China’s present growth story is built on malinvestment

Late last year, I predicted that China, as a major exporter to the West, would feel a huge impact from the meltdown in the global economy, taking it’s growth rate down to 2% (See Top ten predictions for the 2009 global economy). Forgetting about the fact that data are highly suspect in China, I see that prediction as very unlikely to come true due to huge fiscal stimulus in China. The Chinese government is very much wedded to its 8% growth target and will do whatever it takes to come close to that target – including flooding the domestic banks with a wall of money to lend.

However, preventing a downturn with easy money is a dangerous way to reflate the economy. The likely malinvestment will be large, something about which Andy Xie has recently warned.  Moreover, despite the implosion in house prices and shares in the Chinese market during the acute phases through to November 2008, a bubble has re-asserted itself there.  In a recent post, “Does Ben Bernanke blow bubbles too?,” I referred to research by James Montier, now at GMO, which indicated that large increases in liquidity can and will reinflate bubbles even in the face of investors who feel chastened by a previous downturn.  This seems very much to the point in China, where equity prices have risen some 60-odd percent since the trough in November.

Of course, all of this can continue for quite some time. And the Chinese are pulling out all the stops as the recent note by Marc Chandler, Chief Currency Strategist at Brown Brothers Harriman, attests.

There are several developments to note in China.

First, with deflationary forces still gripping the economy (year-over-year CPI has been negative by more than 1% since Feb), weakness in exports, Chinese officials are unlikely to allow the yuan to appreciate very much during the second half of the calendar year.  The pricing of the non-deliverable forward implies expectation for less than 1% appreciation against the dollar over the next 12-months, the smallest expected gain in a couple of months.  Next month will be the one year anniversary of the Chinese decision that in essence appears largely tantamount to re-pegging the yuan to the greenback.  It has been confined to a little more than a 1% range since.  Recall that under the fixed exchange rate regime of Bretton Woods, currencies were allowed to move in 1% bands.  Last July the pricing of the 1-yr yuan NDF implied a 6% appreciation.

Second, the 63% rise in the Shanghai Composite Index has been among the world’s top equity markets in H1 09.  The story is often told is that the large fiscal stimulus efforts has ensured that the economy will gain new traction.  Yet the stimulative measures are impacting perhaps in a way different from the conventional narrative.  Part of the stimulative measures, included removing curbs on bank loans.  Bank loans in China have surged by CNY5.8 trillion.  The rating agency Fitch warned earlier today of the dangers of the massive rise in lending.  Part of the lending–some reports suggest as much as 20% or some $170 bln–has found its way into the equity market.
Third, China and Hong Kong are expected to sign an accord shortly that will allow the settlement of bilateral trade to be conducted in yuan.  Back in April the PBOC announced it would let Shanghai and 4 other cities in the Gungdong province to begin settled traded in yuan.  China subsequently announced CNY650 bln (~$95 bln) in swap lines with a handful of countries, including Argentina, Belarus, Hong Kong, Malaysia and South Korea.  Since Hong Kong is a special administration region for China that a greater share of its bilateral trade is settle in yuan is hardly earth-shattering, but there may be some interesting implications.  Often Hong Kong is used by China and its trading partners to conceal trade as goods often get re-exported from HK.  China and its trading partners often disagree on how such trade should be counted.  More importantly, it takes more than diktat to determine an invoicing currency.  As the SAFE (the State Administration of Foreign Exchange) made clear today, China recognizes that the US dollar will continue to dominate global trade.  China’s desire for the yuan to be more of an international currency and invoicing currency is not greater than its desire to maintain firm control of the currency.   This is to say, China’s ambitions are continue to hemmed in by the realities of a currency that is still not convertible.

The Chinese government is committed to 8% growth for 2009. Hence the massive stimulus and bank lending. But, as Chandler notes, it is doing its best to transition away from an export-led dynamic over the longer-term. Hence, the numerous reports of China doing trade in Yuan and buying up commodities with its U.S. dollar stash.

So, where does that leave us over the medium-term?  In my view, it leaves us in a situation in which the Chinese economic policy is supportive of commodity prices and economic growth worldwide.  To the degree that medium-term economic recovery in the West is dependent on Chinese stimulus, we should feel confident that things are looking good.

The longer-term is quite a bit more murky and here I want to transit to a rather more sinister outlook as established by Ambrose Evans-Pritchard in the Telegraph at the weekend.  Evans-Pritchard sees malinvestment as a worry and quotes from a Fitch rating agency report which says an enormous spike in non-performing loans at Chinese banks is likely.

China’s banks are veering out of control. The half-reformed economy of the People’s Republic cannot absorb the $1,000bn (£600bn) blitz of new lending issued since December.

Money is leaking instead into Shanghai’s stock casino, or being used to keep bankrupt builders on life support. It is doing very little to help lift the world economy out of slump.

Fitch Ratings has been warning for some time that China’s lenders are wading into dangerous waters, but its latest report is even grimmer than bears had suspected.

“With much of the world immersed in crisis, China appears to be one of the few countries where the financial system continues to function largely without a glitch, but Fitch is growing increasingly wary,” it said.

“Future losses on stimulus could turn out to be larger than expected, and it is unclear what share the central and/or local governments ultimately will be willing or able to bear.”

Evans-Pritchard also quotes from Andy Xie who sees the massive over-stocking of commodity inventories in China as an accident waiting to happen, one which will precipitate a double-dip downturn.  While this makes good copy for bearish doom and gloom forecasts, it is a scenario about which we should be worried.

In reality, this crash scenario is pure but not idle speculation.  What seems clear is that the medium-term is looking more positive due to the huge surge in liquidity in China’s domestic economy.  This seems to be a gambit by the Chinese to spur enough domestic demand over the medium-term such that when the next global downturn hits, the Chinese will be insulated from U.S. dollar and America-related events. But, the Chinese are blowing serious bubbles, expanding excessive amounts of credit, and creating serious malinvestments.  In short, the Chinese are playing a dangerous game. If they lose, everyone in the global economy will lose with them.