The dragon economy is low on fire and Beijing will have to act fast if it’s to avoid an Olympic-sized currency crisis, says Tim Bennett.
As the 2008 Olympics begin in a largely smog-free Beijing – at least according to the official blurb – the ruling Communist Party is determined that the Games showcase China’s position as the world’s fourth-largest economy and international superpower. But while Beijing may have had some success with its ‘Great Firewall of China’ – an attempt to block websites critical of the regime in the run up to the Games – it’s much harder to hide the fact that, for the first time in two decades, the dragon economy suddenly looks pretty sickly.
It had all been going so well
With an official annual GDP growth rate of close to 10% since 1973, according to The Economist, China’s transformation from agrarian economy to industrial giant has been built on producing and selling low-cost goods on a vast scale and investing the proceeds in rapid state-sponsored infrastructure and communications expansion. In turn, the West has enjoyed cheap goods from China, offsetting the rising cost of the commodities needed to make those goods. Indeed, China and its fellow BRIC economies – rather than ex-US Treasury Secretary Alan Greenspan or ex-UK Chancellor Gordon Brown – can take most of the credit for what was, until last summer, a global ‘Goldilocks economy’ (not too hot and not too cold), coupling strong growth with low inflation. But the credit crunch has changed all that. While the US economy may be leading the current downturn, China’s economy faces a similarly toxic mix of slowing growth and rising inflation, but with precious little experience of coping with either.
Growth is stalling
“China has slowed down a lot already, but it’s going to slow down more,” says Hong Laing, senior China economist at Goldman Sachs. According to Standard Chartered Bank’s Stephen Green, China could lose 2-2.5% GDP growth this year, sending its overall rate tumbling from around 10.2% to just 8.6%. That’s still very strong and is above Beijing’s stated target of 8%, but is an alarmingly large slump for an economy that has come to perceive 10% as an average.
Reliable numbers are notoriously hard to find for the disparate Chinese economy, but other economic indicators point the same way – down. For example, while CLSA’s purchasing managers index for July “has remained above the no change level of 50 for 32 consecutive months” at 53.3, much of the underlying data shows shrinking employment, rising unsold stocks and falling order backlogs. The outlook “is much less positive than even one month ago”.
China has not decoupled
Decoupling – the theory that the emerging markets could escape the effects of a US-led recession, or even counter them – looks increasingly far-fetched. “If there’s an upset in one part of the world, it affects all other markets,” says Jonathan Compton of Bedlam Asset Management. Take stocks – institutional investors across the globe have been reducing their exposure since last summer. Emerging market stocks, seen as riskier than most, have been battered particularly hard as a result. According to Sujia Gong, writing for the New York-based Epoch Times, there are around 100 million individual investors in China who between them have lost an estimated five trillion yuan in the past year. That’s still a small chunk of a total population of around 1.3 billion, but for those who have been caught, losses work out at about $7,000 per investor. That’s roughly three years’ worth of average wages. No wonder the authorities are trying to prevent local fund managers from talking to the media while the Games are on.
Meanwhile, China has also failed to escape the global property slowdown that is crippling American consumer expenditure and is spreading around Europe. Lehman Brothers China analyst Mingchun Sun reckons prices have slipped 19% from their peak in Guangzhou, 9.5% in Beijing and 9.4% in Shenzhen, and are set to fall much further.
But while tumbling prices for shares and property are bad news for consumer spending in the cities, relatively few people outside them are directly exposed to either. Even in the cities, the crazy lending multiples that resulted in the US subprime mess are not prevalent in China. As Capital Economics points out, most city-dwellers have enjoyed rising real incomes for several years. In other words, China is not facing a consumer-led mortgage meltdown like America. Even so, bad debts will hit Chinese banks, for whom property-related lending accounts for around 18% of their loan portfolios, says Mingchun Sun. That will curtail their willingness to lend to the vital manufacturing sector. And it’s there, in China’s engine room, that the big problems lie.
