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Is the Party Over in China?
China’s National Development and Reform Commission (NDRC) reported today that unsold inventories of cars rose 50 percent from the beginning of the year to a four-year high; this suggests that macro challenges in China have finally reached a crisis point. The future may have finally caught up with China.
Sharply rising inventories in such a strategically important industry as autos suggest that the slowdown in the economy is biting domestic demand such that corporate investment is likely to slow. If inflation weren’t already such a problem, the People’s Bank of China, the nation’s central bank, could ease monetary policy to boost domestic demand. But with inflation recently spiking and real interest rates already quite negative, the central bank is in no position to ease.
Rising inventories, slowing growth and rising inflation suggests a self-reinforcing cycle of gloom for the economy and financial sector, especially when the banking sector inevitably begins to feel the pain of rising NPLs into a slowing economy.
The last time Chinese policymakers faced such a daunting challenge in charting the domestic economy through such treacherous waters was during the Asian financial crisis of 1997-1998 when capital flight was of paramount concern. his time the stakes are much higher and the risks of a crisis are much greater. During the crisis, policymakers could count on capital flight reversing if temporary measures would just provide a bridge through turbulent external conditions. Asia recovered, China hung on and the world exhaled.
This time around, however, China is, ironically facing the opposite problem where so called hot money inflows are the problem. Unlike with the capital flight problem during the Asian crisis, just hanging on won’t solve the current hot money crisis as nothing short of a domestic economic crisis seems likely to slow or reverse hot money inflows into China. The growth rate of foreign exchange accumulation has gone parabolic, with reserve growth doubling in 2006, 2007 and set to double again in 2008 judged by inflows in the first half of 2008 already matching total inflows for 2007. Parabolic growth is a classic symptom of an unsustainable trend in markets.
In the fall of 2003, I advocated a maxi-revaluation of the Chinese yuan. At that time I even argued naively that Chinese policymakers might even consider such an option because they would eventually come to the logical conclusion that if they didn’t do it now, it would only get harder and more painful to do it later as foreign capital continued to pile into the economy in a classic boom–bust cycle.
By June of 2004, I finally gave up on the idea that policymakers might seriously consider a maxi revaluation. All of the rhetoric coming out of Beijing rationalizing the current account surplus as temporary, combined with a number of administrative measures aimed at neutralizing the macro impact of foreign capital inflows, including the beginning of an aggressive sterilization program finally convinced me to give up my “radical” notion that Chinese leaders might actually consider a large adjustment of the yuan.
Since June 2004, my theme on China has continued to be that nothing the authorities did would slow (let alone derail) a booming economy thus as the debate has raged about whether there might be a soft landing or hard landing for China’s economy, my mantra has been: “no landing”. As long as capital inflows continued to surge into the economy – which I didn’t see any reason why they would slow let along reverse—my view for China’s economy was full speed ahead. After our latest research trip to China, I came back with the same bottom line view on China: inevitable crash, but not yet, and meantime, continued boom.
The report on rising car inventories, however, has changed my view. One of the keys to our positive short-term view on China was that as long as inflation remained relatively contained and inventories weren’t building up, there was no reason to think the self-reinforcing cycle of capital inflows, higher investment and growth wouldn’t continue – short of a trade war or protectionist backlash. Rising inventories for cars, however, is a huge red flag, especially with inflation rising into slowing growth.
For the last several years, I’ve talked about Chinese policymakers systematically eliminating the usual canaries in the coal mine that indicate macro stresses, and thus reducing the usual triggers that derail economic booms in other countries, such as rising inflation, rising interest rates, an appreciating currency, bankruptcy or a bank run. Through various administrative measures Chinese leaders have been able to keep such usual canaries in check. Until recently. With hot money flows rising and inflation finally breaking the canaries are finally starting to break their silence.
Rising inventories has always been a potential canary that we’ve kept an eye on because it is something the government can’t really control directly. Until recently, however, rising inventories haven’t been a problem. As long as that remained the case, it was hard to see any serious trigger for a financial and/or economic crunch in China. Rising inventories are potentially the proverbial straw that breaks the camel’s back because they indicate falling corporate profits, slowing investment, and slowing growth, in a self-reinforcing cycle in a downward spiral that is the opposite of the positive cycle in the boom phase of an investment boom/bust cycle.
Sam Baker is director of Asia research for Trans National Research Corporation, a US-based political and economic consultancy specializing in global emerging market research.