Roach on China

The die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle
About six weeks ago, I threw in the towel on the ever-elusive China slowdown call (see my 21 October dispatch, “Wrong on the China Slowdown”). In doing so, however, I cautioned that we simply may have been too early in looking for a downshift in Chinese economic activity. Based on intelligence gathered during a recent visit to Beijing, I am increasingly convinced that is, indeed, the case. In my view, the die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle, driven by an important and surprising contraction in bank lending.
China’s booming investment cycle is on an unsustainable path. For 2005, we estimate that fixed asset investment is likely to exceed 46% of Chinese GDP -- astonishing by historical standards for China or any other economy. Given China’s special investment needs as a large developing country -- namely, urbanization, industrialization, and infrastructure -- there is every reason to look for an investment-led growth dynamic. But the Chinese investment cycle has gone well beyond what those fundamentals might suggest. Even in the heydays of their own development booms, the investment shares of the Japanese and Korean economies never got much above the low-40% range. I very much agree with Andy Xie who recently argued that China is now at a point where its ever-rising investment share is a recipe for excess capacity and deflation (see Andy’s 22 November dispatch, “China: Toward a Deflationary Landing”).
The consensus view in the markets is that China will sustain its investment boom through the 2008 Beijing Olympics -- that it will simply not accept the potential embarrassment of a growth slowdown until after that momentous event is over. Old China hands also note that the Chinese economy never slows immediately after the unveiling of a new development plan. With the 11th five-year plan covering the 2006-10 interval, this historical tendency also suggests any slowdown could be deferred until after 2007. Consider the implications of that possibility: If China stays the course of its investment-led boom, then the fixed asset investment share of its GDP could well be in the 55-60% range by 2008 -- a recipe for a monstrous overhang of excess capacity. With Chinese inflation already quite low -- the CPI increased at only a 1.2% y-o-y rate in October 2005 -- China is not that far away from outright deflation. Should its capacity overhang continue to build through 2008, a deflationary endgame in China would be more likely than not, in my view.
Nor would this be a great thing for the global economy. Despite its relatively small share in the global economy -- only about 5% of world GDP (at market exchange rates) -- China now spends more on fixed investment than any country in the world. In dollar terms, China’s fixed asset investment was running at an annual rate of close to $1,100 billion in the first three quarters of 2005 (at market exchange rates) -- in excess of annualized 2005 investment totals in the US ($987 billion), Japan ($733 billion), and the Euro-zone ($651 billion). If China’s investment boom remains unchecked and its currency continues to appreciate, its dominance in shaping the global investment cycle will only grow. This underscores the distinct possibility of Chinese-led gluts in worldwide capacity -- not just a problem for China but increasingly a deflationary risk for the global economy. In short, China’s investment-led growth boom is now in the danger zone.
So what stops it? The simple answer is one word -- reforms. Up until now, China’s investment binge has been funded largely by its “policy banks” -- huge organizations that were originally integral parts of the country’s central planning apparatus. China would, in effect, gather a massive reservoir of national saving, and the policy banks would then distribute the proceeds to state-owned enterprises, which employed and paid workers. Bank lending in China has not been a market-based, risk-adjusted credit allocation process. It was, instead, the open-ended state-directed funding of a state-owned economy. Unfortunately, given the precarious conditions of a largely unprofitable state-owned enterprise sector, policy lending was also a recipe for a huge build-up of non-performing bank loans (NPLs). Chinese reforms are bringing this vicious circle to an end. It started with an especially aggressive push toward state-owned enterprise reforms in the early 1990s -- shuttering the worst of the lot and privatizing the survivors (actually “corporatizing” since the state still maintains partial ownership). And now the reform process is moving into the next stage -- changing the funding mechanism by converting policy banks into commercial banks.
This could well be the tipping point for China’s runaway investment boom. The public listing of China’s policy banks changes the very character of the nation’s financing architecture. Charged with delivering profitability and shareholder value, publicly listed banks are bringing the days of open-ended policy lending to a close in China. Credit allocation must now follow the best practices of international commercial lending standards. So far, only one of China’s major policy banks has floated its shares, but two others are expected to follow suit within the next year. Collectively, these three institutions account for about 40% of total bank lending in China. The implications are that policy lending must give way to commercially viable lending. To do otherwise is a recipe for open-ended NPL creation -- an outcome that would represent a major failure for Chinese banking reform.
In my conversations with Chinese banking officials and regulators two weeks ago in Beijing, I got the distinct impression that this change in credit culture is now being put in place. Given the legacy effects of a state-owned economy and state-directed policy lending, this is not something the Chinese come by naturally. But there are two key elements of Chinese banking reform that are facilitating this dramatic transformation -- the first being the establishment of strategic partnerships between China’s policy banks and international commercial banks. Secondly, Chinese banking reform also entails the centralization of huge networks of branch banks. Between them, the three policy banks still have over 46,000 branches offices throughout China. Historically, these branches have had great autonomy -- closely tied to local governments and their local employment imperatives. As publicly listed companies, however, branch autonomy is now giving way to an increasingly centralized system of tight internal controls -- necessary not only for consolidated banking system efficiency but also essential for the efficacy of Chinese monetary policy.
There are signs that this dramatic shift in the Chinese bank lending culture is already working. A turn in the bank lending cycle may now be at hand. After peaking out at close to 5.5 times nominal GDP in 2003, total bank lending in China has since declined to around 5 times nominal GDP in 2005. This compression still has a considerable distance to go on the downside; after all, this same ratio was 4.5 times Chinese GDP as recently as 2000. As newly listed Chinese banks, along with those that are about to become listed, move to put their lending practices on a commercially sound basis, I suspect that the days of open-ended Chinese bank lending will quickly draw to a close. At that point, the excesses of a bank-financed investment boom will then come under increasingly intense pressure. All this points to a prompt and significant deceleration of runaway Chinese investment growth. As a senior Chinese banker put it to me over lunch in Beijing a couple of weeks ago, “Policy lending is out. Profitability and shareholder value are in. As commercial banks, our lending must slow. A big investment slowdown is coming -- sooner rather than later. I worry about Chinese growth in 2006.”
The cynics dispute this claim, arguing that the State won’t allow it. But in the end, the State can’t have it both ways -- drawing on international capital willing to bet on banking reform and holding on to uneconomic, state-directed policy lending practices. China doesn’t need 9%-plus GDP growth to keep the magic alive -- 7-8% will do just fine. A more rational, market-based system of credit allocation could go a long way in restoring sanity to an overheated Chinese investment cycle. The sooner the better, in my view. The alternatives of excess capacity and deflation -- and the hard landing that would then occur -- are unacceptable to Chinese reformers. We were wrong on the China slowdown call in 2005, but my guess is we were only early. In light of what I just learned about the rapidly changing bank lending culture in China, I am quite comfortable with the out-of-consensus possibility that Chinese GDP growth is about to slow into the 7-8% range.