Re: China Holds Up The Sky

On Thu, 27 Sep 2007 19:15:37 GMT, PaPaPeng <PaPaPeng@xxxxxxxxx> wrote:

World economy

Stronger China
Sep 27th 2007
http://www.economist.com/opinion/displaystory.cfm?story_id=9867004
From The Economist print edition

Thanks to China, an American recession need not cause the whole world
to crash


Follow up article:-

China's economy

How fit is the panda?
Sep 27th 2007 |
http://www.economist.com/finance/displaystory.cfm?story_id=9861591
BEIJING
From The Economist print edition

China's booming economy is helping to support global growth as America
turns sickly. So now it has to keep up the pace


NO COUNTRY in history has sustained such a blistering rate of growth
over three decades as China. Its economy grew by a staggering 11.9% in
the year to the second quarter. Since 1978 it has grown by an average
of almost 10% a year—more than Japan or the Asian tigers achieved over
similar periods when their economies took off. But eventually every
sprinter trips. Japan's growth averaged 9.5% in the two decades to
1970, but slowed to 4.7% in the 1970s and to only 1% by the 1990s.

As China has grown, it has come to matter much more to the rest of the
world. For the first time it is now contributing more to global GDP
growth (measured at market exchange rates) than the United States is.
Yet, even as growth forecasts for China are being revised upwards,
America is looking at a downturn caused by falling house prices, which
threaten to clobber consumer spending. The fate of the world economy
now hinges not just on America, but also on China's economic fitness
continuing over at least the next two years.

So what immediate threats does China face? The biggest worry is that
the economy is overheating and inflation surging out of control. In
August consumer-price inflation jumped to 6.5%, up from 1.3% a year
earlier and its highest for more than a decade. If China slams on the
brakes, its economy could suffer a hard landing, as happened after
past episodes of inflation.

But inflation is nowhere near previous danger levels in 1988 and 1994,
when it soared above 25% (see chart 1). Moreover, the leap in
inflation does not seem to be a symptom of overheating caused by
excess demand, as it was in the past. It is due entirely to the rise
in food prices caused by supply-side problems. Excluding food,
inflation is only 0.9%. This does not mean that food is unimportant:
it accounts for one-third of the inflation basket, and rising prices
could trigger social unrest. But it is not something that China's
central bank can easily fix by raising interest rates. The bank has
raised interest rates five times this year, but they still remain low
relative to the country's growth rate.

Growing public concerns over inflation recently prompted Beijing to
introduce a freeze until the end of 2007 on a wide range of
government-controlled prices, such as oil, electricity and water. A
more effective way to curb inflation would be to allow the Chinese
currency to rise faster. This would reduce import prices of food and
raw materials and also curb the build-up of liquidity as a result of
rising foreign-exchange inflows.

Unless checked, excessive monetary growth combined with over-rapid GDP
growth could eventually lead to more general inflationary pressures.
In its latest “China Quarterly Update”, the World Bank says that in
the first half of 2007 China grew faster than its potential growth
rate (currently estimated at around 10.5%) for the first time in a
decade (see chart 2). However, excess demand is tiny compared with
previous phases of overheating so the risk of soaring inflation
causing a hard landing in the near future is remote.

Bubble trouble
A second much-talked-about threat is the bursting of China's
stockmarket bubble. Share prices have risen by 400% in just over two
years, and average price-earnings ratios based on historic profits are
around 50 (based on forecast 2008 profits they are a still-racy 30).
Even though almost everyone reckons this is a bubble, history suggests
that a bust is not imminent and that share prices could continue to
rise for a lot longer: both Japan's Nikkei and America's NASDAQ saw
p-e ratios well above 100 at their peaks.

Even if share prices did tumble this year, the impact on the economy
would probably be relatively modest. The total value of tradable
shares—that is, excluding those held by the government—is only 35% of
GDP compared with 180% in America at its peak in 2000. Equities
account for less than 20% of Chinese households' total financial
assets, compared with half in America, so price swings have less
impact on spending. When Chinese share prices collapsed by 55% from
2001 to 2005, GDP growth remained robust. Over the past year there has
been little sign that people are saving less and spending their
capital gains, so a slump in share prices should not have much impact
either.

Share prices can also affect the cost of capital. But only a small
proportion of Chinese companies are listed on the stock exchange and
those that are rely mainly on internal finance. Only 10% of total
financing for investment this year has come from equities. A more
serious problem is that because firms have invested in other
companies' stocks, a slump in share prices could directly hurt their
profits and hence their investment. According to a study by Morgan
Stanley, one-third of listed companies' profits in the first half of
2007 came from share-price gains and other investment income. If share
prices sink, so will profits, which would make shares look even more
overvalued.

