China: More pain than gain

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

China is in for a rough year. The econ­omy is in its most frag­ile state since 1998, at the nadir of the Asian fi­nan­cial cri­sis. Gross do­mes­tic prod­uct grew at an an­nu­alised rate of just 6.1% in the last quar­ter of 2014, and most key in­di­ca­tors sug­gest that the first half of 2015 is un­likely to be much bet­ter. Industrial prof­its are weak­en­ing sharply, which is likely to dampen wage growth and con­sump­tion-the two bright spots over the last cou­ple of years. Dis­in­fla­tion is now en­trenched. The im­plied GDP de­fla­tor last year was just 0.4%, pro­ducer prices have been fall­ing for three years and the steep fall in oil prices, while ben­e­fi­cial in the long run, will only add to the down­draft in industrial pric­ing power and prof­its in the short term.

To th­ese prob­lems add struc­tural and pol­icy-in­duced risks. The con­struc­tion sec­tor, one of the econ­omy’s main growth en­gines, looks chron­i­cally weak as China has al­ready passed the point of peak hous­ing de­mand. To bring sup­ply and de­mand into bal­ance, it is likely that com­ple­tions of new hous­ing floor space, which tripled be­tween 2000 and 2012, will need to decline by 10-15% over the next decade.

Gov­ern­ment pro­grammes for build­ing sub­sidised so­cial hous­ing—a cry­ing need for the poorer half of the ur­ban pop­u­la­tion—have helped prop up con­struc­tion vol­umes for a few years. But this sup­port is now also weak­en­ing, a point em­pha­sised by the news that some lo­cal gov­ern­ments plan to buy ex­ist­ing but va­cant hous­ing units to con­vert them into so­cial hous­ing. While this is an em­i­nently sen­si­ble way to solve the twin prob­lems of ex­cess high-end and in­suf­fi­cient low-end hous­ing, it is surely bad news for the con­struc­tion in­dus­try.

There are also risks on the fis­cal side. This year, lo­cal gov­ern­ments will lose the right to use their land hold­ings as col­lat­eral for loans, a mech­a­nism which has pro­vided about 20% of their net rev­enues in re­cent years. Tax rev­enues are also slow­ing be­cause of the weaker econ­omy. Faced with un­cer­tain rev­enue, many lo­cal gov­ern­ments could well choose to cut back ex­pen­di­ture. Un­less the cen­tral gov­ern­ment is quick to re­spond with in­creased trans­fers, which would push its own deficit above pre­vi­ously ac­cepted lev­els, there are real risks of an in­ad­ver­tent fis­cal tight­en­ing this year.

The pos­i­tive spin on all this is that the gov­ern­ment is se­ri­ous about the struc­tural work needed to set eco­nomic growth on a more sus­tain­able foot­ing. Sharply slower growth for a cou­ple of years is the price that must be paid. The anal­ogy is to the first four years of Pre­mier Zhu Rongji’s ten­ure (19982001), when China suf­fered rel­a­tively low growth, per­sis­tent de­fla­tion and ris­ing un­em­ploy­ment as it over­hauled sta­te­owned en­ter­prises and the fi­nan­cial sec­tor.

There are three cru­cial dif­fer­ences be­tween now and then. First, Zhu swiftly ex­e­cuted large-scale re­forms that opened up new sources of pro­duc­tiv­ity growth. He shifted most of the man­u­fac­tur­ing sec­tor from state to pri­vate hands, pri­va­tized the hous­ing mar­ket and dragged China into the WTO. Th­ese moves paid div­i­dends in the boom that be­gan in 2002. By con­trast, cur­rent pres­i­dent Xi Jin­ping has so far failed to gain much trac­tion in the two re­forms most cru­cial for fu­ture pro­duc­tiv­ity growth: slash­ing the in­ef­fi­cient state sec­tor and dereg­u­lat­ing ser­vice in­dus­tries.

Sec­ond, Zhu had the good for­tune to in­herit a rel­a­tively low debt econ­omy, so he could in­crease over­all lever­age to ease the pain of struc­tural re­form. Xi has far less room to ma­neu­ver. The econ­omy’s debt level is high and ris­ing fast, so over the medium to long term credit must be tight­ened.

Third, in Zhu’s era there was lit­tle doubt that eco­nomic re­struc­tur­ing and growth was the state’s pri­or­ity. To­day there is equally lit­tle doubt that tight­en­ing po­lit­i­cal con­trol tops Xi’s agenda. The pri­or­i­ties are anti-cor­rup­tion, ide­o­log­i­cal pu­rifi­ca­tion and clamp­ing down on the in­ter­net.

As we have ar­gued be­fore, Xi’s eco­nomic and gov­er­nance re­form pro­gramme is se­ri­ous, and his fierce po­lit­i­cal of­fen­sive (par­tic­u­larly the anti-graft drive) is es­sen­tial ground­work for China’s fu­ture. His grand de­sign may even­tu­ally pay off in more ro­bust growth. In the short run, the eco­nomic pic­ture is likely to grow uglier.

The mon­e­tary eas­ing cy­cle that be­gan with last Novem­ber’s in­ter­est rate cut and con­tin­ued with last week’s re­serve ra­tio cut will prob­a­bly see an­other cou­ple of rate cuts this year. Th­ese will be wel­come, as China’s bor­row­ers now face among the high­est real rates in the world. But the most that mon­e­tary eas­ing can achieve will be the sta­bil­i­sa­tion of growth at a lower level, some­where be­tween 6.5% and 7% this year (down from 2014’s full year fig­ure of 7.3%), and per­haps as low as 6% in 2016. China may well fix its deep eco­nomic prob­lems, but the process will take sev­eral years and it will be painful. In the mean­time, don’t ex­pect China to take the lead in pulling the world out of its cy­cle of stag­nant growth and dis­in­fla­tion.

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