Photo: Justin Hee on flickr
For the better part of the past year, my concern about Chinese economy was constantly aggravated by the depressing stories of entrepreneurs who committed suicide, fled the country or emigrated to the Western world. Most media have blamed monetary tightening and the cred crunch for these unsavory episodes.The public outcry for the deteriorating conditions of Chinese entrepreneurship climaxed with the seemingly positive step PBOC (the People’s Bank of China) took on Dec. 5, 2011 to alleviate the liquidity crisis: cut the RRR (reserve requirement ratio) to 21 per cent from a record high of 21.5 per cent.
Right now the outlook for Chinese economy is rather confusing: Should it continue painful structural adjustments to prick the economic bubble built up by a decade-long obsession with excessive growth? Alternatively, should it adopts expansionary policy to reinvigorate the flagging economy? Either way, China is coming dangerously close to an epic hard landing.
1. It’s not a liquidity crisis but a structural problem
For one, it’s easy to lay the blame on tightening monetary policy. But nothing can be further from the truth. The main overseas markets for Chinese goods — Europe and the US — are both busy warding off recessions, which greatly tightens their purse strings. To make matters worse wage inflation is eating away the comparative advantage of China’s manufacturing industry. All this has nothing to do with monetary policy but rather the structural change of China’s economy.
Difficult access to credit for Chinese private small and medium businesses (SMBs), the driving force behind China’s manufacturing industry, is another chronic problem long before monetary tightening. As you can see, the manufacturing sector is bleeding. Purchasing Manager Index (PMI) has dropped to 49, lower than market expectation. This is the first time since Feb 2009 PMI has contracted. Orders are declining, especially overseas orders, and the stocks are piling up.
More than 70% of China’s banking market is controlled by the “big four”- Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China and the Agricultural Bank of China. These state-owned commercial banks skew monetary resources towards the state-owned enterprises or other privileged corporations. This allocation deficiency of China’s banking system provides the breeding ground for China’s huge and complicated shadow banking network, where most credit-starved private SMBs seek costly funding. The shadow banking system is barely regulated or monitored, and is awash in cash that circumvents the negative real interest rate in the commercial banks. In April 2011, 467.8 billion yuan of residential deposit left the commercial banks. We all can guess where the money ended up. Money is chasing positive yields into the wild west of shadow banks.
There is in fact more than enough liquidity to go around. China’s M2 has surpassed that of the U.S. or that of Japan, as China’s M2 is around US$ 11.55 trillion, exceeding the US’s $8.98 trillion and Japan’s $9.63 trillion. Regardless of all the hype about tight monetary policy, in 2010, Chinese banks issued 7.95 trillion yuan of loans, surpassing the government’s target ceiling of 7.5 trillion yuan. In 2011,the total new loan stood comfortably close to 7.5 trillion. As of October 2011, the outstanding balance of RMB deposits totaled 79.21 trillion yuan, whose year on year growth rate is 13.6%. The PBOC’s rate hike only removed 4.75 trillion yuan from circulation. According to Fitch ratings, China’s total social financing in 2011 might top 18 trillion yuan (US$2.8 trillion), a rise of 3.5 trillion yuan from the official target due to inflow of non-banking liquidity. Meanwhile, the PBOC claimed the total social financing of the first 3 quarters in 2011 is 9.8 trillion yuan, 1.26 trillion yuan less than that of the year before. The PBOC’s data suggests an effective tightening monetary policy while the Fitch report implies the opposite. The PBOC proves to be an inadequate central bank to rein in the liquidity binge Beijing has indulged itself in for so long. Under such a gloomy context, China’s credit expansion against all odds is still breathtaking.
(Over the past decade, China’s M2 has surged past the US’s by a wide margin from as low as nearly one-third of the US’s.)
We obviously can’t blame tightening monetary policy for the sorry state of China’s economy. Nor can we really be too optimistic on loose monetary policy to turn things around.