Some analysts also worry that a sharp plunge in equity prices could
seriously hurt banks' balance sheets, causing them to squeeze their
lending. Chinese banks are officially not allowed to lend to investors
to buy shares, but anecdotal evidence suggests that households and
firms have taken out loans disguised as mortgages to buy shares. If
so, the effect of the bubble bursting could be larger than the direct
impact on consumers' wealth—especially if, as seems more likely, the
bubble continues to swell for another couple of years before it
finally bursts.

In many ways China today looks ominously similar to Japan before its
bubble burst at the start of the 1990s, resulting in a decade of
stagnation. Like Japan, China has high rates of saving and investment,
low real interest rates, soaring asset prices, a big current-account
surplus and upward pressure on its currency. After the Plaza accord
between the big industrial countries in 1985, the Japanese yen rose by
80% against the dollar in three years.

Many in China have concluded that the blame for Japan's economic
malaise in the 1990s lay largely with the appreciation of the yen.
Beijing has therefore allowed the yuan to rise by only 10% since July
2005. But Japan's real mistake was its loose monetary policy to offset
the impact of the rising yen—which further inflated the bubble—and
then its failure to ease policy once the bust had happened. By holding
down the value of the yuan and allowing a consequent build-up of
excess liquidity, China risks repeating the same error.

However, Paul Cavey, a China economist at Macquarie Securities,
suggests that China may have more in common with Taiwan in the 1980s
than with Japan. Taiwan's bubble was even bigger, with share prices
rocketing by 1,800% between 1985 and 1990. In Japan, reserve
accumulation did not play a big role in the bubble. By contrast, the
foreign-exchange inflows into Taiwan were greater in relation to its
GDP than those seen recently in China. Taiwan, like Japan, saw a big
rise in its exchange rate, by 60% in the four years to 1989.

In 1990-91 the Taipei stockmarket slumped by 75%, even more than the
Tokyo market did. But Taiwan's growth remained fairly strong because
policy was eased much sooner than it was in Japan. In other words,
contrary to Beijing's fears, a big exchange-rate rise does not
inevitably lead to economic depression.

The other big difference between China and Japan in the late 1980s is
that Japan had a serious property bubble against which banks had lent
heavily. Although a house-price crash would have much nastier
consequences for China's economy than a share-price crash, because 80%
of China's urban households now own their home, there is no evidence
of a nationwide housing bubble. Average house prices across China are
rising at an annual rate of 8%, with double-digit gains in some
cities, such as Shenzhen and Beijing.

In a developed economy such increases might seem a little bubbly, but
not in one in which nominal GDP is growing at an annual pace of 15%.
The ratio of house prices to average income has fallen by 25% in China
since 1999. In contrast, at their peak last year American house prices
had risen by 45% relative to incomes. A collapse in house prices
therefore seems unlikely in China.

If America sneezes
If neither a surge in inflation nor a bust in asset prices seem likely
to derail China's economy over the next year or two, what about a
recession in America? Exports account for over 40% of China's GDP, so
some economists predict that a fall in exports as a result of a
downturn in America would create massive excess capacity and a sharp
fall in profits and investment—the making of a nasty hard landing. But
the popular notion that China is dependent on export-led growth is a
myth; domestic demand is much more important. This year the increase
in China's net exports (ie, less imports) is likely to account for
about one quarter of its growth—a record amount. But even without this
external boost, GDP growth would still have been a respectable 9%.

During America's 2001 recession, China's export growth fell by 25
percentage points, but imports also slowed sharply, so GDP growth (as
officially reported) remained strong. Since then, the share of its
exports to America has shrunk; the European Union and other emerging
economies are now more important markets. In the three months to
August, Chinese exports to America increased by 14% compared with a
year earlier, whereas those to the EU grew by 40%.

America's slowdown so far largely reflects a collapse in
house-building, but if consumers cut their spending, the impact on
Chinese exports would be harsher. The World Bank estimates that if
American consumption falls by the equivalent of 1% of GDP, this could
knock 0.2-0.5 percentage points off China's GDP growth, depending on
how much the Federal Reserve does to cushion the downturn.

A recession in America would reduce China's growth, but since
Beijing's policy-makers are fretting that the economy is starting to
overheat, weaker exports and hence slower GDP growth might be a good
thing. Not only would it reduce the risk of inflation, but it would
also help to trim China's embarrassing trade surplus.

If a fall in exports threatens to slow growth by more than desired,
the government's strong fiscal position means that it has plenty of
room to boost domestic demand by spending more on infrastructure,
education or health. The budget was in small deficit in 2006, but may
now be in surplus—even excluding the large surpluses of state-owned
enterprises. China's public-sector debt is only 18% of GDP, much lower
than the 75% average in developed economies, giving the government
ample room for a fiscal stimulus.

