New Year, new fear?

China resolved for an economic struggle as 2012 begins


06 Jan 2012
Week in China

The festive break is often followed by an early January gloom and the Chinese premier, Wen Jiabao seemed to succumb himself this week, with warnings of a "relatively difficult" few months ahead for the domestic economy.

Of course, when WiC published its first issue in February 2009, the outlook was also an anxious one. But by then China had already started an intensive bout of borrow-and-spend that would last well into the following year. A flood of new credit flushed through the economy, alongside an equally expansionary programme of government investment, in an effort to counter the impact of the global economic slowdown and financial crunch.

Headline inflation in December was 4.2%, well down on its peak last July

By early 2011 the policy tone was changing, taking on a more restrictive form as planners wrestled with the asset price inflation unleashed by the credit binge. Bank lending was ratcheted downwards. Borrowing, spending and pricing curbs were introduced in various sectors, most notably in property.

Another year on, and we seem to be entering a new phase again, with the early signs indicating a relaxation of some of last year's tightening. In the first Talking Point of 2012, WiC looks at what may lie ahead.

Where can we see signs of a new mood?

The first indications came at the end of November last year, with the 50-basis point cut in bank reserve ratios. This was the first reduction in reserve requirements for three years, and came earlier than many analysts had been anticipating, allowing for an additional Rmb400 billion ($63.5 billion) of liquidity in the financial system.

Qu Hongbin, co-head of Asian Economic Research at HSBC, is predicting at least three further cuts in reserve requirements in the next six months, plus a likely reduction in interest rates by mid-year.

Of course, it helps that headline inflation in December was 4.2%, well down on its peak last July of 6.5% in year-on-year terms. That leaves more scope for policymakers to switch their primary focus away from curtailing inflation back towards one aiming to stabilise economic activity.

Also signposting the new direction was the statement issued by the annual Central Economic Work Conference – an event attended by top Communist officials in mid-December. It warned gloomily of the "extremely grim and complicated" global outlook. This strengthens the case for pro-growth policies to regain top billing. By contrast, at last year's conference inflation was singled out as the most pressing issue (see WiC91).

President Hu Jintao then reiterated the new priorities in his New Year address two weeks later, saying that China would be aiming for "relatively fast" growth this year.

Despite this, HSBC says that we should now expect annual growth of 8.6% for 2012, compared to its final forecast of 8.9% for full year 2011.

And the major obstacles to hitting growth targets?

Two risks are getting most mention: the impact on the wider economy of a dramatic slump in property prices, and the likely consequences for China's exporters of weak international demand for their goods.

In the latter case, the primary concern is exposure to the flagging eurozone, which also happens to be China's biggest export market. This is something we wrote about first in WiC124 and similar fears have continued to be expressed in the Chinese press over the past two weeks, with a slew of stories on the potential for a sharper slowdown. Export growth for November (the most recent data available) shrank to 13.8%, which doesn't sound so bad until you hear that it's the lowest gain since 2009.

Generally, exports are said to have fuelled a major share of China's overall economic growth since 2000. But a problem with using total exports as the performance metric is that much of China's trade surplus has included a high portion of imported goods that are then reassembled before being exported. This means that the true contribution from the export sector can be overstated, which is why many economists prefer to talk about net exports – total exports minus total imports – instead.

By that metric exports haven't been quite as significant, accounting for 10-20% of the growth of recent years. And for this year, HSBC points out that the contribution is already expected to be "negligible". Although a further slowdown will have an impact, it may not be quite as calamitous as sometimes thought, says the bank.

But doesn't that make investment at home more important?

Certainly, investment has been the crucial contributor to growth over the last three years and it will be expected to do the same in 2012.

Here is where property prices come more fully into the spotlight. As the Lex column in the Financial Times puts it: "In the year ahead investors should get used to studying Chinese apartment prices and transaction volumes as closely as they do housing starts in the US." Prices were already falling in 49 of the 70 largest cities surveyed in November and HSBC is forecasting price drops of at least 20% in first tier cities like Shanghai and Beijing this year, as well as smaller 10% declines in tier-two cities over the same period.

Much of this has been achieved by design, says China economy-watcher Patrick Chovanec. The efforts to dampen speculation via purchase restrictions (things like residency requirements, larger down payments and more onerous mortgage rules) started out almost two years ago but until recently were enforced half-heartedly, which is why the final figures for real estate investment last year will be up almost 30% in year-on-year terms.

