China borrowing from the future?


It’s easy to get caught up in the excitement over the rebound in the Chinese economy and miss underlying weaknesses which point to some major problems ahead.

To some extent, in a desperate effort to compensate for collapsing export trade, China might have borrowed from the future in order to achieve a swift recovery.

“The (Chinese government’s economic) stimulus programme borrows from a future investment cycle,” writes the online research publication, the China Economic Quarterly (CEQ), in its Q2 report.

“Since 1978 China has run relatively regular five-year investment cycles followed by five years of retrenchment.”

Spending by the State on infrastructure and industry boomed in 2003-07 and so the following five years were supposed to involve the reductions in expenditure necessary to repair a big hole in the national balance sheet.

But, of course, the reverse has happened with infrastructure and industrial projects scheduled for the next 5-10 years now set to be completed over the next 3-4 years. This includes speeding up investments in the refinery and petrochemical industries.

“China could be in for some rough times after the stimulus money runs out in 2011,” the CEQ adds.

Repair work to the national budget might not be the only reason why longer-term prospects could be a lot bleaker than many expect.

China might also fail to boost domestic demand sufficiently to compensate for export trade which might take many years to recover.

“For the first time in the 30-year reform era, China faces an extended period – five years or perhaps longer – in which exports will provide no significant contribution to growth,” says the CEQ.

The reason is the well-documented collapse in the West’s debt-financed consumption binge.

On the surface, it looks as if China is making great headway towards realising more of its enormous domestic-growth potential: retail sales grew by 16% in Q1 this year, up from 15% in the first quarter of 2008.

If you dig deeper, though, as the CEQ again does, you discover that retail sales include many “institutional” purchases, meaning those by state-owned enterprises (SOEs).

The government has increased military salaries by 50% and is providing rebates of 13% and 10% respectively off rural purchases of household appliances and automobiles.

Despite all this cash sloshing about, however, when you take away the institutional purchases from the retail sales figures, the CEQ concludes that there is little evidence of a pick-up in consumption.

Longer term, this can be fixed if efforts to create much better pension and healthcare systems lead to more spending and lower savings levels.

Compared with the West, and particularly the US, the Chinese keep an awful lot more of their money bank deposits.

But here’s another potential pitfall: all that money sloshing around (the CEQ estimates the total stimulus will be worth Yuan5-6 trillion, or 15-18% – much bigger than the originally announced Yuan4 trillion) could end up creating another non-performing loans crisis similar to that of the early 1990s.

This could force China’s banks to lower interest rates on deposits in order to repair their balance sheets, warns Peking University finance professor Michael Pettis on his blog, China Financial Markets.As bank deposits are such an important method of saving money in China, lower interest rates could lead to more money being saved as compensation, leading to damaged consumer growth, he adds.

Numerous economists are also warning that too much of the stimulus is in the form of loans to the SOEs, which can be less efficient in boosting the economy than private companies.

The private sector, hammered by the collapse in export trade, is in contrast reported to be struggling for finance.

An inevitable slow down in bank lending, the result of the huge rise in loan growth during Q1, could also be put yet another brake on the economy.

“RMB (Yuan) net lending fell sharply to YuanB592bn in April from YuanMB1.9tn in March, broadly consistent with our expectation,” writes Jun Ma, Chief Economist Greater China for Deutsche Bank, in a report.

“We believe this reflects the success of the window guidance by the PBOC (People’s Bank of China) and the CBRC (China Banking Regulatory Commission) that advised banks to “appropriately control loan growth”; the decline in new project approvals; as well as the slower pace of equity capital injections from the central government budget.

“Going forward, the continuation of these factors will likely lead to a further decline in net lending to about Yuan300-400bn per month in the remainder of this year.”

A further worry remains the potential global deflationary effect in H2 of China stockpiling raw materials, including perhaps chemicals and polymers.

Imports of polyethylene (PE) and polypropylene (PP) have, for example, been at record levels in Q1.

However, it’s impossible at this stage to say whether this involves major stockpiling or is more the result of better demand and big production cutbacks by Sinopec and PetroChina earlier this year.

In the case of iron ore and copper, though, the steep rise in Q1 imports (iron ore was up by 33% and copper by 62%) are being widely attributed to state-backed inventory building and strong investment demand.

“China is stock piling commodities – everything from metals to oil,” said a chemicals industry source.

“The argument is that it’s better to store financial reserves in commodities rather than US dollars.”

“There has also been some stock piling of gasoline and diesel in anticipation of price increases by the government.”

Gasoline and diesel prices were indeed increased from early June – the first time since March.

But if you put five economists in a room, goes the old adapted saying, you are likely to get at least ten different opinions.

It can be just easy to interpret some of the recent data in a much more positive way, and it might just be possible that the current euphoria will create a self-fulfilling prophecy of a sustained recovery.

It’s worth being aware, though, that a 50% rise in the local stock markets since the start of the year and lots of positive macro-economic news might not tell the full story.

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