China always surprises. It did it again last week.
Not the Google spat. The authorities have always tried to restrict the US firm and favour local rivals. No, it was the central bank’s decision to raise the reserve requirement ratio (RRR). It makes for a less exciting headline, but it could mean a lot more for the Chinese economy.
The RRR sets the amount of funds that a commercial bank has to keep with the central bank as a percentage of its deposits. Raising the RRR effectively reduces the amount that a bank can lend. So this is China’s first step towards tightening monetary policy.
That’s a very encouraging move. In the past, I’ve said that the biggest risk in China is that the authorities let the stimulus carry on too long and allow the economy to overheat. The fact that they are tightening now suggests that this probably won’t be allowed to happen – and that should dampen some of the more extreme fears about a China bubble…
Are there any bubbles in China?
First, why should investors worry about monetary policy in China being too loose? At the end of 2008 the authorities removed restrictions on how much banks should lend, especially to sectors such as real estate, where they had tightened hard the previous year. They instructed the banks to lend, hoping that the flow of credit would ease the economy through the global recession.
China’s banks are still majority state-owned and take their orders from the government at a time like this. So they did as they were told. And as you can see below, outstanding loans are up more than 30% year-on-year.
Figure 1: Outstanding loans in China year-on-year growth
This drove a strong economic turnaround at a time when China’s key export markets were still in severe recession. But it also led to fears that the money was being wasted. More bearish analysts pointed to strong rebounds in the stock and property markets as evidence that much of the lending was simply creating asset bubbles. Meanwhile, the money that wasn’t flowing into these channels was being invested in areas where China doesn’t need more investment.
The accuracy of these criticisms is mixed. Sure, the stockmarket rebounded very strongly (see below), but so did stockmarkets everywhere. The CSI 300 index is on a price/earnings ratio of 18 times forecast earnings. It’s hard to argue that this is a bubbly valuation for an economy with China’s growth rate.
Figure 2: The CSI 300 has rebounded strongly
With property, the situation is more nuanced. As I’ve said before, China’s residential property market is complex. It’s a mistake to look at apparently high house price-to-income ratios and conclude there’s a bubble. But there are signs of bubbly prices in some hot markets. The authorities have tried to contain this by raising minimum deposits and removing tax breaks among other things.
This is definitely a tricky line to tread. Residential construction has been a major driver of the rebound and is a key employment sector. Clamp down too hard and the sector will have a hard landing – as it did from the end of 2007. Don’t contain the excesses and it will eventually turn into a bubble. This is probably the area where policymakers are most likely to get it wrong, simply because it’s very hard to get it right.
A glut of shopping centres
There are stronger signs of a bubble in commercial real estate (CRE) – or more accurately, a burst bubble. Far too many new offices and shopping centres were built in the last few years and supply is way ahead of demand, leading to extremely high vacancy rates. Figures of 30% or more get bandied around for offices in some major cities.
I’m not talking about projects like the infamous South China Mall in Dongguan. That’s not an investment. It’s a giant folly like London’s Millennium Dome, done by a local businessman who wanted to show what a big shot he’d become. (If you haven’t seen this story, there’s a good video clip here).
Rather, if you go around many shopping centres that are theoretically in the right places (i.e. in big wealthy cities such as Beijing and Shanghai where there are potential buyers) they’re still severely underused. Even the units that have been let to retailers often see little traffic. The reason? There just aren’t enough affluent people in China yet to shop in these places.
But this problem was created before the global recession. And at least there isn’t much sign of a rush into starting new CRE projects (although ones started before the bust are still being finished and will add to supply in the next couple of years).
More worrying would be a flood of investment in industries such as steel. In recent years, China has built up significant excess capacity in these sorts of heavy industries. In fact, it has switched from being a net importer to a significant exporter (see chart below from UBS). Obviously, investing in yet more capacity would be a waste. On top of that, efforts to dump the surplus in export markets would make trade tensions worse.
Figure 3: China has switched from being a net importer to a significant exporter
China still needs more investment
But so far, there isn’t a lot of evidence that industries like steel are where the money is mostly going. As the chart below from The Economist shows, the big rise has been in infrastructure spending. This is something that will benefit China in the long run.
