Submitted by Dee Woo,
The Making of China's epic hard landing
1. The unsavory episodes of China's economy
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, fleeted the country or emigrate to the western world in droves. Much of the media has blamed the credit crunch and monetary tightening for all these unsavory episodes. The public outcry for the deteriorating conditions for Chinese entrepreneurship climaxed with the seemly positive step the People's Bank of China(PBOC) took to alleviate the liquidity crisis: cut the reserve requirement ratio (RRR) to 21 percent from a record high 21.5 percent on Dec 5 2011.
Right now the outlook for Chinese economy is looking rather confusing: should it continue the painful structural adjustment to burst the economic bubble built up after so many years of high growth? Alternatively, should it adopts the expansionary policy to reinvigorate the flagging economy? Either way China is approaching dangerously close to an epic hard landing.
2. It's the structural problems and not a liquidity crisis
For one, it's easy to lay the blame on the tightening monetary policy. Nevertheless, nothing can be further from the truth. The main overseas markets for Chinese goods, Europe and the US, are both battling a possible recession, which greatly tightens their purse string. To make the matter worse, the cost push inflation, especially the wage inflation,is eating away the comparative advantage of China’s manufacturing industry. All this has nothing to do with the tight monetary policy but the structural change of Chinese economy.
(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 contracted. The orders are declining, especially overseas orders, and the stocks are piling up.)
In any case, the difficult access to credit for Chinese private small and medium businesses (SMBs), the driving force behind China’s manufacturing industry, is a chronic problem long before the monetary tightening. More than 70% of the Chinese 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 the monetary resource towards the state-owned enterprises or other privileged corporations. This allocation deficiency of Chinese 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 awash with cash fleeting the negative real interest rate in the commercial banks, hardly regulated and monitored. 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 wild west of shadow banks.
Contrary to what many might like to assume, China now is not even close to suffering a liquidity crisis under the tightening monetary policy. There is more than enough liquidity to go around. China’s M2 has surpassed that of the U.S. or Japan, as China’s M2 is around US$ 11.55 trillion, exceeding the U.S.’s US$ 8.98 trillion and Japan’s US$ 9.63 trillions. Regardless of all the hype of tight monetary policy, in 2010, Chinese banks issued 7.95 trillion yuan of loans, breaching the government's target ceiling of 7.5 trillion yuan. In 2011 the total new loan will stand 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 rating, China's total social financing in 2011 may 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 last year. 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 have indulged itself in for so long during the boom time. Under such a gloomy context, China's credit expansion against all odds is still breath-taking.
(Over the past decade, China's M2 surges past the US's by a wide margin from as low as nearly one third of the US's.)
We obviously can't blame the tightening monetary policy for the sorry state of China's economy. We can't really pin our hopes on the loose monetary policy to turn around its fortune either.
3. The undoing of Beijing Consensus
Monetary policy alone won't fix the structural deficiencies of Chinese economy. The well-being of Chinese economy is hugely 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 export. The substantial and increasing wealth gap in China has shackled the 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 incurring inflation and bubbles than propelling GDP and employment ahead. This is the serious sign for 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 economy ahead is what we know as Beijing consensus. It works beautifully for the past decade when the world is prospering in the 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-fueled 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 Chinese 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.)
4. The consumption-led economy is the only way out
The dire situation in the US and Europe calls for another round of quantitative easing. With both Japan and UK firmly committed to QE and deteriorating market conditions, 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. Or else fight for the overseas markets in vain and be prepared for trade wars. Or else try to reignite the economy with more wasteful investment and be prepared for a colossal asset bubble and epic hard landing.
5. The outlook for China's inflation and economic bubble
And also, don't be too optimistic about China's inflation prospect. Indeed, China's CPI tumbled to 4.2%,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, to say volatile at least. 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. The inflation will be lurking if these structural problems persist.
Overall, there are both internal structural factors and external global factors, which contribute to the making of an epic hard landing in China. China will be really vulnerable when the US and Europe both unleash the quantitative easing. These are things China has no control of. Nevertheless, the best China can do to avoid the worst is to continue the painful structural adjustment: marketize the “big four”-dominated banking industry to allow for more efficient monetary allocation; Transform the labor intensive low value-added economy to the high value-added knowledge economy; reform the wealth redistribution system to empower the broad consumer base and honor its promise of a consumption-led economy.
China's hard landing would be a tragedy not only to China but to the world. Without China's growth of consumption economy, 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. The Chinese economy already stands close to the edge. What speculators do is to push it over and profiteer handsomely from the chaos.
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. They should look at the dollars in their hands with fear and doubt. So called Beijing consensus makes little sense, because the world is fast changing, 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 this will be the best time in history to short China.