China Struggles to Control Its Collapsing BubblesLike a cheap toy bathed in lead paint, Chinas economy is more dangerous than it looks on the surface.
In recent months, despite the best efforts of Chinese technocrats, the worlds biggest stimulus program has backfired, and the true state of the Chinese economy is beginning to emerge. This evidence is revealing symptoms of a crumbling system that was built on an unsustainable growth model that relies on ever-increasing exports, even as demand for those imports is shrinking.
For a time, this growth in exports, and the enormous cash flow it provided, enabled the Chinese to provide employment for a large subset of the population. Under this system, typical market factors such as profits could be ignored as long as the government was able to keep money flowing down to its population.
The plan was to slowly build a self-sustaining consumer economy like the United States, South Korea, or Japan. Unfortunately, the financial panic of 2008 disrupted global trade and forced China to shift from exports to capital spending. The resulting $586 billion stimulus program led China to build railroads, highways, and even entire cities simply to keep people employed. The main result has been the creation of real estate and commodity bubbles, which now threaten to explode.1
Undoubtedly, Chinas leaders knew this capital spending boom was unsustainable, but they hoped to prop up the economy, at least through the major party leadership transition in 2012. But now, things seem to be unraveling faster than expected. Recent symptoms of this are evident in three key areas:
1. Industrial activity
2. Housing
3. The banking system
A cooling Chinese economy was indicated by the sharp slowdown in Chinas industrial activity in November 2011.2 The month saw HSBCs purchasing managers index, or PMI, drop three points to 48, which is the lowest its been since the U.S. stock market bottomed in March of 2009. More significantly, the PMIs industrial production sub-index fell, moving from 51.4 to 46.7.
Exports have also been off, bringing Chinas annualized export growth in October 2011 down to 16 percent. While this would be a highly desirable number in a developed economy, it signals trouble for China, where growth was 18 percent in September and 24.5 percent in August.
Since Chinas economy is so export-driven, things looked good during the four or five years of tremendous growth in exports leading up to 2009. But then, China experienced its first significant drop as it emerged onto the global stage. Exports did improve slightly in 2010. However, growth in 2010 and 2011 has not been sufficient to sustain targeted employment levels ? and as we end 2011, the numbers indicate things are getting worse, rather than better.
This comes as no surprise when we consider that Chinas largest export market is currently Europe, which is reeling from its own debt crisis. The Chinese are paying close attention to how the EU handles its current financial crisis, because the outcome could greatly affect how China operates its economy.3
The challenge is to maintain a trade surplus in the face of falling export levels and import levels that remain stubbornly high because of Chinas very large demand for commodities. These commodities are used not only for the manufacturing of exports, but also to fuel the enormous domestic investment boom.
After the drop in exports in 2009, the Chinese government reacted with a huge increase in domestic investment in hopes of stabilizing its economy. This move came at a time when there had been a lot of talk of moving away from an export-based economy to a consumer-based economy. This increase in domestic investment sidetracked this shift and instead coincided with another grand plan already underway: urbanization.
The idea was to promote the growth of cities, which would generate more consumers, who would then drive the consumer-based economy. To entice citizens to move to the cities, infrastructure was needed, including housing. As weve outlined in previous issues, the rapid growth in construction led to a housing boom, fueled by speculators. The boom turned into a bubble, with highly inflated home prices that have prevented the nonurbanized population from buying and moving into the cities. As The Wall Street Journal4 reported in December 2011, the average price of an urban apartment has soared to eight times Chinas average annual income, and millions of luxury apartments are vacant, while low-income workers cant find affordable housing.
This situation presented the Chinese government with a dilemma. It needed to slow down the rising home prices so housing would be more affordable, but at the same time needed to keep prices stable. A large drop would have two undesirable effects:
- It would undermine the collateral for the loans from state-owned enterprises.
- It would erode the value of the assets that have become the "nest egg" for the middle class and the most popular investment for the wealthiest Chinese.
Through the governments use of credit curbs, it now appears the bubble is beginning to deflate rather quickly. Recent evidence supports this conclusion:
- Sales of real estate in September and October 2011 were off by 40 to 60 percent from a year earlier.
- Chinese real-estate stocks have dropped by more than 30 percent from their peak.
- The government reported that, of the 70 cities surveyed in October, home prices fell in 33 of them.
- Developers are trying to move unsold inventory by slashing prices by more than 20 percent.
These dropping prices may be good news for those looking to buy, but as IHS Global Insight analyst Alistair Thornton observed, "Aside from the euro zone, the key risk facing the Chinese economy is an unexpectedly sharp drop in the property market."
Recent buyers are panicking over dropping prices, and protests have been common, such as one at a sales office by 200 homeowners demanding a refund from Greenland Group, a leading developer.
This cooling of the housing market is already beginning to have a domino effect on the economy. With less investment in building, related sectors, such as steel and cement, are taking a hit. Analysts point out this is one of the factors driving the steep drop in the PMI.
A recent survey of Chinese construction companies by Credit Suisse revealed additional negative effects of the downturn in the housing market:5
- Tight credit and a slowdown of sales have put a squeeze on property developers cash flow. This has led to a delay in payments to construction companies for work done. Around 80 percent of these companies report delays of three months or longer. This is identified as their biggest business issue.
- Homebuilders also report that developers have begun asking them to slow down their work on current projects. In addition, they are expected to pay more of the up-front costs of construction.
In response to this potential housing meltdown, the Chinese government is planning to overhaul a mortgage-refinance program that would aid homeowners. This is another clear sign that the real estate market, and therefore the Chinese economy, is in trouble.