Figure 4: China has seen a big rise in infrastructure spending
Some analysts point to the country’s extremely high investment levels for the last couple of decades and question whether there can still be any need for more infrastructure. After all, in duration and intensity, China’s investment boom exceeds anything seen elsewhere in developing Asia.
Figure 5: China’s investment boom (via Pivot Capital)
But comparing China to Korea or Thailand misses the point. China was extremely backward three decades ago. It has a huge population spread over a vast area. Some parts are now relatively developed, but others have seen little improvement since reforms began. It has a lot of catching up to do.
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So, for example, plans to build a high-speed rail network across the country by 2012 are not obviously wasteful. New infrastructure may not pay for itself immediately when linking areas that don’t yet need it. But it will help to speed up development in those areas and so pay off in future growth.
Of course, just arguing that China has plenty of scope to invest doesn’t mean that the investments being made are sound. Undoubtedly there will be some malinvestment. So how do we know that doesn’t account for most of it?
That’s a tough one. Signs of overinvestment such as empty offices or inefficient steel plants are obvious and always get attention. Investments that work don’t stand out so readily. However, we can say that studies generally don’t support the idea that China’s heavy investment in recent years has been squandered. For example, the return on invested capital in China seems to have been stable and in line with the rest of the world in recent years. We would have expected it to fall if there had been a high level of waste.
We’d also expect to see weak or negative growth in an economic variable called total factor productivity growth. This essentially measures improvements in efficiency and technology in an economy. However, estimates by Andrew Cates of UBS suggest that China has had the highest total factor productivity growth among emerging markets over the last two decades.
This doesn’t rule out serious mistakes in the latest investment boom. But it suggests that so far Chinese investment has paid off. It’s probably worth extending the benefit of the doubt for now.
The economy mustn’t be allowed to overheat
The idea that China is in a Japan-style trap, building bridges to nowhere in a effort to keep growing, is misleading. I’ll look at Japan’s lost decade again in a future article but the similarities between the two countries are small. If there is any useful comparison to be made, China today is probably more like the Japan of the sixties than the eighties.
However, it’s not impossible that China could develop into a bubble in the next couple of years – one that would produce a hard landing, although not a Japan-style bust. This would happen if policy is not tightened strongly enough and the economy is allowed to overheat.
Why is there a risk of this? Bear in mind the limits to China’s growth. Domestic consumption in China has been growing at around 8% a year in recent years. It’s unlikely to grow any faster than that in the future. GDP growth has been significantly higher than this only because of rapid growth in exports and investment into export capacity.
As the leading low-cost producer, China may still be able to grow its share of world exports from here. But if it tries to expand them too much it will create a lot of aggravation. It certainly doesn’t need to invest as much in export capacity as it has done, although it can invest in higher-value industries.
There is plenty of scope for investing in infrastructure – rail, power, water, waste and environment, low-to-middle end housing among others – and welfare services such as education and healthcare. But there’s a limit to how much and how quickly this can be done.
So without the export engine and without the ability to increase infrastructure investment indefinitely to compensate, China’s sustainable growth rate is probably lower than we’ve become used to – maybe 8-10% rather than 13%. That’s still impressive by global standards and will deliver good returns – as long as China accepts that’s the limit.
We can’t call a bubble this far in advance
If it recognises that restriction, it will need to continue tightening over the next year or so to stop the economy overheating. This could cause some pain. Growth may dip below 8%. If there are bubbles in some residential property markets, speculators will lose money when they burst.
Meanwhile, banks will eventually have to face up to bad loans on their balance sheets. And there are probably quite a lot of these. The lending boom has probably allowed many non-performing loans to be rolled over and kept current, but ultimately the losses on those overbuilt offices and shopping centres will come out.
The authorities may be unwilling to face up to this and decide to keep policy loose for too long. If that happens, China will be heading for a credit-fuelled bubble that will probably burst fairly spectacularly. I know some investors who are convinced this will happen and are holding back, anticipating that the aftermath will be a great buying opportunity.
They may be right. But that depends on what policies China follows in the next year or so. And no investor has any idea what the thinking is in Zhongnanhai. If the government gets policy more or less right, investors who wait for a serious crash will look back in a decade’s time and see a missed opportunity.
To me, it makes more sense to be invested in China, but to be always suspicious that a bubble is developing – and to get out at the right time if it does. Of course, the tighter policy gets over the next few months, the less likely that outcome will be.
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