China’s Economy: After the Stimulus

Three economists discuss their outlooks for China’s economy.Despite the global economic downturn and uncertainty about the health of the global economy, China’s economy remained a relative bright spot in 2009. Though global trade contracted 12 percent—and Chinese exports slowed—China’s economy as a whole remained fairly resilient. Now, as many major economies begin to emerge from the downturn, China’s economy is speeding ahead, registering 11.9 percent growth in the first quarter.

To discuss China’s sustained economic growth—and challenges that remain—CBR Assistant Editor Daniel Strouhal interviewed three China economists in May.

China’s economy continued to grow rapidly in 2009 and the first quarter of 2010. With demand in the United States and many of China’s other trading partners still relatively low, will China be able to maintain rapid growth? Is domestic demand beginning to drive the economy?

Ting Lu (China economist at Bank of America-Merrill Lynch): We expect China to grow 10.1 percent in 2010. We believe that China’s gross domestic product [GDP] growth has already peaked at 11.9 percent year on year in the first quarter of 2010, in part boosted by a low comparison base, and it will drop to about 9.0 percent in the fourth quarter of 2010 and in 2011. From a long-term perspective, the post-crisis potential growth of the Chinese economy will likely be 9.0 percent, down from the 11.0 percent pre-crisis level.

From 2009 to 2010, the major source of China’s growth acceleration will likely be exports, which dragged down GDP growth by 2.5 percentage points in 2009 but could contribute 1.6 percentage points in 2010, according to our calculation. The difference here would be 4.1 percent. If consumption and investment growth maintain the same pace, China’s GDP growth in 2010 would be 12.8 percent (8.7 percent year on year from consumption and 4.1 percent year on year from exports). We think consumption growth could be stable, but capital formation will slow on higher comparison bases and macro tightening.

Already factoring in a slowdown in fixed-asset investment [FAI] growth this year, we don’t expect the property tightening measures to lead to a collapse of FAI growth in China. The PRC government is determined to curb property speculation, but it has no intention of slowing real estate FAI growth. Instead, the PRC government aims to expand housing supply by discouraging land hoarding, and it will also aggressively advance the construction of welfare housing.

Stephen Roach (chair of Morgan Stanley Asia): I think there’s good momentum in the Chinese economy heading into mid-year 2010. At that point, China’s stimulus, which has played an important role in producing rapid growth, together with a turnaround in the inventory cycle in the West, will begin to fade. Growth prospects in the second half of this year and in early 2011 are still somewhat in doubt, and the risks of that forecast are now underscored by what seems likely to be a reduction of Chinese property investment stemming from the fairly aggressive actions that the PRC government took in mid-April to take a lot of the air out of the property bubble. The domestic demand support to the economy has largely been in the investment area, which is probably in danger of having run too fast, too hard. It’s also been in some of the consumer durables areas, especially in the auto sector, where there have been special incentives provided to car buyers. These types of factors are more temporary than sustainable.

China is likely to return to a more flexible currency policy in the second half of the year. Such a move, together with likely persistent sluggishness in underlying end-market demand growth in the West, would also underscore a little bit of downside pressure to exports. So when I add it all up, I think that China’s momentum in the first half of this year is going to be hard to sustain in the second half.

Victor Shih (political economist and professor at Northwestern University): For 2010, I think growth will be robust, but investment continues to play a large part in China’s growth story. I am not entirely convinced that domestic demand can completely replace the role previously played by exports to produce marginal growth. However, given that investment is still growing robustly over last year, growth will almost certainly surpass 10 percent this year and will remain robust through the first half of next year.

How successful was China’s massive government stimulus? Has the stimulus given rise to any unexpected—or particularly difficult—challenges?

Lu: The stimulus measures were successful overall from a cost-and-benefit perspective. In 2009, China gained an additional 4 percentage points of growth, thanks to the ¥4 trillion [$586 billion] stimulus, but the cost of this Keynesian management may be 1-2 percent of China’s GDP. Because of an overly loose credit policy in 2009, the property bubble was inflated when the economy was not overheated, and there was a rapid rise of Chinese local-government debt.

This seemingly high 11.9 percent year-on-year GDP growth in the first quarter is not sufficient to conclude that the Chinese economy was overheated. If adjusted for the low base, GDP growth in the first quarter was just 6.2 percent year on year. Going forward, we think that year-on-year growth of GDP, industrial production, and FAI will post noticeable slowdowns in the second half of 2010. The top risk for the Chinese economy is still the property market, in our view.

