Worrying About China
China is the world's most dynamic economy, and hopes for vigorous global growth in the coming year hinge in part on a continued expansion there. By one estimate, China, while it represents just 3% of world gross domestic product, will account for 10% to 15% of any expansion the global economy will see this year. But China is still a developing country, fraught with social instability and a financial and industrial infrastructure that is often rickety at best.
Can China cope with the challenges? Some analysts see reasons for concern. Recent electrical brownouts raise new questions as to whether China's energy-hungry manufacturing industries are taxing the ability of China's power sector to feed them. The abrupt government takeover of debt-ridden Shenzhen brokerage China Southern Securities, as well as the $45 billion bailout of two state banks that was announced on Jan. 6, once again highlight the fragility of China's financial institutions. The government preaches the need for economic reform, but actual reform, especially in the financial system, is slow to materialize. How much should Western governments and investors worry? Here are some key questions and answers.
1. Just how fast is China's economy growing, anyway?
Fast -- even faster than you think. Many economists are convinced China's GDP growth hit double digits for 2003, though the government claimed just 8.5% for the first three quarters. Morgan Stanley notes that electricity consumption -- which usually correlates closely with GDP -- has grown 15% annually over the past two years, so it seems pretty clear that Beijing has been lowballing its numbers. It's not that China necessarily wants to hide growth, but rather that it honestly doesn't know how fast it's growing. Beijing sets GDP and tax revenue targets for the provinces and major cities, and when they meet those goals early, regional officials may decide they've performed well enough for the year and save some growth for next year. "In the middle of last year, local governments started telling companies not to pay taxes because they had already met their targets," says Morgan Stanley economist Andy Xie.
2. Does that mean China is in danger of overheating?
Not really. Normally, an overheated economy suffers from inflation and a tight labor market. China, though, only recently emerged from six years of deflation. And while consumer prices grew 3% in November, most of that was the result of higher energy costs and rising food prices after a bad harvest. Similarly, China's urban unemployment is growing as the economy restructures. It may be as high as 15%, way above the official figures of just over 4%.
China's real problem is that it's stuck halfway between a command economy and a market economy: Capital allocation is still largely state-controlled. So officials too often steer investment through the state-owned banks to fund uneconomic enterprises. And even when central policymakers try to stop the waste of resources, local governments often ignore Beijing's edicts, pushing local banks to lend to their cronies' real estate or infrastructure projects. "The problem is not overheating, it's misallocation of resources," says Andy Rothman, China strategist at CLSA Asia-Pacific Markets in Shanghai.
That's leading to overbuilding, particularly in steel, real estate, and autos. In the first 11 months of 2003, fixed-asset investment -- money spent on plant and equipment -- grew 29.6%, while steelmaking capacity more than doubled, and real estate investment was up 32.5%. "Construction of new [steel] capacity is outstripping growth in demand," warns Xie Qihua, president and chairwoman of Shanghai Baosteel Group Corp.
3. Why should the rest of the world worry if China's economy is growing too fast?
If Beijing cannot cool down the economy to acceptable levels, it might be forced to slash government spending on infrastructure and cut back on bank credits. In that case, growth could slow dramatically -- and the effect would be felt around the world. China is replacing Japan as Asia's most important economy, and the country has become vital to corporations everywhere. Germany's exports to China -- mostly of capital goods -- are expected to rise 20% this year, to $24 billion, well ahead of its $14 billion in exports to Japan, according to the Association of German Chambers of Commerce & Industry. Some 14% of Motorola's sales, or $3.7 billion, came from China in 2002. The country accounted for virtually all of Volkswagen's sales growth last year. Samsung Electronics expects to sell $8 billion worth of chips, flat screens, cell phones, and consumer electronics there this year -- about 12% of its total, vs. the 20% the company sells in the U.S.
To get a taste of what could happen, consider the last time China's economy seriously overheated, in 1993. Beijing slammed on the brakes to stifle double-digit inflation and slow runaway investment in real estate and commodity production. That caused a sharp drop in both economic activity and demand for products from abroad. Steel imports, for example, fell to 22.8 million tons in 1994 from 33.5 million tons in 1993. China today buys 20% to 25% of the traded volume of many commodities, including iron ore, chromium, and manganese, according to market researcher Global Insight Inc. So if China slows even to 8% growth, commodity prices could tumble by 15%, Morgan Stanley predicts.
The second reason outsiders should worry about a Chinese slowdown is that China is the world's biggest manufacturer of just about everything. So if domestic demand dries up, China might try to export its way out of a crisis. While mainland steel is mostly low quality, and China obviously can't uproot unoccupied apartment buildings, the world could still see a glut in many goods. China's production of steel, aluminum, autos, textiles, ships, and machinery are all expected to double by 2007, according to investment bank Credit Suisse First Boston. "China is on a wild [capital expenditure] spree," says Dong Tao, the bank's chief economist for non-Japan Asia. "Two or three years down the road, this will bring a major supply shock to global industry."
