Will China slow down?

There is bound to be slowdown in China's growth towards the middle of this year

One of the most important issues facing investors today is the question of China. Will it slow appreciably in 2004 and if so what are the reasons?

It is a question the answer to which has implications for commodities, global financial markets as well as the global economic outlook. China as is well known is the consumer on the margin for most commodities, accounting typically for 20-25 per cent of global consumption and 40-50 per cent of incremental demand.

Along with the US consumer, China is one of the two pillars of growth driving the global economy. Most investors have large positions in Chinese stocks, with the 'H' share index rising by over 100 per cent in 2003.

Thus everyone has to have a view and it will be one of the bigger calls investors have to make in 2004.

First the reasons behind why the economy may slow.

China is currently clearly growing much faster than the official figures of 8-9 per cent, most seasoned China hands feel current GDP growth is more near 10-11 per cent.

This assertion is supported by electricity demand numbers which show demand growth of 14.3 per cent in the past six quarters compared to an average of 7.8 per cent over the previous ten years(source: Morgan Stanley).

This growth is being driven by fixed asset investment which accounted for over 47 per cent of GDP in 2003. The surge in capital formation is being fuelled by a surge in credit with some commentators pointing out that China created about $ 500 billion of credit above trend over the past seven quarters(source: Morgan Stanley).

The increase in loans outstanding relative to GDP was nearly 25 per cent in 2003. One also had M2 growth running at nearly 20 per cent in 2003(a 25-year high).

The question of course is, why is this rapid growth negative? Why do the authorities want to slow it down? China after all needs to grow at 8 per cent plus just to ensure social harmony.

At least 10 million new workers come off the farms every year looking for work in urban centres and the state owned enterprise (SOE) sector makes about eight million workers redundant every year.

Also, with a savings rate of over 40 per cent and cumulative inflows of foreign direct investment (FDI) exceeding $ 500 billion, China has no shortage of capital or labour constraining its growth potential.

The issues worrying the authorities are really two:

First of all the banking system is not sophisticated enough to allocate capital/credit in a disciplined fashion. There is a very serious risk that this credit surge will lead to surplus capacities and a large build up in non-performing assets(NPAs) which the authorities desperately want to avoid.

Part of the credit has also gone to fuel the property bubble which can only end badly. Given the pace of credit acceleration and magnitude, one should not be surprised if at the end of this investment boom we have a bigger NPA problem than in 1992-93.

The Chinese authorities clearly do not want to deal with the fiscal and deflationary consequences of this bust.

The second worry for the authorities in China is inflation which has begun to accelerate and reached a seven-year peak(though still at only 3 per cent).

Food and industrial materials are driving the inflation numbers and in both areas we are seeing shortages of a structural nature. If inflation were to continue to accelerate over the summer as some commentators expect and approach 7-8 per cent, then the Chinese authorities will have to respond with higher interest rates.

Given the impact higher rates will have on consumption, growth, retail credit and investment demand, the authorities would prefer a soft landing by slowing the economy now rather than risk a sharp correction later if the economy were to continue to accelerate and rates forced to rise.

Given the above, the Chinese authorities have clearly come out and said that the central government would take measures to curb investment in overheated industries, including steel, aluminium and cement. Premier Wen Jiabao made a speech calling for credit curbs to avoid redundant capacity.

The PBC governor also announced formal money and credit growth targets for 2004, both of which imply a significant slowdown from the pace of 2003.(M2 growth of 17 per cent in 2004,was 19-20 per cent in 2003 and volume of new loans dropped 13 per cent in 2004 over 2003).

Reserve requirements were of course raised earlier. The Chinese authorities are now finally showing clarity and focus in their desire to implement a slowdown.

The outcome of all this is that after peaking in the middle of 2003, bank credit and M2 aggregates have slowed sharply over the last five months with the January numbers only reinforcing this trend. The same trend is visible in fixed asset investment spending (the real target), with growth falling on a monthly basis.

In my view, the above trends are the most important indicators of the current cycle. This has been a credit and investment fuelled upturn and the slowdown in both these variables implies that it is only a matter of time before the economy responds.

China also has huge sensitivity to US consumption through export growth. To the extent consumption is affected in the US by potential Fed tightening the impact on China's exports could be significant. This may slow the economy independent of efforts by the Chinese authorities.

The doubters of a China slowdown point to the huge foreign exchange (Forex) inflows. The PBC is forced to buy up the excess foreign currency inflows, resulting in an automatic injection of equivalent renminbi into the banking system.

To control money supply and credit growth, the PBC will have to suck out these inflows through sterilisation operations. The challenges and costs of this sterilisation operation is rising as monthly Forex flows cross $ 15 billion.

Some people question the ability of the PBC to control financial conditions with this quantum of inflows. Given the authorities' clearly expressed desire to control credit/money growth, the costs of this sterilisation programme do not seem prohibitive and it is unlikely to be a deterrent to slowing the economy.

The nay sayers also point to import and production growth which show no signs of cooling off and to various other indicators of physical activity in China which continue to accelerate.

The point here is that these tend to be lagging indicators and they should decelerate as well, provided credit and investment demands continue to slow. In fact, inventories as a share of GDP have already begun to rise, highlighting the divergence.

I do believe that China will slow towards the middle of the year and while the reported GDP numbers may not show much of a drop for 2004-05, slowing from 9 per cent (2003) to maybe 7.5-8 per cent, this will disguise the impact.

It will actually be a slowing down from 10-11 per cent (2003) to 7-8 per cent and the mix of growth will shift away from fixed asset investment towards consumption. The impact on certain industrial commodities and capital equipment could be very severe.

The two main drivers of the global economy are the US consumer and Chinese fixed investment. With the personal savings rate in the US at approximately 1 per cent and capital investment in China at 47 per cent, neither driver is sustainable at the current rate. Both at some stage will have to correct to more normalised levels.

Things should start to get very interesting from the middle of 2004 onwards.