Roach: The stimulus provided a huge boost to fixed-asset investment spending. The surge in investment spending alone accounted for about 70 percent of the 8.7 percent [GDP] growth in 2009. Obviously, the economy would have grown much more slowly had it not been for the impacts of the stimulus. I think it created a situation where the investment sector, which had already been excessive as a share of GDP, became more excessive, ending the year at close to 47 percent of China’s GDP. This is a record for China—and a record for any major economy in the modern history of the world.

The investment stimulus was funded by an unprecedented surge of bank lending in China. A disproportionate share of bank lending was directed to local investment companies, in part funded by local government units that drew support from this bank-lending binge. These local investment companies are unlikely to provide further support for Chinese growth in the months and quarters ahead. The economy is not overheated except in the property sector itself. That’s less of a construction problem and more of a pricing problem, with speculators rushing to buy multiple homes to take advantage of a property bubble. The government recently introduced some very tough measures aimed at reducing multiple purchases of real estate by individual speculators. So unlike the West, where we tend to let asset markets get out of hand and impart a devastating blow to our asset-dependent real economies, the Chinese moved pretty quickly to preempt that. I think they’ve done what will turn out to be a good job.

Shih: [The stimulus] succeeded in generating some of the highest growth in 2009, but implicit government debt grew tremendously as a result. To be sure, China did not do anything that the rest of the world did not do. But local authorities are showing no signs of slowing down. At a time when the PRC government should begin thinking about retrenching, local authorities continue to announce very ambitious investment drives. If this momentum is not stopped soon, debt may rise to a challenging level. The central government needs to find ways to transfer some of this liability back onto the center’s ledger by issuing bonds. The money raised by bond issuance would be used to repay local debt.

Massive lending related to China’s stimulus raises questions about the growth of nonperforming loans (NPLs). How will the potential rise of NPLs affect China’s development?

Lu: NPLs will inevitably rise in China because of the stimulus, especially from loans to local-government projects. This could bring down some rural credit unions or small urban commercial banks, but the majority of local-government financing vehicle (LGFV) NPLs will be absorbed with the help of fiscal transfers from upper-level governments.

The central government may ask some provincial governments to set aside a special amount to help local governments repay some LGFV debts. The rest will be taken over by the People’s Bank of China [China’s central bank] as the lender of last resort. We estimate that NPLs from the loose credit policy in 2009 are no more than ¥550 billion [$80.6 billion], and we do not expect Beijing to set up a national asset-management company like it did a decade ago to absorb NPLs.

Roach: I think this NPL issue is overblown. There are certainly issues in terms of the debt quality of locally funded and state-directed investment companies. The China Banking Regulatory Commission [CBRC] is scrutinizing these loans very carefully. There may be some charge-offs associated with some of this lending in the second half of this year, but they are unlikely to be devastating and nowhere close to what the charge-offs in China were in the early 1990s.

The most important thing to recognize is that the bulk of the stimulus went to infrastructure—roads, bridges, rail—where the risks of loan quality are much less problematic than is the case in other forms of investment, such as in apartments, office buildings, or even factories. Though many aspects of the stimulus were unsustainable, this was a necessary step for China to take in the depths of the crisis. The consequences of these actions are unlikely to deal a devastating blow to Chinese financial institutions, provided they are disciplined at addressing these issues quickly, as they appear to be.

Shih: Even without NPLs, China’s banks are already finding it difficult to recapitalize. The CIC [China Investment Corp.] will likely have to inject additional billions of US dollars to restore banks’ capital base. If there were a couple trillion yuan in NPLs, the banks would need to be massively recapitalized, further shifting China’s foreign-exchange reserve toward ownership in Chinese bank shares. Credit expansion will likely slow, which will slow the economy. Some of this dynamic may begin to play out in 2012.

China’s local-level government debt appears to be on the rise. How much will local-government debt affect the country’s development? Does this debt have any implications for foreign companies that operate in China?

Lu: Our general view is that LGFV debt is a problem we cannot ignore, but we believe it is manageable. Beijing may have to bail out some LGFVs and provide support to some small banks, but the chance that China will suffer a full-blown financial crisis is extremely low. The path to the final solution could be painful, however. Project cancellations—a “killing the chicken to scare the monkey” step we have long expected as part of the tightening package in 2010—may play a key role in bringing LGFVs to heel.