Manufacturers are faltering
Something is going badly wrong in Guangdong province, described by BusinessWeek as the world’s “single biggest manufacturing base” for a host of electronic goods, shoes, toys, furniture and lighting. One factory owner may have exaggerated the region’s woes by saying “everyone is shutting down”, but times are certainly tough. The “official” China Federation of Logistics and Purchasing PMI recorded the first contraction since it began in 2005, falling to 48.4 in July from 52 in June. Six of the 11 sub-indices are now at record lows. The Federation of Hong Kong Industries expects 10% of all Hong Kong businesses in the Pearl River Delta to close this year.
This is down to a cocktail of factors that go far beyond the closure of construction sites and smog-producers for the benefit of athletes gathering in Beijing. First off, there’s the simple fact that the world’s main growth engine, the US consumer, isn’t buying as much stuff any more. Japan, for example, has already seen export demand waning – in June export earnings fell by 1.7% year-on-year, the first fall in 55 months.
To make matters worse, the rising yuan has also made exports more expensive for overseas customers, just as they are becoming more price-sensitive. Some argue that this shortfall in demand will be plugged by internal consumption, but this seems unrealistic. Emerging markets are growing rapidly, certainly, but according to Jim Walker of Hong Kong consultant Asianomics, Britain alone still consumes more than India and China put together.
Exporters also suffer from more localised problems. Power supplies are under growing pressure as China faces its worst power crisis since 2004, says Reuters. Power supplies in the Shandong province, a major industrial base in the East, are running at just under 30% of peak demand, with many generators lying idle due to coal shortages, malfunctions and lack of transport. Meanwhile, firms in other regions have been forced to close for up to four days a week to preserve power for residents and public amenities.
Another problem is that Chinese labour in key areas such as Guangdong just isn’t that cheap any more. This is partly due to rising wages – an unskilled worker now costs around 1,000 renminbi (£77) a month to employ, compared to around 500 rnb in Vietnam. Another factor is the cost of implementing a raft of new employee protection rights, and also new safety regulations, following catastrophic errors such as shipping poisonous dog-food and lead-painted toys to America.
The outlook for Chinese firms is “bleak”, says Edward Chancellor on Breakingviews. “Profits are set to be crushed by a combination of weak export growth and rising input costs”, while the slowdown will reveal the fact that the country has huge overcapacity, “in an economy which has relied on exports to absorb new supply”. Lehman Brothers goes as far as to say that “an export-led slowdown could trigger a chain reaction, which, in the worst case, could threaten the stability of China’s financial and economic system”.
Some firms will move to less developed, cheaper provinces within China, while more will simply close and make way (or so Beijing hopes) for higher-margin technology and service businesses. But creating these new industries will require time and massive investment, just as banks, under pressure to maintain minimum reserve levels, are becoming reluctant to lend. In the meantime, the authorities are facing another big problem: inflation.
The spectre of inflation
“We must… control excessive price rises,” said President Hu Jintao in a recent news conference, albeit without mentioning how. China, like much of the rest of the world, is catching an inflation bug. According to BNP Paribas analyst Charles Huang, China’s Consumer Price Index continues to rise at an annualised rate of well over 7%, hitting its highest level since 1996 in June, while headline producer price inflation surged to a series high of 8.8% last month. Sure, some prices have dropped – oil is well down from its peak of over $140 per barrel and pork prices dropped around 30% in June – but Chinese firms are now estimated to be raising the price of finished goods by an annualised 10%-20%. As a result, “unlike in the last 20 years, when China exported deflation, from now on China will export inflation”, says Peter Lau, CEO of giant Hong Kong clothing retailer, Giordano.
The traditional response to inflation is to tighten monetary policy to try to slow the economy down. And China’s authorities have been making a half-hearted attempt to do so. But the dilemma they face is that slower growth means fewer jobs. In the West, recessions tend to be bad news for the party in power. In China, a slowdown could mean revolution. The Chinese may be less willing to tolerate the restrictions of living under Communist Party rule if the government is no longer delivering new jobs and a better standard of living. That makes the idea of loosening monetary policy to fuel growth a lot more attractive. But the reality is that the authorities may not have as much control over their economy as they wish. China’s fate may be dictated as much by foreign speculators as by its Communist party.
