competition. Yet they are very liquid. So the banks lend and lend in the hope of earning themselves out of insolvency, since their liabilities far exceed their capital. The only way to stop the credit cycle is by fiat because there is no functioning market mechanism that provides an alternative.
But who, today, will be the new Mr. Zhu? Despite being his protege, there is no evidence that Mr. Wen -- or any of today's other leaders for that matter -- is ready to launch an austerity program. This opens up the possibility of a prolonged period of rhetoric, one with more unspecified "macro measures," multi-point "plans" and investigative "teams" dispatched from Beijing, as the investment boom continues.
Back in 1993, the question of whether China would slam on the economic brakes was not terribly important for the outside world. In the whole of the 1990s, the United States exported more to Taiwan than to mainland China. But in the past two years the scale of the China boom has sucked in unprecedented imports -- up by $170 billion in the last two years.
So the question of whether the credit continues is rather more important this time. It affects other Asian nations whose economic and stock-market recoveries have been heavily dependent on sales to China. It affects the bottom lines and stock prices of very large companies like BHP Billiton and Rio Tinto, both beneficiaries of China's maniacal orders for commodities. It affects the exchange rate of a currency as significant as the Australian dollar because of the country's commodity-based economy. And it affects the outlook of those ceaselessly optimistic investors, who think that the increase in China's demand for power, steel and cars last year is a reliable guide to demand for the next decade.
There are no easy answers to what will happen and when. Because the point is that China's basic problem is that the country is still far too dependent on the whim of men rather than systems. All that can be said is that an economy driven by spiraling state-mandated investment will eventually see economic gravity reassert itself.
Either that happens through the traditional emergency braking method or, in a new scenario, because of some external driver. Under current conditions that would be rising dollar interest rates which once again threaten China with capital flight and jack up the costs of much-increased state debt.