In late 2007, the Chinese government was scrambling to control a capital-spending boom. The central bank was concerned about 11 per cent growth in gross domestic product, far above its official target of eight per cent. It was also worried about money flooding in from exports and direct foreign investment. By November 1, the People’s Bank of China had raised its one-year lending rate five times and reserve requirements eight times to soak up excess liquidity.
My firm’s research had then predicted the government would curb capital spending and excess liquidity, just as exports weakened. Then, as excess capacity mounted, direct foreign investment would disappear and deflation would reign.
That’s essentially what happened in 2008 and 2009, as the effects of China’s fiscal and monetary restraint coincided with the worldwide economic slump. The growth rate dropped to six per cent, which in China, constituted a major recession. Don’t be surprised if history repeats itself in the next few years.
This time around, some signs of cooling are already apparent. Besides dampened housing demand, the HSBC Flash China Manufacturing Purchasing Managers Index fell to 50.1 in June, its lowest level in 11 months. Passenger vehicle sales grew 33 per cent in 2010, when the government subsidised small-car purchases. However, sales rose only three per cent this April over a year earlier.
MONEY, BANKS, STOCKS
Growth in the broadest measure of China’s money supply has declined from 30 per cent year-on-year in December 2009 to 15 per cent year-on-year at the end of May. Bank loans fell 25 per cent in May, compared to April. Excavator sales fell 10 per cent in May from a year earlier, possibly foreshadowing a construction bust. The 14.3 per cent decline in the Shanghai Composite Index last year and the 10 per cent drop since mid-April also don’t bode well for growth.
Despite all these negatives, with recent data showing first-quarter GDP expanding by a still-healthy 9.7 per cent, and consumer inflation at its highest levels since July 2008, China has continued to tighten its economic policy. The government raised banks’ reserve requirements to 21.5 per cent in June, the ninth such increase since November. And it would probably continue to tighten until it sees decisive results, that is, a hard landing.
What will happen next?
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NO FLOATING YUAN
For one thing, even though a hard landing could cause hot money to flee the country and weaken the yuan, China will not float its currency. Many Western governments argue if China allowed the tightly controlled yuan to float freely, it would rise against the dollar and other major currencies. That, the thinking goes, would discourage exports, encourage imports and quickly eliminate China’s chronic trade surplus.
The Chinese have repeatedly told Western officials they would not be pushed into floating the yuan. They worry a jump in the currency’s value would wreak havoc on Chinese exporters and force them to move production to cheaper venues. A stronger yuan would also reduce the value of China’s foreign-currency reserves.
Furthermore, exchange rates have only limited effects on import or export prices and, therefore, imports and exports themselves. The key determinant of a country’s exports is the economic health of its trading partners. If their economies are robust, they buy more of everything, including imports.
The dammed-up zeal to own the Chinese currency would dissipate quickly if all barriers were removed and it became clear that a more expensive yuan was not ending China’s trade surplus. Pressure from foreign governments for a stronger yuan would then evaporate, as would interest in owning more Chinese currency in anticipation of higher values. And the removal of restrictions that prevent Chinese from diversifying their investments abroad might actually depress the yuan by encouraging money to flow out of China.
HOLDING TREASURIES
China also won’t be selling its $1 trillion in reserves of US treasuries in great amounts. The Chinese are well aware that doing so would be disastrous for their economy, because the resulting nosedive in treasury prices and the dollar would decimate the value of China’s remaining holdings of US debt and other assets. A global depression might well ensue, with China and other export-dependent countries as the biggest losers.
EXCESS CAPACITY
Instead, China’s most likely reaction—to focus still more on exports—will exacerbate its hard landing. If consumer spending doesn’t increase substantially in the next few years, China will have a serious problem using all the industrial capacity it has built, partly to keep people employed. Capacity is mushrooming so rapidly that even in China’s booming economy, most manufacturers still see flat or falling utilisation rates.
This unused capacity portends weak profits and trouble for the loans that financed it. My judgment is it would, once again, be used for exports aimed at the US and Europe. And once again, this would add to excess global supply and exert downward pressure on prices.
Then China, along with other export-dependent emerging economies, would be competing fiercely in a world of slow growth and deflation.
(The writer is a Bloomberg columnist)