FOR a long time, investors have been right to assume that China’s policymakers would do enough to prevent the multiple imbalances in its economy from coalescing into a major slowdown or even a full-blown crisis. That assumption may not be valid anymore. Not only is China’s economy losing momentum despite a range of policy measures last year but also the imbalances appear more threatening than before.
Chinese leaders, however, face a dilemma in that the policy measures needed to support growth could also aggravate the very imbalances that they are trying to reduce. Yet, if the right balance of policy measures is not achieved quickly, China’s travails will worsen to the point where the global economy will be hit as well.
The economy: slowing, more deflationary, marked by capital outflows
First, the latest purchasing manager indices show that the broad economy is decelerating. Despite a small bounce, the official manufacturing PMI has indicated a manufacturing contraction for two straight months — January and February.
Forward-looking indicators, such as new orders, remain at multi-year lows. The lead indicator for exports has turned negative as well. While the non-manufacturing sector remains firmly in expansionary mode, it, too, has been losing momentum steadily.
Second, deflationary pressures are becoming entrenched:
• Consumer price inflation fell to a five-year low in January. At just 0.8%, China is on the brink of outright deflation. Producer price deflation intensified to -4.3% y-o-y in January, from -3.3% last December, continuing a three-year pattern of depressed prices that hurt corporates’ pricing power.
• Worse still, deflation looks set to deepen. The growth in broad money supply has decelerated sharply, to only 10.8% y-o-y in January; this is the lowest growth since records began. Excess capacity in key production sectors will push prices down further.
Third, the shake-out in real estate prices is worsening. Average home prices fell 5.1% y-o-y in January, the steepest decline so far since the series began. If home prices fall even faster, as is likely, deflationary pressures will intensify. The knock-on effects on construction activity could deduct 1 to 1.5 percentage points off gross domestic product (GDP) growth.
Fourth, the financial dimensions of the economy look dicey. Bank of International Settlements data shows that short-term debt (less than one-year maturity) expanded sevenfold from March 2009 to US$850 billion (RM3.1 trillion) in September 2014. China now has one of the highest shares of short-term external debt among emerging economies.
China’s massive foreign exchange reserves should provide some cushion, but they are beginning to fall, down US$150 billion in 2H2014, mainly because of a huge capital account deficit of US$91.2 billion in 4Q2014, from just US$9 billion in 3Q2014. In fact, capital flight is accelerating, with anecdotal evidence that highly indebted borrowers are shifting their cash assets abroad to hide their wealth from creditors.
What’s more, total debt in China has soared from 121% of GDP in 2000 to 282% in 2014, with much of that sharp rise occurring between 2009 and 2011 alone. No less than the head of the State Administration for Foreign Exchange’s balance of payments department warned that conditions were increasingly reminiscent of the 1997-98 Asian financial crisis.
In short, the overall economy is slowing, with only a still robust services sector preventing an even sharper fall. However, the combination of the imbalances — a weakening real estate sector, deflation and excess capacity-reducing pricing power and cash flows of highly indebted corporates, this corporate sector difficulty putting investment (49% of GDP) at risk — suggests rising downside risks to growth.
Policy has to turn more aggressive, but is constrained
As the National People’s Congress is about to begin its annual session, much of the focus has been on whether it will announce a lower growth target of 7%. (Chinese Premier Li Keqiang last Thursday announced an economic growth target of about seven per cent.) However, there are far more important policy questions that Chinese leaders face.
First, the People’s Bank of China (PBOC) faces a genuine dilemma in using monetary policy: it needs to be proactive enough to reverse deflationary pressures, but it also needs to maintain rigorous credit controls because China’s volatile financial system could well direct new credit into areas with severe imbalances, such as real estate, state enterprises, shadow banking and local governments.
For some time, the PBOC took the view that the risk posed by these imbalances was worse than the risks to growth and that weak inflation was a positive since it provided reforming policymakers with a good opportunity to enact price reforms that would raise the prices of key inputs.