Other symptoms of a crumbling system can be seen in the banking and monetary sector:
- For the first time since October 2007, Chinas central bank reported a currency capital outflow. This represents a slowdown in direct foreign investment and a drying up of speculative money into China, leading to growing fears of a hard landing of the Chinese economy.
- In response to a sell-off of shares of the countrys battered banks, Chinas sovereign-wealth fund stepped forward in mid-October and bought shares.6 This sell-off is a symptom of another troublesome factor in China: a loss of trust in the integrity of corporate earnings and government statistics.
- A surprising change in bank reserve policy is another symptom of a slowing economy.7 Analysts shared a long-held consensus that the Chinese government would not relax bank reserves, but rather gradually foster easier credit and liquidity. They turned out to be wrong. After beginning to raise bank reserve requirements in 2009, the central bank announced in October that the requirement for 20 rural cooperative banks would revert to 16 percent from 16.5 percent. Then, in late
November, in yet another surprising move, Chinas central bank lowered the reserve ratio for the biggest banks from a record high of 21.5 down to 21 percent. This was the first cut in three years, and is aimed to ease credit strains and bolster a weakening economy that is at its slowest pace since 2009. It is seen as a way to make funds available for lending to small, cash-strapped firms. The move was certainly influenced by concerns over a global economy that is affected by the euro zones struggle to address its two-year debt crisis.
- In another sign of a faltering economy, local governments with high debt burdens are putting pressure on Beijing to ease monetary policy. They share a very real concern that the slowdown in exports could raise unemployment, which would spark unrest.
The governments fear of widespread social unrest cannot be overstated. This is an additional, very vivid sign of collapsing bubbles.
Balancing central control and free markets relied on a compliant and complacent population. But recent anti-government protests have become increasingly common. Issues driving public anger include corruption and police abuses and a general loss of confidence in Chinese government and corporations. In some regions, riots and demonstrations are being staged by discontented workers. Perhaps most troublesome for the government is how this violence has exposed its limitations in controlling its urban population through "social management," such as censorship and surveillance. Instead, it must resort to displays of raw power, including paramilitary police and armored vehicles.
Referring to the growing economic crisis, outspoken Chinese real estate tycoon Ren Zhiqiang asks, "Why doesnt the government work on land supply, land prices, and tax incentives?8 Why doesnt it raise wages and lower home purchase taxes, and raise the affordability for the citizens?" This is what a good Keynesian would ask. Of course, the answer is: It wont work. If this is what the Chinese are relying on to keep their economy afloat, there will indeed be a very hard landing.
Considering this trend, we offer the following three forecasts:
First, the European crisis will force China to rethink its timeline for economic change.
This crisis, and the fact that it is expanding globally, is moving Chinas need to change economically to the forefront. When its economy was booming and exports were flowing, China had the ability to push back economic change. The flood of money masked a flawed system. But now, the system has been exposed and reveals the need for change, which may also hasten a political change.
Second, as the Chinese real estate bubble deflates, the price of commodities will fall.
Since real estate has been such an important part of Chinas overall economy for the past several years, any decrease in its value will have widespread repercussions. The slowdown in the building industry will cause an equal drop in demand for many commodities, such as copper and steel. A slowdown in industrial output will further depress demand. Together, these shrinking demands will cause a worldwide drop in commodity prices, which will be a shot in the arm for economies that can benefit from a lower cost of raw materials.
Third, investors in Chinese banks have a bumpy ride ahead.
With widespread corruption and contracts that are meaningless, investors, particularly foreign investors, are putting their money at great risk. They need to remember that politics play an integral part of business in China, and that banks are basically instruments of state policy. To put it in gambling parlance, "the house always wins" when it deals with foreign investors ? and Chinas banks are the house.
References List :
1. The Wall Street Journal, December 3, 2011, "Chinas Hard Landing." ⓒ Copyright 2011 by Dow Jones & Company, Inc. All rights reserved. http://online.wsj.com 2. Investors Business Daily, November 23, 2011, "Chinas Factories Falter, Raising Hard Landing Fears," by Reinhardt Krause. ⓒ Copyright 2011 by Investors Business Daily, Inc. All rights reserved. http://news.investors.com 3. Stratfor.com, November 10, 2011, "Portfolio: Eurozone Debt Crisis Reveals Chinas Economic Weakness," by George Friedman. ⓒ Copyright 2011 by Strategic Forecasting, Inc. All rights reserved. http://www.valuewalk.com 4. The Wall Street Journal, December 3, 2011, "Chinas Hard Landing." ⓒ Copyright 2011 by Dow Jones & Company, Inc. All rights reserved. http://online.wsj.com 5. MarketWatch, November 25, 2011, "China Home Builders Face Longer Payment Delays," by Chris Oliver. ⓒ Copyright 2011 by MarketWatch, Inc. All rights reserved. http://www.marketwatch.com 6. The Wall Street Journal, October 11, 2011, "China Props Up Bank Shares," by Dinny McMahon and James T. Areddy. ⓒ Copyright 2011 by Dow Jones & Company, Inc. All rights reserved. http://online.wsj.com 7. Bloomberg News, November 30, 2011, "China Reserve-Ratio Cut May Signal Slowdown." ⓒ Copyright 2011 by Bloomberg L.P. All rights reserved. http://www.bloomberg.com 8. Reuters, October 25, 2011, "Shanghai Homeowners Smash Showroom in Protest Over Falling Prices," by Esther Fung, Amy Li, and Josh Chin. ⓒ Copyright 2011 by Reuters, Inc. All rights reserved. http://blogs.wsj.com
