If China Cools, Will Asia Freeze?
By Bruce Einhorn
The announcement last week that Beijing plans to spend $45 billion to bail out two of its state-owned banks put a spotlight on the precarious state of the Chinese economy. On the one hand, China is on fire, with a gross domestic product that probably grew in the double-digit range last year. But the country also suffers from high unemployment and an ailing banking system (see BW, 01/19/04, "Worrying About China").
To get a sense of what the problems are and what Beijing might do about them, I recently spoke to two Hong Kong-based China watchers, UBS economist Jonathan Anderson and Credit Suisse First Boston economist Dong Tao.
According to Anderson, "China is not in danger of overheating. China is overheating." While the official growth rate for 2003 is likely to be 8.5%, Anderson says the real figure is much higher -- closer to 11.5%. "The economy is already running much faster than we think is sustainable," he says. The cause: "Investment and more investment -- in residential property, autos, steel, aluminum, cement, the tech sector. There's just an enormous amount of capacity."
Anderson also points to the liberalization of housing markets and increase in car ownership, which have led to a jump in mortgage and auto financing. Hence, the money supply by yearend 2003 was expanding by about 20% and loan growth by around 23%, vs. about 14% and 11%, respectively, the previous year.
Until recently, regulators could do little. But Anderson thinks that's changing -- and that policymakers in Beijing have the tools to solve this problem. One way is by raising banks' reserve requirements from 6% to 7%. As a result, "smaller banks have had to curtail lending," he says. The central bank has been trying other things to drain money from the system, such as recalling outstanding loans to the banks or issuing bonds. "Instead of lending out cash, the banks are lending it back to the central bank," he explains.
How badly off are the banks? Despite China's current boom, they're facing mountains of bad loans. While the banks say their nonperforming loans are around 20%, Anderson believes that the real figure is much worse -- more like 40%. "Technically they're insolvent," he says of China's banks.
Will this doom the financial system? Anderson thinks not. "We're not really expecting a banking crisis -- quite the opposite. The banks have operating profits. They may be insolvent, but they're in no danger of running out of liquidity."
Anderson sees the economy slowing this year, with GDP growth of 9.5% in 2004 and 7.4% in 2005. An overheated economy will cool -- it won't be a case of a bubble popping. "We're slowing, but we're not crashing," he says.
What does a cooling China, which has been the biggest source of export growth for its neighbors, mean for the rest of Asia? Last year, China accounted for about half of the region's total export growth, much higher than the usual 10%. "Asia is going to have a more difficult time," says Anderson. Exports to China amounted to 10% of Taiwan's GDP, 8% of South Korea's, 9% of Malaysia's, and more than 8% of Singapore's. In the new year, Anderson expects a big drop in the pace of export growth to China.
Like Anderson, CSFB's Tao believes that China's economy has overheated. But he's less optimistic that Beijing is willing to take the short-term steps necessary to deal with the problem. "Loan growth and money supply are running out of control," he says. But, "because there are no signs of inflation, I don't anticipate that the government will tighten right away."
To illustrate the severity of the overcapacity problem, Tao points to China's steel industry. Its production is 200 million tons -- more than Japan and the U.S. combined. But China is also the largest buyer in the global steel market, purchasing 31 million tons -- 20% -- of the world's steel last year. "All the producers in China point to this 31 million and say: We're still importing, we're justified in building more," says Tao. As a result, the country's steel production will double in the next three years.
And it's not just steel, he points out. "Aluminum will double," he predicts. "Autos will double. Ethylene will double. Textiles will double. Shipbuilding will double. Machinery will double." And those industries that don't double their capacity will see increases of 30% to 50%, he believes.
For those of us who followed Asia in the 1990s, this all sounds eerily familiar. Is China today repeating the mistakes of Southeast Asia that led to the Asian financial crisis of 1997 and 1998? "I think that there are some similarities," concedes Tao. "But it's not quite exactly the same."
One difference is that Southeast Asia's expansion at the time was driven largely by loans from foreign banks. But in China, "this round is financed largely by domestic credit," he points out. That means "the government has much more say -- better control -- and more room to maneuver. It's not going to be a sudden-death situation like the Asian crisis."
The Asian crisis started with the devaluation of the Thai baht, and the contagion quickly spread. Might a slowdown in China have a similar impact in the region? Tao says there's good reason to be concerned that other countries will feel some pain from China's hangover. "Global growth prospects will be affected," he says.
Take Japan. Its exports to China rose 36% in the first eight months of 2003, while exports to the rest of the world were flat. China is now Japan's largest export market. Likewise, Taiwan, Korea, and Southeast Asia increasingly rely on Chinese markets.
For now, though, Tao doesn't expect a quick reversal. "When and how China will tighten is the million-dollar question," he says. It might start this year if shortages of things like power and raw materials drive up prices and hurt exporters' margins. "Maybe Beijing will take more aggressive action," says Tao. But, he adds, "for the time being, the policy is status quo."
Einhorn covers technology from Hong Kong for BusinessWeek. Follow his weekly Online Asia column, only on BusinessWeek Online
Edited by Patricia O'Connell