2. The undoing of the Beijing Consensus
Monetary policy alone won’t fix the structural deficiency of China’s economy. The well-being of China’s economy is leveraged on the consumption economy of the US and Europe. American and European economic turmoil together puts a massive strain on the demand for Chinese exports. The increasing substantial wealth gap in China has shackled domestic demand so much that it fails to pick up the tab left over by the US and Europe markets. China is now saddled with a serious excess capacity problem, which forces down the marginal returns on the investment and makes investment more effective in incurring inflation and bubbles rather than propel GDP and employment ahead. This is a serious sign of over-investing and overheating. In 2010, China’s export/GDP ratio is about 37% , and Investment/GDP ratio is 45.8%. According to David M. Kotz and Andong Zhu’s research, China’s export plus fixed investment contributes almost 70% of GDP growth since 1999 while domestic consumption contributes roughly 30%. Using the export/investment combo to power the economy forward is what has become known as Beijing consensus. It has worked beautifully for the past decade when the world was prospering amid globalization and free trade. However, now its good run is finished for good.
To overcome the current economic malaise, the US and Europe must check their deficit-fuelled consumption economies into the rehab. They must increase their chronic low saving rate, produce more and import less. That means the export-led growth engine for China’s economy may be gone for good.
(According to Economist Intelligence Unit and US bureau of economics analysis, China will depend on an export-led economy late until 2030.)
3. The consumption-led economy is the only way out
The dire situation in the US and Europe calls for another round of quantitative easing in those areas. With both Japan and UK firmly committed to QE and market conditions deteriorating, the embattled US and Europe will be more and more reduced to monetary aggressiveness. In the end, we will see a global competition of currency devaluation. China will lock horns more frequently with the US, Europe and other export nations over currency issues. The trade tension will flare up.
The only way out for China is turning its economy into a consumption-led one. The other two options are: fight for the overseas markets in vain and be prepared for trade wars; or try to reignite the economy with more wasteful investment and be prepared for a colossal asset bubble and epic hard landing.
4. The outlook for China’s inflation and economic bubble
Don’t be too optimistic about China’s inflation prospect. Indeed, China’s CPI tumbled to 4.2 per cent, the lowest level since September 2010. Nevertheless, the battle against inflation is far from over. China is the world’s biggest importer of food and commodity. With the global competition of loose monetary policies, the food and commodity inflation will be persistent, if not volatile. China will face the serious threat of imported inflation and cost-push inflation regardless of whatever monetary policy it adopts. That combined with negative real interest rate and diminishing marginal return in industries will push more and more money into asset investment and speculation. Inflation will be lurking if these structural problems persist.
Overall, there are both internal structural factors and external global factors that contribute to the making of an epic hard landing in China. China will be vulnerable if the US and Europe both unleash quantitative easing. These are things over which China has no control. The best China can do to avoid the worst is to continue painful structural adjustment: marketize the “big four”-dominated banking industry to allow for more efficient monetary allocation; transform the labour intensive, low-value-added economy to a high-value-added knowledge economy; reform the wealth redistribution system to empower the broad consumer base; and honour its promise of a consumption-led economy.
China’s hard landing would be a tragedy not only for China but for the world. Without growth in China’s domestic consumption, the global economic recovery will be a prolonged and painful process. The icing on the cake for this article would be what I said in “The Boom And Bust Of China’s Rise“: hedge funds and Fed’s QE2 are not all to blame for all these. China’s economy has already stood close to the edge.
While the US enjoys the luxury provided by the dollar’s world currency status and diplomatic alliance with many major trade partners to export its liquidity and inflation, China enjoys none of that. It should look at the dollars in their hands with fear and doubt. The Beijing consensus no longer makes much sense. Pegging a country’s growth to a certain set of policy tools or a certain reserve currency(the US dollar) is equally dangerous. The battle between Keynes and Friedman has long proven the only consensus is to adapt and change. Right now China needs to adapt and change fast. Or else, this will be the best time in history to short China.