China Policymakers Too Timid?

Chinese policymakers are trading the mistakes of overly-aggressive stimulus in 2009 to 2010 for an excessively timid one today. Key decision makers in Beijing risk undershooting their 2012 growth target even more than they overshot the official 8 percent GDP target in the 2009 and 2010 stimulus years.

We put the odds at 3 out of 4 that the Chinese economy substantially underperforms the new 2012 GDP target of 7.5 percent based on two factors: 1.) we believe the slow and tepid policy response so far this year has already sowed the seeds of a hard landing, and 2.) we expect policy caution to remain the modus operandi of policymakers in 2012.

For example, the stimulus announced last week sounds impressive – 25 subway approvals, worth 800 yuan or 1.7 percent of 2011 GDP. But the spending is scheduled between the second half of 2012 and 2018 – seven years, which equates to about 10 billion yuan per month. Between 2009 and 2011 the official banking system plus the shadow banking system were creating credit to the tune of 1-1.5 trillion yuan per month. The 1,254 miles of new roads and new ports, plus all of the other recently announced infrastructure spending amount to no more than one quarter’s worth of additional credit injected into the system in just 2011, spaced over six to seven years.

Further, even if policymakers suddenly deploy an aggressive monetary reflation program in the months ahead, we believe the results are likely to be disappointing given signs of liquidity trap conditions emerging in China’s private sector, as evidenced by overcapacity and shrinking profit margins in many industrial sectors resulting in weak demand for medium to long term loans.

In 2009, GDP grew 8.7 percent and in 2010 GDP grew 10.4 percent, 70 and 240 basis points higher respectively than the official 8 percent target. This “overshooting” of GDP growth can largely be explained by the explosive loan growth that took policymakers by surprise during this period.

When loan quotas were removed in late December 2008, Chinese banks took full advantage of the massive deposit / liquidity reserves they had accumulated during the capital inflows days 2004 to 2008 by pursuing a historically unprecedented lending boom that resulted in an unsustainable investment boom as well as property and local government debt bubbles.

Policymakers recently announced a revised target of 7.5 percent GDP for 2012 and 2013. Some analysts took this as positive sign signaling not only a shift to a more sustainable growth rate, but also a window of opportunity for Beijing to gradually engineer a rebalancing of the economy away from investment. The way we see it, the lower GDP target reflects a combination of caution, practical constraints to policy easing and tighter domestic liquidity conditions, all of which we believe is likely to play out in a new development stage for China characterized by GDP chronically underperforming official targets.

Chinese economic policymakers are given credit for having pulled all the right levers to keep China’s economy on track over the past decade. Actually, they consistently missed their growth targets by 200 to 500 basis points on the low side as the economy barreled ahead thanks to the stimulatory effects of plentiful capital inflows.

Policymakers most dramatically lost control of the economic policy levers in 2009, when loans made through June equaled roughly the entire 2009 annual loan target. The key lesson we take from the capital inflow era of 2005 to 2011 is that it is very difficult to fine-tune economic policy and easy to get upside surprises on growth in the midst of a positive self-reinforcing macro cycle described above.

Now, however, China’s economy is just as likely to underperform policy targets in a new era of capital outflows, for similar reasons growth overperformed in the capital inflow period. Self-reinforcing macro cycles, no matter positive or negative, are difficult if not impossible for policymakers to fine-tune.

One of the strongest and most important conclusions from a recent trip to China is that the massive capital inflows that China enjoyed over the past eight years are reversing. We expect that the monthly net capital outflows China experienced beginning in late summer and early fall 2011 -- and that have continued on and off since -- will turn into a chronic trend that will continue until important structural reforms are implemented in the service sector, including and especially, liberalized interest rate and foreign exchange regimes.

We still believe China is well positioned for another 10- to 20-year run of exceptional gross domestic product growth given the opportunities for sustained productivity gains in the underdeveloped and heavily regulated service sector, including banking, finance and logistics, among many others. Unfortunately, such reforms are not forthcoming for a number of reasons.

First, Chinese policymakers prefer step-by-step reforms (such as the recent tiny baby step relaxation of deposit and lending rate corridors) over big bang approaches, which argues that meaningful service sector reforms remain years away. In the context of a historic political and party leadership transition taking place over the next year, and a period of extraordinary internal jockeying in the highest corridors of communist party hierarchy, it is likely Chinese policymakers will be even more conservative in implementing structural reforms, especially in the banking sector.

Liberalizing the service sector is much more difficult and complicated than liberalizing the sectors that have so far underpinned the China miracle growth story since the 1980s, including the export manufacturing, heavy industry, agriculture and the property / real estate sectors. This is because important service sector industries are more jealously protected by powerful domestic interests compared to exports, including and especially the banking and financial services sector. This has been Japan’s experience, as powerful vested interests have blocked financial sector reforms since their property and stock bubble collapsed in 1989, and the country has struggled with two lost decades and counting of below trend GDP growth.

Implementing structural reforms in China’s banking sector is the key service sector reform that can -- and some day will -- trigger a new era of high growth. This is because liberalizing interest rates provides the key to rebalancing the Chinese economy away from investment and towards consumption. Under the current “financial repression” model, consumers are forced to subsidize production, investment, and bank earnings as deposit rates and lending rates are both held artificially low, while the spread between the two rates is kept artificially wide.