Local-level debt should not have a direct effect on foreign companies operating in China. Though infrastructure construction, which was jump started in 2009 and heavily geared to less-developed central and western China, may at first have a low return on capital, it will have longer-term positive implications for foreign capital: Foreign investors will be able to explore domestic market opportunities in those regions or relocate to take advantage of lower production costs.

Roach: As I noted earlier, the surge of local debt has been funneled through municipal investment companies. This played an important role in implementing much of the infrastructure stimulus package. There clearly has been a big increase in debt, and that’s particularly worrisome given that the debt service associated with those obligations is largely funded out of local-government revenues, which themselves are heavily dependent on property-market transactions. To the extent that the property market cools off, that will inhibit the debt servicing capacity of local government units.

CBRC is looking at this local-debt issue very closely right now. In large part that’s because so much of the local investment-company debt was funded by Chinese banks, and the last thing that China wants is a new surge of NPLs. So I think this problem is going to be addressed. I don’t think that it will have a lasting impact on China’s economic development because, unlike in most economies where the investment in property dynamics can suffer from a shortfall in demand, there is ongoing outsize migration from rural communities to urban cities in China that runs somewhere between 15-20 million people a year. That creates a huge natural demand for shelter. This will ultimately provide a good deal of support for local-government revenues—and the debt-servicing capacity of that revenue stream.

Finally, I don’t think there are any real serious implications of the local-debt issue on foreign direct investments of Western and other multinationals that choose to set up in China. I think they do it largely because of the phenomenal labor-cost arbitrage between their workforce and the Chinese workforce, as well as very efficient logistics of a modern, China-centric Asia supply chain.

Shih: I think local governments have massively overbuilt infrastructure in many places. If the world faces a double-dip recession, the marginal gains from additional infrastructure investment in China going forward will be constrained. It is hard for me to imagine how China can effectively stimulate the economy in the future besides the Keynesian “digging a ditch and filling it up again.” Much of the infrastructure built before 2008 will likely be useful for China’s economic future, but I think the rush to accelerate investment in 2009 introduced a lot of dubious projects.

Some local authorities have massively subsidized local businesses, which may give them unfair advantages vis-à-vis their foreign competitors. Wind-turbine production is one example.

Do you think China will allow the renminbi (RMB) to appreciate against the US dollar in 2010? If so, by how much? (Note: Just as CBR was going to press in late June, the People’s Bank of China announced plans to make the RMB more flexible but provided no details on timing or method.)

Lu: Our expectations for the RMB can be summarized in four points—peg, band, one-off revaluation, and timing of the move:

• China and the United States might already have reached an agreement on one thing: China will unpeg the RMB from the dollar and start a crawling peg to a basket of currencies.
• The US-China negotiation could hinge on two issues: the size of the one-off revaluation (possibly zero) and the pace of the RMB’s appreciation against the basket. A small token one-off revaluation cannot be excluded, or the United States might ask for faster RMB appreciation against the dollar.
• The current daily RMB-US dollar movement band could be widened from 0.5 percent to 1.0 percent or more, though that would be largely a token move.
• Regarding the timing, it might be impacted by the European debt crisis. We believe there will be no move to appreciate the RMB before the end of September.

Roach: This is obviously a serious issue in the global policy debate right now. Though the premier himself has not made specific pronouncements on RMB policy, the People’s Bank of China Governor Zhou Xiaochuan has been reasonably clear: [He] has underscored the point that the current currency policy, which is pretty much a fixed peg between the RMB and the US dollar, must be viewed as a temporary set of measures that was taken in the depths of the crisis. Consequently, as China now moves away from dealing with the crisis, there’s good reason to believe that it will be returning to the pre-crisis currency policy, which is a gradual RMB appreciation. That should be viewed as an important feature of China’s post-crisis exit strategy. So I do think that the RMB will resume a process of gradual appreciation in the second half of this year—somewhere in the 2-4 percent range. That will be helpful, but it will not necessarily take all the heat off the currency issue as a serious bone of contention between China and the US Congress.

Shih: I think China will appreciate [the RMB] on its own terms, depending on the alignment of domestic interests. It would be a mistake to think that China will appreciate [the RMB] because senior PRC officials, especially those in the central bank, have signaled in that direction. Given the crisis in Europe, China has more reason now to delay the revaluation as it assesses how exports perform in the coming months.