FOR INVESTORS FOLLOWING the China story, Sars is now a fading memory. Their fears that the People’s Republic’s economy would be knocked sideways by the virus have proved unfounded. GDP growth this year is back on track and will break through the 8% barrier again. Other figures for the year to July are equally impressive. Exports are up 34%, investment in fixed assets jumped 32%, foreign investment has risen 34%, and both bank loans and money supply have risen by 20%.
It would seem that after briefly slowing in the spring, China’s economy is now once again at full tilt.
But such impressive numbers are themselves causing concern. Instead of doctors whipping out their thermometers every few minutes, it’s now economists who are checking for signs of overheating. Some believe that in certain sectors China could be a bubble waiting to pop. Eddie Wong, ABN Amro’s chief strategist for Asia, is in this camp. “This is an over-investment bubble. And I think it’s a fairly serious one,” he says
Others are uneasy in a vaguer way. They are sure there is trouble ahead, but not too sure exactly where. Dong Tao, CSFB’s chief economist for Asia, says: “This is not a normal overheating so there’s a big debate about whether the economy is overheating or not. My argument is that you can check the body temperature but just because that may be normal doesn’t mean that everything is fine. The best indication is investment and credit growth, and on that score I believe China has already entered a phase of overheating.”
Optimists point to the consumer price index, which shows an inflation rate of just 0.5%, as a sign that everything is fine and under control. But more fearful economists reckon they are ignoring other vital information. As Tao says, the CPI is not the best indicator of whether China is about to boil over. “The CPI is heavily weighted by food because two-thirds of the population lives in the rural sector. But it’s not an adequate benchmark given that two-thirds of activity is in the industrial sector.”
Another reason, Tao believes, why the problem may be hidden is because investment rather than demand is driving the economy. “It’s creating new capacity, which will lead to price wars and lower prices,” he says. “And this is where the problem is. If it’s not handled well, we will see another round of non-performing loans.”
China’s banking sector is already burdened by a non-performing loan ratio of over 40%, and it’s not clear how many more bad assets the banking sector can bear before its back breaks. “Every industry seems to be over-invested and there will be a crunch at some time,” says Tom Byrne, a sovereign analyst with Moody’s Investors Service. “But at the moment it will just add more to the government debt.”
A reprise of the Asia crisis? The figures are enough to cause alarm in the Chinese establishment. The country’s leaders are only too aware of the problems that arise when bubbles burst. As one economist says: “We last saw what is happening in China in the rest of Asia in 1997. And the Chinese economy may go that way too. There are tremendous domestic imbalances and too much investment in crummy assets. There will be a crash, the money will go pouring out and you have a reprise of the Asia crisis.”
Ma Gai, minister for the state development and reform commission, last month warned that if things are “not cooled the investment fever in some industries will affect China’s robust economic growth”.
The industries that Gai was alluding to include steel, iron, building materials and the auto sector.
Iron has experienced a spike in investment of 130% in the first six months of this year alone. In the auto sector investment is set to double over the next two years and car production had already rocketed by 83% year on year to June 2003. Steel received an extra 21% injection of capital.
China’s progression from communist economy has demanded strong pro-growth policies for the past 20 years. Now the country is spewing out exports so fast that it would seem that any slack from the possible oversupply that Gai talks about would soon be taken up overseas anyway, especially if the US economy recovers.
It’s a premise that Wong of ABN Amro wholly rejects. “China now invests more than 42% of its GDP into fixed-asset investments,” he says. “And it’s totally wrong to assume that just because China is believed to be the world factory they can afford this capacity ratio and will export the excess.”
He notes that last year’s foreign direct investment was an impressive $50 billion, but points out that this was only 10% of China’s $500 billion of fixed-asset investment. And if FDI for asset acquisition is discounted, FDI accounted for just 4% of the $500 billion that went into capacity investment. Yet foreigners still accounted for 52% of the country’s exports.