However, the latest move to cut policy rates just weeks after a sudden decision to reduce reserve requirements suggests that the PBOC and its political bosses are more worried about the risks to growth now than deepening deflation. Further cuts in the benchmark interest rate, reductions in the reserve requirement for banks, and easing of restrictions on the real estate sector now seem inevitable. The government had started ramping up spending on infrastructure and will surely step up spending even further. Yet, it cannot be too aggressive because some of these policy options could well stimulate undesired borrowing that could add to existing imbalances.
Second, it is not clear how much leeway the PBOC has to depreciate the renminbi — and here, too, the PBOC is constrained. Although the renminbi has fallen bilaterally against the US dollar, it has risen in inflation-adjusted, trade-weighted terms by 31% since July 2011, when the dollar bottomed out. With the US dollar virtually certain to appreciate further, the renminbi will suffer lose more competitiveness unless its link to the US dollar is ended. The risks of a fall in currency competitiveness are greater today because slower growth in China means less of the outsized productivity gains that allowed it to absorb the effects of a stronger currency. Of course, the PBOC cannot weaken the renminbi too aggressively because competitors will react by depreciating their currencies, a currency war in which there will be no winners and many losers. So, at best, we will see a small depreciation of the renminbi.
Third, should China continue to pursue structural reforms when the focus has to be on risks posed by weaker growth and rising deflation? It appears that political leaders have decided to continue pushing reforms in some areas. A pilot reform scheme to allow the sale of collectively-owned rural construction land has been launched and, if successful, could be implemented nationwide, substantially liberalising the land market. Reforms to expedite urbanisation are likely to be stepped up.
Implications for Asian economies
The Chinese economy will affect Asian economies through several channels:
• Demand for capital goods: The most vulnerable component of the Chinese economy today is fixed asset investment, which is already weakening as businesses that are weighed down by massive excess capacity and weaker cash flows become more careful about raising spending on plant and equipment. The main losers will be exporters of high-tech machinery such as Germany, South Korea and Japan.
• Demand for commodities used in manufacturing and construction: The Baltic Dry Index, which measures bulk shipping rates for carrying commodities, has collapsed to a record low, mostly caused by weakening Chinese demand. Downward pressures on economically sensitive commodity prices will worsen unless policy stimulus is successful. Commodities that feed into real estate and manufacturing production, such as base metals, coking coal and rubber, are clearly at risk. While Indonesia would be hurt somewhat as it exports coal, rubber, nickel and copper, the main losers will be countries such as Australia and Brazil.
• Weaker demand for intermediate goods: Southeast Asian economies are major exporters of components to China, much of which is used by Chinese companies manufacturing for export. But a growing share is for domestic use as well so there will be a modest impact on Asean exporters of such intermediate goods.
• Global imbalances: It is quite likely that China’s investment rate will fall significantly while its national savings rate will remain more or less stable. China’s current account surplus — the difference between investment and savings in an economy — could therefore surge. Coming at a time when US Congressmen are already threatening legislation against “currency manipulators”, this could well lead to greater protectionism against China.
• Currency volatility: Commodity currencies such as the Australian dollar are clearly at risk from a sharper slowdown in China’s commodity demand. However, if the PBOC shifted its strategy towards even a mild overall depreciation of the renminbi, as we believe is likely, other Asian currencies are likely to follow suit and we will see big swings in Asian currencies.
• Capital flows: As China’s impact on the world economy grows, global investors’ risk appetites are increasingly influenced by prospects for China’s economy. Greater investor concerns about China will certainly reduce investor risk appetite for emerging markets in particular, and risk assets in general. On the other hand, if Chinese economic agents anticipate further economic risks and a higher chance of renminbi depreciation, they will step up the pace of capital flight, sending larger amounts of Chinese capital, legally or illegally, out of the country.
To conclude, the Chinese economy is at risk. It needs more aggressive policy actions to prevent a downward spiral. Policymakers are responding, but their understandable need to tread carefully means that policy is not as anticipatory as it should be. Our baseline scenario is for China to suffer frequent bouts of stresses in economic activity and finance, but avoid a full-blown crisis. In this scenario, there will be downside risks for Southeast Asia, but the biggest losers will be elsewhere.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in Forum, The Edge Malaysia Weekly, on March 9 - 15, 2015.
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