The campaign finally began to bite more deeply in the final quarter, with signs of falling prices in a number of cities (see WiC128). There is little sign of a change of heart from the State Council as we begin the New Year. The statement from the Central Economic Work Conference was again a telling one, with references to property policy being maintained "unswervingly".

The underlying problem here, according to Nicholas Lardy at the Peterson Institute, is that investment in the property sector has been the single most important driver for growth, and currently accounts for at least 11% of total GDP.

This level of contribution can't be maintained in 2012, Lardy says. Banks are seeking to reduce their financial exposure to the sector (property-related loans have doubled since 2004) and households will lose some of their enthusiasm for real estate as an asset class. Property's share in household wealth has also doubled since 2004, again an unsustainable rate, Lardy believes.

Any counter arguments? Shanghai Securities News agrees that property investment is likely to slow significantly, although thinks it will still grow by 20% in the year ahead. The newspaper thinks that this will be enough for overall growth to exceed 8%, in part alleviated by the ongoing construction of millions of units of lower-priced social housing.

Local treasurers are heavily reliant on land auctions ... If returns continue to fall, plenty of these loans could turn sour

Nor will Beijing want to see land values fall too far, as 2012 and 2013 are peak periods for the repayment of local government loans taken out during the credit boom. As WiC has reported before, local treasurers are heavily reliant on land auctions for their revenues. If returns continue to fall, plenty of these loans could turn sour.

Some think too that lower house prices could even leave consumers with more discretionary income to spend on other items, which could be important if investment levels pull back in general.

Fortunately, household incomes are already growing strongly. HSBC also reports that the potential wealth impact of a property slowdown can be overstated, as less than 10% of current homeowners have mortgages.

What prospects for a new stimulus package if things don't go to plan?

They're unlikely, as the political transition planned for this year is another complicating factor. Historically the investment cycle tends to pick up in the first year after a change in government, once the new leaders have taken on their roles. That would seem to make 2013 look more promising than 2012.

On the other hand, investment activity often accelerates in the second year of China's five-year plans, as projects start to move from the drawing board into implementation. That would put 2012 back into the frame, as we are starting out in year two of the latest five-year plan (the twelfth, for those keen on such details).

It is also being suggested that – should economic conditions worsen significantly – the authorities could bring forward some of the Rmb1.7 trillion of spending promised for strategic "new industries", including areas like new energy, water conservancy and new materials.

But the wider consensus is that there is little appetite for a re-run of anything close to the scale of stimulus seen in 2009/10, which created a short-term boom but also inflation and a spike in problem loans.

Hence Wen's statement on Tuesday that the leadership is looking to be more specific in its approach. "We can't talk about the scale of the loans and liquidity on a general level but should analyse the situation of different industries and by one," Wen warned.

The speculation is that this could include policies to boost domestic consumption in preferred areas, like vehicles and domestic appliances. Another area for potential reform – this one mentioned by Qu at HSBC – is tax cuts for small-and-medium size enterprises and individuals.

Other signs to look out for?

Purchasing managers' indices (PMIs) will be watched closely. December's numbers turned out to be a little better than expected, with both the government's official PMI and the index published by HSBC scoring better than the previous month. HSBC's was up to 48.7 points from 47.7, and the government's version actually showed an expansion in activity, up from 49 points to 50.3 (scores over 50 indicate growth).

Even so, analysts cautioned against reading too much into the results, warning that the "festival effects" of Western and Chinese New Year celebrations (the Lunar New Year starts on January 23 this year) had boosted sentiment.

"China is beginning to see a net outflow of capital, reversing a long-term pattern of large net inflows"

Others have been looking more at capital flows. HSBC's Qu noted on December 22 that there seems to have been a hot money outflow in October and November, with declines in FDI too. "China is beginning to see a net outflow of capital, reversing a long-term pattern of large net inflows," he concluded. Money leaving China suggests rising anxiety (although, it could also reflect more aggressive investment by Chinese companies abroad).

Given this ambiguity, another of WiC's preferred warning signals is gaming revenues in Macau. These rose last year to $33.5 billion and were up 25% for December alone – an odd statistic for a month when China's economy was slowing.

This makes more sense when you realise Macau offers an escape route for 'smart money' to leave the country. Once this cash reaches the casinos – helped by some financial engineering from the junket operators – it becomes Hong Kong dollars. Much is gambled but plenty also flows into banks offshore.

So if gaming revenues continue to surge this year – and Chinese growth slows (the most bearish first quarter GDP forecasts go as low as 6%) – it's a safe bet that corrupt officials and savvy businesspeople are feeling fearful about the future and are getting their money out.

And when they get concerned, the rest of us should too...

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