The currency problem
As Bloomberg’s William Pesek points out, last week the yuan posted its biggest weekly loss since China scrapped its tight dollar peg to allow the renminbi to move within slightly wider limits in 2005. The fall came as the Politburo, the Communist Party’s top decision-making body “left little doubt” that the currency gains of recent years are over for now. From here, the emphasis is to be on “steady growth”.
The problem the Politburo has is that attempts to control inflation by letting the yuan appreciate much faster against the US dollar this year (it rose by 18% in the first quarter alone) in the hope of containing Chinese import prices are backfiring. That’s partly because a strong currency hurts China’s heavy industrial exporters, but also because it has attracted an international army of speculators betting on further rises, which has unleashed “the biggest wave of speculative capital ever to hit an emerging economy”, as The Economist puts it. Official dollar reserves jumped by $115bn during April and May alone. Beijing now has a total stockpile of $1.8trn.
Speculative inflows on this scale are proving harder and harder to handle. “Hot” dollars can be temporarily taken out of circulation by the government swapping them for yuan. But that means printing more yuan, which boosts the domestic money supply, running the risk of pushing inflation up. To stop that, Beijing has been mopping up extra yuan by selling government bills (IOUs) and raising the minimum reserve holdings imposed on banks. But that route – “sterilisation” – is becoming more difficult and expensive. The alternative, raising bank reserve ratio requirements, already hiked 16 times since January 2007, hurts bank profits, discourages lending and further impedes economic growth. The danger as growth stalls, says economist Brad Setser at the Council for Foreign Relations, is that Beijing may be tempted to “end appreciation altogether, cut rates and relax lending curbs” – an incendiary package that could risk pushing Chinese inflation up to the double-digit levels “seen in the Gulf”.
China is waking up, perhaps too late, to the fact that it is now more exposed to the “easy come, easy go” rules of global finance than perhaps any other country. Should the stalling economy prompt rash short-term policy decisions from a Beijing already “surprised by the size of the slowdown”, as Xing Ziqiang a CICC economist puts it, hot dollars could flood out of the economy as fast as they’ve been rushing in. The scene would then be set for an Olympic-sized Asian currency crisis that would dwarf 1998. As Edward Chancellor puts it on Breakingviews, “the Chinese business cycle usually ends in devaluations, not revaluations”.
None of this means the emerging market growth story is at an end. China will continue to be an important global player – the Chinese people won’t overnight turn their backs on consumerism and the march towards industrialisation. But in the forgiving economic environment of recent years, it’s been easy to forget that markets don’t move in straight lines. China remains an immature economy under a totalitarian leadership. There are many hurdles to overcome before it becomes the world’s largest economy and right now it’s set to stumble.
How to short China
Long term, we believe in both the Chinese growth story and the commodity ‘supercycle’. But in the short term, as the global economy goes into a slowdown, two asset classes in particular look vulnerable to further big falls: Chinese equities and global commodity prices.
Chinese stocks have already fallen significantly, but that doesn’t mean they can’t fall further. As Edward Chancellor points out on Breakingviews, “a sharp economic slowdown will dampen demand for commodities and bring more bad news to Shanghai’s beleaguered stockmarket”. For investors looking to play falling stock prices, shorting highly volatile individual Chinese shares is neither possible nor particularly sensible. However, there is the Ultrashort FTSE/Xinhua China 25 Proshare (AMEX:FXP), which offers twice the inverse daily performance of 25 listed Chinese firms and is up over 22% over the last three months. Be aware, though, that the expense ratio is high for an ETF, at 0.95%, and being in American dollars, the currency movements influence the performance for a British investor. Also, the gearing of two times makes even this diversified ETF quite volatile.
As for commodities, there are now a number of exchange-traded commodities (ETCs) offering inverse performance, so you can buy one and profit as commodity prices fall on the back of falling Chinese manufacturing demand. There are short ETCs on everything from aluminium to cocoa (see www.etfsecurities.com for more). However, as individual commodities can be pretty volatile, a better bet is a broader ETF, such as ETFS Short Industrial Metals DJ-AIGCI (LSE:SIME), which is also up 22% year to date. The expense ratio is once again on the high side, at 0.98%, but it remains a far safer way to play falling prices than spreadbetting, for example.