Wednesday, July 22, 2009

Skepticism of the Chinese Economy

Generally speaking, the global press seems to be rather optimistic about China's economy - one of the bright spots in a dismal world. The reality is considerably darker. Real estate prices (not to mention their stock markets) are reaching new frenzied levels, driven by unrestrained and cheap borrowing - especially by state owned enterprises. As Glenn Reynolds notes, "[China's] banking system isn’t sounder than ours. They’re just better at hiding problems."

A few choice quotes from a long but fascinating post by Michael Pettis at ChinaFinancialMarkets:

Observations by one of his readers: "What was most distressing was that the [real estate development in Guiyang, as an example of real estate development across China] has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms. of farmland well north of town. Every building we got close enough to see was either incomplete/under construction, or empty. Our tone gradually went from “Haha, another one!” to “Oh my God, another one.” We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon. The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction."

His response:
Will we see a crash, or a steady slowdown? My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e. to slow them down, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system – I don’t know about the informal), suggests that if a serious problem emerges we will probably see more of a “Japanese-style” contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on.

This is a long way of saying what I have often argued – that what we should expect in China is not a financial collapse but rather a long period – maybe even a decade – of much slower growth rates than we have become used to. There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment. This is not a note of optimism, by the way. As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly.
Accordingly, economists polled by the WSJ believe that China's economy will, euphemistically speaking, "slow":
But the extraordinary jump in growth in the second quarter as a massive fiscal and monetary stimulus took hold is unlikely to be sustained, most economists think. That’s not surprising since China is now much closer to a normal level of activity than it was six months ago. The forecasts of the economists in the poll center on the quarter-on-quarter expansion slowing to an annualized 9.8% in the third quarter and 9.0% in the fourth quarter. The range of forecasts is still very wide, and the consensus on at least some slowdown masks a continued debate over how much private-sector investment will kick in later this year to support the government’s stimulus.
Update: On China's recent stimulus spending (Victor Shih):
banks are asked to finance projects with dubious commercial viability [...] State Council researcher Wei Jianing estimates that at least 20% of the new credit has gone into the stock and real-estate markets instead of generating real benefits to the economy. [...] if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation.

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