China’s Growth is Neither Surprising Nor Cause for Celebration

Although I am often surprised by how eagerly foreign commentators have embraced the Chinese fiscal stimulus story and see it as a great, shining success, I am happy to say, mercifully, that in China there is a lot more skepticism. There seems to be a serious debate among Chinese policymakers over the stimulus package.

The debate lists, on one side, people centered on the PBoC, the CBRC and the National Bureau of Statistics, who are worried that the stimulus may be exacerbating Chinese imbalances. On the other side are people in the State Council, the Ministry of Commerce and in the provincial and municipal leadership who are more worried that any half-heartedness will lead to a significant rise in unemployment.

In the past week or so the former, with whom I am of course in complete sympathy, seem to have become increasingly worried and have been making a lot of noise. The formidable Hu Shilu, editor of Caijing, (and by the way Evan Osmos wrote a very interesting article about her in the current New Yorker) recently made a strong case against continuation of the current fiscal program when she wrote in an editorial this week that “a policy that encourages loose lending and investment is driving China’s economic engine down an old, unsustainable path.”

Various signals suggested China’s economy had returned to a stable track by the end of the second quarter, giving us an opportunity to reassess macroeconomic policy. Data released by the National Bureau of Statistics showed that China’s GDP rose 7.1 percent in the first half of the year, and 7.9 percent in the second quarter alone. Apparently, China’s economy has bottomed out.

Arduous efforts contributed to this upward trend. External developments have had a much more serious impact on China’s economy recently than during the Asian Financial Crisis a decade ago. However, first half growth was only a bit below the level recorded in 1998. And although heavily dependant on exports, China may yet achieve its 2009 growth target of 8 percent, even while other major export countries report contractions.

These achievements could intoxicate Chinese policymakers. But we see no miracles here. In fact, economic growth recovery in China is being driven by investment. Some 6.2 percent of the country’s first half GDP growth rate can be credited to investment, while consumption accounted for 3.8 percent. The net export business contributed a minus 2.9 percent to the growth rate figure.

Hu makes the point that the “surprisingly high” Chinese growth is neither surprising nor cause for celebration. It is the automatic outcome of a huge stimulus, and the real question, as I have argued many times, is not whether high current growth indicates that China has turned the corner on the crisis (it most certainly has not, in my opinion), but whether the cost of achieving this growth is excessive and will lead to more difficult conditions in the future.

It’s long been acknowledged that China’s traditional methods of achieving economic growth cannot be sustained. However, we are now racing down this traditional path of economic development.

Dramatic increases in the currency supply and lending have been backing this investment, the single most important engine of economic growth. M2 increased 28.5 percent and yuan-based lending rose 34.4 percent in the first half, setting new records for each. But nominal GDP growth was only 3.8 percent during the first six months of 2009. And these astronomical increases in currency and lending are a double-edged sword that can support GDP growth as well as endanger the economy.

…It’s high time we re-emphasize the actual policy of moderation. A moderately loose monetary policy is necessary for an unpredictable, downward-sloping economy. However, monetary policy that’s too loose will have more drawbacks than merits once an economy levels out. It’s only a matter of time before loose monetary policy leads to inflation and asset bubbles.

She concludes, very diplomatically I think:

In the current economic environment, the more quickly China’s economy grows, the greater the effort needed to adjust future methods of economic development. Now is the right time to consider the timing of exit from stimulus. The third quarter can be a crucial juncture.

She is not alone in criticizing the stimulus. Another formidable lady, Wu Xiaoling, former People’s Bank of China vice governor, was interviewed by National Business Daily on Wednesday, and warned that the combination of excess capacity and excessively loose monetary policy was leading to asset bubbles. According to an article in yesterday’s South China Morning Post,

“Under conditions of overcapacity, excess money supply will not lead to rises in price indexes, but it could generate asset bubbles,” she said at a forum in comments reported by the Chinese-language National Business Daily. “The money has really gone out and if it is a time when there is no investment in the real economy and no one will put the money in banks to earn interest, then the funds will flow into the property market and stock market,” she said.