Only when Chinese policymakers liberalize interest rates will households be relieved of their burden in subsidizing other actors in the economy and will their share of the economy be allowed to normalize and structural rebalancing be facilitated.

Liberalizing the banking sector, however, is akin to climbing Mount Everest for senior Chinese leaders: i.e. a long and arduous journey fraught with peril. This is because liberalizing the sector means liberalizing the interest rate regime, which is tantamount to undoing the financial repression model that at least superficially has served China so well and that at the same time has allowed top party leaders to maintain a period of super-normal GDP growth – all the while providing a mechanism for consolidated rent extracting for the party.

Premier Wen Jiabao has openly acknowledged that two related issues threaten China’s future: 1) party corruption, and 2) the monopoly power of the big four banks. Unfortunately, such challenges are easier identified than solved given the elites’ entrenched interests in continuing the old system.

The difficulty of implementing banking sector reforms is evident in the continued increase in economic imbalances since rebalancing became a policy priority in the 11th Five-Year Plan which went into effect in 2006. Wen reiterated the importance of rebalancing in a 2007 press conference in which he introduced “the paradox of the ‘Four Uns’” – a Chinese economy whose strength on the surface masks a structure that is increasingly “unstable, unbalanced, uncoordinated, and ultimately unsustainable.”

Rebalancing has again been made a priority in the 12th plan released last year. Yet, ever since 2006, consumption as a percentage of GDP has remained in decline, falling from 50 percent in 1990, to 46.4 percent in 2000, to 39 percent in 2005, to 35.1 percent in 2010 and to 34 percent (estimated) in 2011.

As the slow reform scenario plays out, it is likely to be characterized by chronic GDP growth disappointment well below the 20 year average GDP growth rate of 9.5 percent, policy missteps and multiple false economic dawns. Moreover, this new era is likely to last for many years, possibly a decade -- the mirror image of the previous near decade-long cycle with positive self-reinforcing macro trends.

Large trade surpluses beginning in the early 2000’s set the stage for the self-reinforcing set of bubbles we believe are now unraveling -- i.e. in confidence, GDP growth, asset values, investment returns and liquidity -- all of which were underpinned by a one-way appreciation of the yuan. The trade surpluses pumped high-powered money into China’s economy via foreign exchange accumulation. Relatively easy money conditions facilitated robust growth in both credit and fixed asset investment, which led to high domestic GDP growth. High domestic growth attracted even more risk capital on shore, leading to a virtuous trend of capital inflows, foreign exchange accumulation, super-easy domestic liquidity conditions, high credit and investment growth and super charged GDP growth – all of which led to a “managed” one-way appreciation of the yuan such that the currency remained undervalued when it was de-linked from the US dollar in 2005.

The unusual (at least since 2005) downward pressure on the yuan that began showing up in the fourth quarter of 2011 -- and that has persisted since -- is a result of the negative growth shock that began playing out in the third quarter of 2011. This depreciation trend accelerated earlier this year as expressed in the yuan’s roughly 1 percent depreciation versus the US dollar in June 2012 alone. Although, the yuan / USD exchange rate has stabilized since June, we believe this pause in yuan depreciation masks unexpressed underlying weakness in the yuan as policy makers have propped up the yuan by selling foreign exchange.

Thus, a brand new problem is shaping up. That is the emergence of a vicious cycle characterized by slowing GDP growth and a chronically over-valued currency driving capital outflows and tighter domestic liquidity conditions (exacerbated by bank deposit flight), all of which is contributing to much more difficult policymaking environment sure to lead to policy missteps and the further unraveling of a confidence bubble.

China’s stellar growth record created a seemingly “do no wrong” reputation for Chinese economic policymakers, which created a confidence bubble on top of a historic capital inflow-driven liquidity bubble. This confidence bubble has been eroded in recent years by a number of scandals and black marks on government credibility, including the melamine milk scandal, a deadly vaccine scandal, the SARS panic in Beijing, school collapses highlighting shoddy building standards in wake of the Sichuan earthquake, countless industrial accidents, high speed rail failures, not to mention worsening air and water pollution, corruption scandals, and last but certainly not least, the Bo Xilai affair.

Symptoms of increasingly brittle confidence in Chinese leaders and in their ability to manage the economy include the increasingly common “naked official” trend. This is the practice by party officials of moving their families offshore while remaining on shore to take advantage of lucrative on shore rent-seeking activities. We were told by the US Consulate that applications for visas have exploded in recent years as more and more Chinese elites have looked to hedge exposure to political, social and economic risks in China by exploring off shore travel, investment, education and living alternatives. Such hedging behavior is symptomatic of a new era arriving for China that we believe will be characterized by an extended period of net capital outflows, sub-trend GDP growth and an increasingly complicated policy making environment for Chinese officials. Until Chinese policy makers are willing -- and able -- to pursue a pain-for-gain policy approach including interest rate liberalization that will necessarily sacrifice short term growth and elite privilege for economic rebalancing, a new virtuous cycle of sustainable high growth is likely to prove elusive along with super power ambitions.

(Sam Baker is an Asia specialist with Trans National Research in New Jersey, USA)

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