20th September 2012
Why China is facing its worst down cycle in a decade
By James White
This has been China’s worst down cycle since the end of the 1990s. I don’t think this is a coincidence.
In 1997 China made the decision, under Jiang Zhemin, to reform much of its banking and State Owned sectors. In a painful process, China restored the balance sheets of its banks and made its SOEs, at least those that survived, more profitable. I believe the current cycle is achieving many of the same aims. The process explained in Wenzhou is just one example where the government is using the cycle to remove capacity and create reform. It is, however, market rather than legislation led. Another example is in steel and other energy-intensive sectors, where China has been discouraging capacity increases. Rather than legislate, the government seems to be using the market and tight credit conditions to remove capacity. This is the creative destruction that sets up a new cycle in growth.
Little short term support
It’s for this reason that I don’t expect substantial short-term support for the Chinese economy from authorities, despite weakening activity indicators. Indeed, as long as employment growth does not slow too much further, it’s unlikely we’ll see action until 2013. The caveat, of course, will be quicker mobilisation post announcement of the roads and urban transit projects.
There are, however, some important signs of a natural and more imminent turn in the economy’s cycle. Depreciation in the RMB and the fall in commodity prices is, at the margin, boosting profitability. More important is the stabilisation in property prices. Property is so essential to the Chinese financial system. It is the best form of collateral. As prices start to stabilise and even rise, the financial system itself will stabilise. This will allow for greater credit flow as both the demand and the supply of credit increase. This is crucial to financing the NDRC’s recently announced projects including 23 city subways and 13 toll roads.
No structural change
The common theme in discussing China’s structural change is a belief in a shift to a consumption based economy. This will not happening this decade, other than at the margin. There are two reasons for this: theory and action.
A shift to a consumption based economy by a relatively poor nation would be catastrophic for income equality. It would cement the privileged position of urban Chinese and expose rural Chinese to even higher prices. As I discussed in a previous post, Is China going to be the first online retail economy?, economic activity in China is constrained by supply, particularly in cities outside the top 10 or 20. The only way to remove these constraints is invest in infrastructure. Supporting consumption through lower income taxes or larger subsidies would act as a tax on rural dwellers. Greater demand from urban dwellers without supply side improvement would only lead to higher prices, most damaging to the rural poor.
Indeed, to be clear, investment and consumption should not be seen as mutually exclusive components of GDP. Investment in public goods, economic and social infrastructure, raises the productivity of Chinese labour and in turn wages while cutting the cost of goods and services in the economy. Both lead to higher living standards and consumption.
Future policy = infrastructure
Probably more important is what we’re hearing from officials. The statements from policy makers are clear. Future policy is based on urban development, industrial upgrade and improved transport networks. This is backed up by recent announcements for investment in roads and urban transport. The latter is essential to urbanisation and sustainable development in the property sector. It’s only subways that can make property in suburbs accessible to young low to middle class families, the targets of urbanisation.
Investment will remain the growth pillar for China.
So what does this mean for investment markets?
I’ve been a believer that the poor performance of China’s equity market is a crucial driver of the economy’s stability. Poor equity performance is reflective of high levels of competition driving down profit margins and aggressive investment that has boosted productivity but not capital returns. These trends ahve been structural and made equity returns weak. These conditions may not hold in coming years. The removal of excess capacity in certain sectors suggest Chinese companies may finally have some pricing power. If these conditions persist then I do worry about economic stability and the likelihood for higher inflation than observed in the last ten years as sufficient capacity is not created to cope with higher demand.
For iron ore markets, crucial to Australia, I would make one key point. State owned China understands it missed an opportunity to increase resource security in 2009. I don’t think it will miss this opportunity. Part of its strategy will be to hold commodity prices low. The caveat is the difficulty of long term manipulating iron ore prices. There has been a buyers strike recently and a build up of inventory. But this can’t last, storing bulk commodities is much more difficult than storing copper.
I’ve not touched on the leadership transition. It seems October 18th is a likely date. I’m comfortable that policy will remain largely intact. China’s going through a period of creative destruction designed to set it back on the straight and narrow.