The most recent macro data releases from China give rise to the strong conclusion that Chinese policymakers have unwittingly hit the monetary brakes too hard and thus the balance of risk has finally tipped slightly in the direction of a hard landing in 2012.
The odds appear slightly better than 1 in 2 – the definition of a hard landing for China being growth below 5 percent for two quarters. When a hard landing scenario finally plays out, the possibility is growing of an even bleaker outlook: 3 to 5 percent growth for a year or longer.
Time is of the Essence
The risk of a hard landing will continue rising over the coming weeks unless and until policymakers reverse course and implement aggressive and timely policy easing. Despite ominous signs of a sharp slowdown in growth evident in macro data releases and other select bank and financial sector data in the recent past, policymakers can probably kick the hard landing can down the road by six months to a year or so with an aggressive policy reflation operation. The question is whether they will.
These ominous signs include worse-than-expected Purchasing Managers’ Index results, a year-on-year decline in foreign direct investment in November, the first since 2009, a sharper-than-expected decline in the consumer price index in November, weak external demand reflected in slowing exports, a lower than expected growth rate of M2 in November, deposit and capital flight, and continued currency weakness.
Ability (Yes) vs. Willingness (???)
Chinese policymakers still retain what seems to be ample dry powder with respect to three main policy levers: monetary, fiscal and administrative, suggesting that they could hypothetically reflate economy (albeit temporarily) if they pulled out all of their policy stops right now.
Dry powder on the monetary side includes roughly 16 trillion yuan worth of bank reserves currently locked up on bank balance sheets resulting from a historically high reserve requirement ratio of 21 percent. Dry powder on the fiscal side includes a large fiscal surplus through the first 11 months of the year, equaling roughly 2 to 3 percent of gross domestic product. Dry powder on the administrative side includes restrictions on real estate that could be unwound quickly in order to reverse the nascent (but alarmingly sharp) decline in real estate transactions and primary market prices.
Policymakers did announce a surprise 50 basis point cut in reserve requirements on November 30, which has been interpreted by some analysts as a clear signal of a new easing posture for monetary policy. Nonetheless, other, more conservative analysts continue to argue that it is too soon to call an aggressive easing cycle. For one, the rhetoric by top leaders remains quite reserved as evidenced by quotes coming out of the recently completed Central Work Committee Conference completed on Dec. 14. For another, the 50bps reserve requirement ratio cut is roughly enough to keep liquidity relatively stable (and not easier) as bank deposit inflows have slowed considerably in recent months and caused average bank loan to deposit ratios to rise.
What to Watch
Credible evidence of timely and sufficiently aggressive policy easing – enough to prevent a hard landing in the short term – would include a basket of policy actions implemented before the end of January, roughly as follows: stimulating higher loan growth in the range of 1 trillion-plus yuan in December and January 2012 – more or less double what the September-November 2011 period); further reserve requirement cuts of 200 to 300bps; a fiscal stimulus plan in the range of 1 to 2 trillion yuan; and, last but not least, a reversal of key real estate restrictions.
Time is of the Essence: Part Two
A commitment in word and action roughly along these lines is crucial by policymakers in the next weeks, not months. The nature of credit-fueled asset and investment-led growth bubbles is that they overshoot on the way up and on the way down. When an easy credit-fueled asset bubble is in an expansion phase, asset values go way beyond any reasonable valuation metric based on present value/future cash flow analysis and economic growth rates may also surpass historical precedent.
This is because in an investment-led, credit-fueled growth bubble, such as has played out in China over the past several years, easy credit conditions drive high rates of investment growth, which drive higher economic growth begging more investment, and so on, in a self-reinforcing cycle. Unfortunately, when a credit bubble unwinds in a debt deflation bust, the same cycle occurs in reverse: asset prices overshoot past fair value on the downside and growth also declines and suffers as distortions sown during the boom are worked out – or not – by the private and public sector.
The longer the work out process takes to play out, with delays typically caused by well-intended government interventions, the longer the sub-trend growth cycle lasts — as seen in Japan’s anemic growth and asset value performance since the stock and real estate bust in 1989. Japan’s GDP growth has averaged a puny 1 percent a year since 1989 while the stock index remains mired in a secular decline, falling from a high of 39,000 in 1989 to current levels around 5500.
It is very difficult, if not impossible, to reverse a self-reinforcing debt deflation cycle once it reaches a critical mass of momentum no matter what policy-rabbits decision makers can pull out of their collective policymaking hats. Thus, timing is everything.
In order for policy reflation to work, it is imperative that Chinese leaders change gears soon and pursue timely and aggressive deployment of reflationary policies including a combination of monetary, fiscal and administrative measures as outlined above. The 50bps cut in reserve requirements on November 30 is a step in the “right” direction, but not nearly enough to make likely a reversal of emerging signs of a sharp softening in the Chinese economy in general and in particular in the real estate market.
Adjusting expectations for the timing and scope of the “easing” bogies listed above based on progress or lack thereof, we will continue to raise (or quite unlikely lower) our odds of a hard landing, especially if the A-share market continues to flounder reflecting tight domestic liquidity conditions.
No Way Out
Given the leadership transition cycle upcoming in 2012 and 2013, policymakers may be willing — and still able, although the clock is ticking fast –to do whatever it takes to avoid a hard landing in the first half of 2012 even if it means compromising on inflation fighting, which it must. That is why it is necessary to stop short of assuming a hard-landing in 1H2012 is inevitable.
But Chinese policymakers must act quickly and deploy aggressive reflationary policy measures as soon as possible lest a larger than anticipated growth slowdown manifests into a self-reinforcing and irreversible downward cycle characterized by slowing growth, eroding public confidence, currency depreciation, bank deposit flight and capital flight – all of which will facilitate an unavoidable domestic credit crunch and, ultimately, a hard landing for the Chinese economy. In a weakening currency and capital flight scenario, policymakers can print all of the money they want to reflate the domestic economy, but the liquidity will merely flow offshore.
(Sam Baker is Director of Asia Research for the US-based Trans-National Research, which in the last year has led three programs to China. He can be reached at firstname.lastname@example.org or by phone (1 201) 760-1818.)