A P: China ? hard or soft landing

The odds favour China managing a smooth economic deceleration

Over the last month the debate on whether China will slow down or not has been conclusively answered in the minds of most investors. Just look at the downward price action in the H share index (Chinese companies listed in Hong Kong), as well as the reaction in global commodity prices.

Investors now finally believe that the Chinese leadership is serious when it talks about slowing down growth and making it more sustainable. The debate in fact has now shifted to whether the growth slow down will become a hard landing (sharp, quick deceleration) or can the Chinese authorities engineer a soft gradual deceleration in growth (soft landing).

Those who argue that China is overheating and in danger of a hard landing point to the current unsustainable rates of GDP growth, excessively high rate of investment, property price inflation and commodity price rise, all of which continue to accelerate despite the measures taken recently to cool the economy.

The starting point for the overheating argument is that China's GDP is currently growing much faster than the published 9.7 per cent (1st quarter, 2004), more like 11-12 per cent which is clearly unsustainable and above its potential.

This growth surge is being fuelled by an investment/GDP ratio of 45 per cent (higher than the Asian crisis countries before 1997) driven by bank credit.

Moreover fixed asset investment continues to accelerate, rising by 43 per cent in the 1st quarter of 2004. By 2007 many sectors including steel, autos, aluminium and textiles will double their capacity courtesy this boom.

In the case of real estate which accounts for about a third of all investment, property prices have risen by 20-50 per cent in many coastal cities including Shanghai. Prices have continued to accelerate in most cities despite measures taken in June 2003 to cool the property market.

Commodity price inflation over the last 12-18 months has been very evident. Led by China which accounts for between 40 per cent and 50 per cent of incremental demand, a whole range of industrial commodities like steel, copper, iron ore and lead have seen price increases of 50-90 per cent in the last 12 months.

The risks of this commodity inflation are twofold, either it will feed into consumer price inflation (CPI), forcing the Chinese central bank to raise rates, or it will crush corporate profitability and lead to further NPAs.

While the signs of overheating are apparent and China's history of boom/bust cycles points towards a hard landing, it may be premature to take a very pessimistic view. The current state of the Chinese economy is quite different from the massive overheating of previous cycles.

First of all inflation remains very low, with non-food CPI remaining around 0 per cent ( headline CPI is at 2-3 per cent), and despite rising commodity prices even PPI remains subdued at 3.5 per cent.

This is a far cry from the over heating cycles of 1985-1988 and 1992-1995, wherein inflation peaked at 28 per cent and 25 per cent respectively.

Inflation is critical, as an abrupt slump in economic growth or hard landing, is almost always caused by serious monetary tightening aimed at controlling inflation.

With inflation remaining subdued there is no need for the central bank to slam on the brakes, it can stretch out its tightening agenda in order to reduce the shock to the economy and bring about a slow and gradual economic deceleration.

Also this economic upswing is much less volatile than previous cycles. For instance GDP growth increased from 5 per cent to 14.5 per cent between 1982 and 1985 and from 4 per cent to 14 per cent between 1991 and 1993.

Compared to those periods, the current upswing which began in 1999 and has seen growth rise from 7 per cent to 10 per cent is quite subdued. Given the lower volatility of the upswing, the natural tendency of the economic deceleration is also to progress smoothly.

Another difference is that the rapid growth in investment this cycle may not be totally irrational. Over 20 million Chinese move to the cities every year currently ( it was less than 10 million in the 1990s), this number will continue to increase as the government relaxes its household registration system.

This migration coupled with the liberalisation of consumer finance has led to strong demand for infrastructure and durable goods partly supporting this investment surge. Investment is also more balanced between the public and private sectors, unlike in 1992-1995 when it was entirely state driven.

One more mitigating factor is that the problems of overheating are confined to certain pockets of the economy. Property for example, despite its upward move has become more and not less affordable in 31 out of 35 cities where property prices and incomes are tracked.

Thus while the chances of a hard landing cannot be totally dismissed, the odds still favour the Chinese authorities being able to engineer a gradual deceleration.

The current overheating in China is confined to only a few sectors and is much milder than previous cycles. One can also argue that the government is acting much earlier in this cycle, much before things have gone out of control.

The reason the economy has not shown any significant signs of slowdown yet is simply that the Chinese authorities did not fully start to clamp down till February 2004 (lowering M2 and loan growth targets and hiking bank reserve requirements).

There is a good chance these measures will be effective as the big four banks in China (accounting for 60 per cent of total loans) are likely to be self motivated to limit loan growth as they approach their IPO deadlines. The latest measures to differentially raise reserves for weaker banks will also force them (weaker banks) to come in line.

Interest rate hikes are possible, but likely to be a last resort as inflation is benign and the government is worried about deflation reappearing if the economy slows too rapidly. It is also a very blunt instrument to counter selective over-investment, and will only exacerbate the FX inflow issues.

While the government will continue to implement measures to curb investment growth, it is simultaneously trying to boost consumption, through improving rural incomes and improving access to consumer credit. If successful this will ensure that domestic demand growth is stable and the economic slowdown far more manageable.

The biggest fear of the hard landing camp is the difficulty the central government has in controlling investment due to China's political structure. Because provincial and local officials are still by and large promoted and judged on the basis of economic growth, they often duplicate investments.

For example China has 120 auto companies, 130 aluminium plants, 4,000 cement factories and massive fragmentation due to this phenomena. Indeed almost all of the investment growth so far this year has come from the local governments(60 per cent growth year-on-year, January-February, 2004) in defiance of central government orders to scale back.

Premier Wen's attempt to assess provincial leaders more on social/environmental issues rather than just economic growth should hopefully temper irrational investment behaviour at the local government level.

Thus while the consensus is leaning more and more towards a hard landing for China, I feel the odds actually favour China pulling off a slow and gradual economic deceleration. While this outcome may still not make China shares good investments, the prospects for the rest of the region improve considerably.