China’s central bank may have to raise banks’ reserve requirements to mop up excess liquidity, she said, adding that this was simply a tool for managing the money supply and should not be misunderstood as monetary tightening.

…Ms Wu said that China faced a dilemma in easing the rate of loan growth. Inflationary pressures would arise if lending continued at the same pace, but without sustained lending, many big projects may wind up unfinished because they are contingent on longer-term financing.”

Although an increasingly large number of Chinese academics and think tank researchers have been raising warning cries, I think she is the first official or ex-official to go so public with her worries. That doesn’t mean other public officials don’t act as if they are worried. The CBRC for example announced this week the good news that the NPL ratio declined from 2.42% at the end of 2008 to 1.77% at the end of June.

Part of this reflected an actual decline in NPLs, and most of it of course reflects the surge in new loans, but the CBRC is not acting complacent. They have reinforced credit control policies on second-home purchases and their spokesman insisted earlier this week that there would be “strict enforcement” of the CBRC’s mortgage lending policy.

According to another article in Caijing, “the authorities have consistently been encouraging banks to raise their loan-loss coverage, reflecting fears that the massive surge in new credit extended in the first half may lead to a rise in bad loans.” The South China Morning Post had this to say on that subject:

Beijing has required banks to raise their bad-loan reserve ratio to 150 per cent at the end of the year, forcing the lenders to set aside an additional 70billion yuan ($79HK.4 billion) as provision amid deteriorating asset quality, a fresh sign of China’s mounting worries about a backlash from its stimulus package.

Liu Mingkang, the chairman of the China Banking Regulatory Commission, told a government working conference over the weekend that all mainland-based banks including local units of foreign giants such as Citigroup and HSBC Holdings must boost their reserve ratio to 150 per cent, as risks were increasing amid a torrent of imprudent loans in this year’s first half.

“Rapid growth in banking loans has led to accumulated risks,” Mr Liu was quoted in a CBRC statement as saying. “Reckless operations of banks were seen as some banks rushed to extend loans without due diligence.”

The article goes on to quote She Minhua, a banking analyst at China Jianyin Investment Securities as saying “The requirement is basically a message that asset quality deterioration is deepening. A serious problem will probably surface in 2010.”

And Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said earlier this week that China, the world’s largest steel producing nation, should curtail “reckless investments” in the industry by withholding project approvals. According to an article in Bloomberg:

China’s demand for steel is about 500 million metric tons, less than the annual output capacity of 660 million tons, Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said at a conference in Beijing today. Zhu is reiterating figures given by the China Iron & Steel Association in February for last year.

Crude steel output in China rose to a record 266.6 million tons in the first half as the nation’s $586 billion stimulus package spurred demand from builders and carmakers. Annualized, this would beat the 460 million tons output forecast by the steel association for this year.

“The industry must produce according to market needs, and avoid adding to the excess capacity,” Zhu said. “They should avoid reckless investments. The government must also take action to curtail additional investments by companies that are already in excess.”

Even Justin Lin, the World Bank’s chief economist, and someone who has been more of a cheerleader for China’s economic model than a critic, made a statement that suggests to me an indirect criticism of the fiscal stimulus package, although he (and others) may disagree with my interpretation. According to a July 15 article in the Telegraph:

Justin Lin, the bank’s chief economist, said factories running idle around world threaten to trap economies in a vicious cycle, risking further spasms of financial stress, requiring yet more rescue packages.

“Significant excess capacity has been built up and unless this issue is addressed, we will face a deflationary spiral and the crisis will become protracted,” he told an audience in Cape Town.

Mr Lin said capacity use had fallen to 72pc in Germany, 69pc in the US, 65pc in Japan, and as low as 50pc in some developing countries, mostly touching lows not seen in modern times.

The traditional cure for countries caught in slumps is to claw their way back to health through devaluation, but this cannot be done today because the crisis is global. “No country can count on currency depreciation and exports as a way out of recession. Unless we deal with excess capacity, it will wreak havoc on all countries. There is urgent need for global, co-ordinated fiscal stimulus,” he said.