In the short term, therefore, an American downturn is more likely to
cause sniffles in China than a heavy cold. Indeed, an American
recession might be a blessing in disguise to China: if weaker exports
forced the government to do more to boost domestic demand it would
help to rebalance the economy and make growth more sustainable in the
long run.

The bigger danger is that an American recession would inflame
America's increasingly protectionist mood and make trade sanctions
against China more likely. In an election year, politicians will need
a scapegoat. But import barriers would do more harm to America's
economy than China's. If China was forced to depend less on exports
and more on consumption it would gain in the long run.

Running out of fuel?
In recent months there has been much talk about a new threat. China,
it is claimed, is running short of cheap labour—the main source of its
extraordinary growth. This is nonsense. It is true that average wages
have risen by around 15% over the past year, but labour productivity
in manufacturing has risen even faster. Indeed, wages have been rising
at double-digit rates for a decade with no harmful impact on growth,
because higher labour productivity has actually reduced wage costs
(see chart 3). There are localised skill shortages, but it is hard to
believe that China's labour surplus is exhausted when almost 60% of
the population still lives in rural areas. The wide income gap between
rural and urban areas will continue to attract workers from farms to
factories.

In any case, it is not true that China's growth has been based
primarily on cheap labour. Over the past decade, the increase in the
labour force has contributed an average of only 1% a year, or
one-tenth of its GDP growth. It is true that the population of working
age will peak by 2015 and then start to shrink. But an analysis by the
World Bank argues that China is unlikely to face a labour shortage for
many years. The decline in the working-age population can be offset by
making it easier for surplus labour to migrate into cities.

One thing China does not seem short of is capital investment. Indeed,
some economists have long predicted that overinvestment as a result of
an artificially cheap cost of capital will lead to China's downfall.
Sooner or later, it is argued, overcapacity will lead to a plunge in
capital spending, bringing the economy crashing to earth.

According to government figures, China's investment amounts to over
45% of GDP and is growing at 25% a year. But many economists reckon
that is grossly overstated. For example, land purchases are wrongly
counted as new investment when they are really just a transfer of
ownership. If China were massively overinvesting, one would expect the
return on capital to be falling. Instead, corporate profit margins
have been rising. Mr Cavey estimates that average capacity
utilisation, measured by the ratio of sales to assets, has been rising
not falling—in strong contrast to Japan during its 1980s bubble.

Worries about rising excess capacity feed another long-standing
concern that China's banks, groaning under the weight of
non-performing loans, are heading for a crisis. Official figures show
that non-performing loans had fallen to 7% of all loans early this
year from almost 30% in 2001. But independent analysts suggest the
true figure may be closer to 20% (down from over 50% at its peak). The
fear is that an economic downturn and falling profits could lead to a
surge in new bad loans.

China's fragile and inefficient banking system is certainly a drag on
its economy, but the risk that a banking crisis could bring down the
economy seems small. China has huge foreign-exchange reserves
available to protect its banking system. Capital controls limit
capital flight. And the government, unlike Japan's in the 1990s, has
plenty of money if necessary to write off bad loans.

The list of potential threats to China's economy is long and some
might shave a couple of percentage points off its growth rate (leaving
it close to 10%). But none seems likely by itself to cause the economy
to collapse in the next two years—ie, during the time when America's
economy is likely to stumble. But what if several blows land at the
same time? For example, an American recession breeds greater
protectionism, global financial turmoil unnerves Chinese stockmarket
investors, share prices collapse and a downturn creates social unrest.
The overall impact on the economy would then be more painful.

China's best insurance against this is that its budget finances are in
better shape than those of any other big economy. China's leaders are
acutely aware of the risks of social unrest and they will be willing
and able to try to spend their way out of trouble. That makes a sharp
downturn in China less likely in the near future. But what about
farther ahead?

China's economic success has been based on the essential ingredients
of growth: high savings, openness to trade, good education and strong
productivity growth. This means its long-term prospects remain strong,
although its trend growth rate will inevitably slow as its economy
matures and its labour force starts to shrink.

Tao Wang, Bank of America's economist in Beijing, says she is
optimistic about China's economy in the short term and the long term,
but thinks the medium term looks risky. There is a high chance of a
sharp slowdown sometime within the next ten years. The problem with
years of rapid growth is that it hides problems that are then
painfully exposed when times are hard. But for the time being, the
chances are that China can keep sprinting even if America takes to its
sick bed. That is good news for the world.


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