Hong says: “No matter how inefficient the investment is, total domestic investment that’s related to exports is no more than 10%. [So] 96% of fixed-asset investment is done by locals and 90% of that fixed-asset investment is not related to exports. And while domestic consumption is growing it still only accounts for 45% of the GDP.”
That, says Wong, is not enough to soak up oversupply. “There is a lot of talk about why China can have such a high investment ratio. But we have heard it many times in Asia. We heard that they could have current account deficits of 10% and investment ratios of 40% without causing problems, but then the Asia crisis came.”
For now, though, the problems seem distant. If China continues this type of investment, demand will, in the short term, also remain strong. After all, the Chinese need a lot of steel to build steel plants. “But,” says Wong, “once the steel plants are finished, the demand will disappear. And problems like this, if they don’t solve them, will be big. The problem is that there is no guarantee that it’s not too late.”
It was steel that Gai specifically highlighted as one of the sectors possibly storing up problems for the future. He pointed out that any structural imbalances here will undoubtedly hit the fragile banking sector because it is estimated that between 50% and 60% of new investment into the steel sector comes from bank loans.
Bank loans into real estate have also helped that sector rocket. In the first half of this year, investment grew 36.7% nationwide. In Shanghai, the figure is reckoned to be 55% higher. It’s just another boom that Chinese bankers could live to regret funding. As Wong says: “A lot of investments during the past year are financed by bank loans. New bank lending is more than double last year’s and outstanding loans up 23% in July alone. They need to control this excessive lending. The credit bubble is quite real.”
Painting over the rust What concerns analysts is that the banks don’t appear to have learnt any lessons. Yen Wei, a banking analyst at Moody’s, says: “A lot of the banks are lending again and that worries us. We aren’t sure if the lending is directed in the right direction because in their haste to lend they are employing less than transparent methods.”
This sort of comment should raise the hairs on the back of investors’ necks. It leads to a worrying question: are the banks extending new loans to anyone who will take the money in a desperate and misguided attempt to water down their existing NPL ratios?
The People’s Bank of China after all wants the NPL ratio for the banking sector to be around 15% by 2007. Some banks may be close to that. As one economist puts it, they are just painting over the rust. Another takes a different view. “The NPL ratio does not mean anything at the moment due to the rapid rise in the loan book,” he says. “What we should be looking at is the absolute level of the NPLs. And while these new loans are not going to become NPLs anytime soon, at some point people will realize that this is another serious problem for the future.”
The whole system still suffers from a serious distortion. There is now a very low risk weighting of 20% attached to lending to state-owned enterprises, no matter how poorly performing they may be. Banks think that it is advisable to lend to SOEs because they have to put aside less of their capital, so making it more profitable. John Waddle, UBS’s head financial institutions analyst for Asia, says: “Right now the system is skewed because the banks are avoiding lending to the small and medium-size enterprises in the private sector because it requires more capital. But to change it would mean having to increase the capital requirements for lending to the SOEs, which means that you would have to increase the pricing on the loans. And this would definitely be a hard adjustment process.”
The government wants to avoid credit curbs and price controls, since it is using GDP growth and the investment boom to soften the blow of millions of workers being thrown out of employment by continual restructuring. But some sort of controls might be necessary. And this has economists worrying too. They look to the hard landing that Korea suffered when it attacked the problem of consumer lending getting out of control. “The question is will they allow this to continue,” says Tim Condon, ING’s chief economist for Asia. “The danger is a Korea-type situation. If you see China suddenly want to control the property market for example, they would have a hard landing and everyone should clear the decks.”
The Chinese authorities might not have much choice. If they don’t want the economy to go pop then they will have to introduce measures such as gently raising capital requirements while issuing more treasury bills to soak up the excess liquidity. Wong at ABN Amro has the last word. He says: “They have two choices. Control the over-investment now and hopefully there will be a soft landing. Or let the ratio of investment rise until it blows up.”
FDI in China ($ billion)
Source: Morgan Stanley