4. What is Beijing doing to deal with the problems?
Premier Wen Jiabao and his government are making a cautious effort to slow things down. The State Development & Reform Commission has issued new rules restricting investment in steel plants and aluminum foundries and is limiting licenses to companies seeking to produce passenger cars. And the People's Bank of China, the central bank and banking regulator, is putting restrictions on lending to some luxury housing developments. The trouble, though, is enforcement: Beijing may say "stop," but that doesn't mean local officials and companies listen, particularly when they see others rushing into profitable businesses.
The central authorities keep trying, though. People's Bank of China has raised reserve requirements for banks to 7% from 6%, which should limit the capital available for new loans. Because of China's growing savings pool and the $403 billion reserve of hard currency that must be converted into yuan, the money supply has been increasing at 20% a year -- which encourages lending. This year, China says it wants to hold growth of the money supply to between 12% and 13%. And on Jan. 1, the central bank started giving commercial banks a bit more flexibility in setting interest rates. That not only allows them to earn better margins but is also a step toward more commercially sound lending. Hong Kong-based UBS economist Jonathan Anderson says the People's Bank now has allies elsewhere in government in its effort to cool off the economy. "Before, it was a lonely battle for the central bank," he says. As a result, Beijing can count some successes. Loan growth in the fourth quarter was down by a third over the year-earlier period. So the betting is that China will successfully manage a soft landing with growth this year somewhere in the 7% to 8% range.
5. Even with the new rules, the state-owned banks are effectively insolvent.
Is there still a danger of a financial meltdown?
Not likely near term. The banks are in bad shape, but that's been true for years. With all deposits in the big state-owned banks guaranteed by the government, Chinese citizens -- who bank 33% of what they earn -- feel safe putting their $1.32 trillion in savings into savings accounts.
Still, big problems remain. Standard & Poor's estimates that bad debt could be as high as 45% of outstanding loans, so a full bailout could cost about $600 billion, or some 40% of last year's GDP. Add in China's other liabilities, including the underfinanced social security system, and the price tag for fixing the banks could equal or exceed GDP, some say. Officially, dud loans in September made up 21.3% of the portfolios of the so-called Big Four banks, down from 26.1% a year ago. But the main reason for the change is a flood of new loans, many to inefficient state enterprises.
That's bad news for bank balance sheets, since state enterprises often don't repay their debts. It's also bad for the fast-growing but cash-strapped private sector, which struggles to find adequate financing. Like Japan, China may never have a sudden collapse of its banks: Instead, it will have to spend more and more to keep the financial system stable, which will strain government finances. China's "financial system is heading for a Japan-style quagmire," says Donald Straszheim, an independent economist who is generally bullish on China. Already, the total national debt including foreign loans stands at 176% of GDP, estimates Morgan Stanley.
6. What is the significance of Beijing's $45 billion bailout of the Bank of China and China Construction Bank?
It's good news, but China needs to go much further if it hopes to really solve the banks' problems. The infusion continues earlier reform efforts, including a 1998 cash injection of $33 billion and the creation four years ago of asset management companies to help dispose of bad debt. Bank of China and China Construction Bank are the best managed of the Big Four, and the government says the capital infusion is in anticipation of stock listings for the pair.
The bailout, though, won't be enough to force the banks to get smarter in their loans. As long as they are still owned by the government and controlled by the Communist Party, lending decisions will continue to be driven by politics and connections rather than commercial considerations.
7. One way to slow growth would be to revalue the undervalued yuan. What are the chances of that happening?
Very small. The Chinese may at some point expand a bit the very narrow band in which the yuan trades, or change its peg to a basket of currencies rather than the dollar alone. But Chinese officials don't want to revalue the yuan for fear of slowing exports -- and job creation at export-oriented factories. A revaluation that really reflected China's trade surplus and foreign exchange reserves would probably increase the yuan's value by 40%. That's just not possible for Beijing right now.
8. Could SARS be a big factor again this year?
Despite the confirmation on Jan. 5 that China has a new case of SARS, experts are saying there is no reason for alarm. Even if new SARS cases begin to emerge, the mainland is unlikely to face another epidemic. Beijing seems to have learned a lesson from the leadership's disastrous failure last year to admit to the problem and deal with it quickly.
This time around, the government's top health officials are threatening to deal harshly with any coverups of the disease's spread. In any event, keep in mind that China's economy threw off the impact of SARS much more quickly last year than anyone had expected. The dangers to China this year are of the economic variety -- and they may prove harder to contain than SARS.
By Dexter Roberts in Beijing, with Bruce Einhorn in Hong Kong, David Fairlamb in Frankfurt, Moon Ihlwan in Seoul, and Nanette Byrnes in New York