But for all the warnings I don’t want to exaggerate my account of rising skepticism among Chinese economists and regulators. In spite of possible back-door attempts by the PBoC and the CBRC to manage the excesses associated with the fiscal stimulus, it is pretty clear I think that policy is still being managed largely by policymakers who are far more worried about rising unemployment in the short term than about asset bubbles and an exacerbation of the unbalanced development model.

The front page of today’s People’s Daily, for example, makes this clear. They cite Finance Minister Xie Xuren’s insistence that “China will stick to proactive fiscal policy in the second half.” According to the article, which is also carried in Xinhua:

China will continue its proactive policy and reform its economic structure in the second half of this year to boost economic growth, Finance Minister Xie Xuren said Thursday.

Xie told local financial bureaus at a conference in Beijing on Thursday that the proactive policies, which included increased investment from government, tax cuts and subsidies to low income families, had taken effect in stimulating a recovery of the national economy.

Xinhua today also prominently cites Peking University professor Li Yining as saying that “China should stick to its proactive fiscal policy and moderately easy monetary policy to fuel the economic growth as the foundation for recovery is not solid yet.” I was not at the conference, so I wonder if professor Li’s comments were spun a little, because according to the Xinhua article he also said that “the current economic advance was pushed by investment, which was not the final demand – stable economic recovery should be sustained by increased consumption,” and warned that Chinese banks should “improve credit quality and structure.”

So for all the rising skepticism among policymakers and scholars I think there is little doubt that we are going to see still more fiscal stimulus along the lines we have already seen. If there is indeed global excess capacity, as Justin Lin says there is, I cannot see how an investment-driven program to increase capacity, and one which is almost certain to involve a huge additional misallocation of capital (after all, 8% growth given the sheer size of the fiscal and banking stimulus is actually a disappointingly low level of growth), can be much more than a short-term stop gap. On the contrary, I think it will make the medium term adjustment even more difficult.

On that note I want to recommend Victor Shih’s excellent OpEd piece in the Wall Street Journal – Asia yesterday. He argues that:

Should this pace of credit expansion continue for the remainder of the year, China may well face a difficult trade-off down the road. The economy is unlikely to face a financial crisis because most of the debt is owed to domestic investors and depositors and China can still prevent large-scale capital flight. However, if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation. High inflation is destabilizing, as it has caused major runs on the banks before. If additional credit expansion in the face of rising inflation is not an option, the greater the extent to which lending is uncontrolled at the moment, the bigger a nonperforming loan problem the central government will face in the future.

An often overlooked ingredient to China’s success story is that generations of top-level central technocrats like Chen Yun, Yao Yilin and Zhu Rongji time and again used their political influence to constrain local investment bubbles, thus forestalling high inflation and major financial crises. Past retrenchment campaigns were unpopular and controversial, but senior technocrats nonetheless maneuvered to stop uncontrolled local investment. As credit continues to rocket toward the stratosphere, China is in increasing need of such leadership again.

Before closing this long post I want to add three additional comments. The first involves a conversation I had with one of my Tsinghua students who graduated in 2003 and now works as a currency trader. Last year he bought a few apartments in Chengdu, the capital of Sichuan, his home province, for speculative purposes, and in spite of surging land prices he seemed to think it was a terrible trade.

I asked him why, and he said that although real estate prices had gone up dramatically since he bought the apartments, and he needed the money back, he nonetheless found himself unable to sell the apartments. That’s a little weird, I thought. Rising prices should mean eager buyers, but he can’t get anyone to take the apartments off him?

Has any other of my blog readers experienced anything similar? Of course the historian in me remembers that during the final two years of the Japanese bubble, when land prices soared to levels never before seen in history, there were complaints by sellers that transaction volume was so thin that they couldn’t actually sell their land.

My second comment concerns university unemployment. I have been writing for three years that unemployment among college graduates in China was soaring, and that authorities were understandably nervous. So nervous, it seems, that they have been putting pressure on university to do more to get jobs for their graduates by limiting their next-year enrollment to the number of graduates this year with jobs.

There are, of course, two ways to improve statistics. One way is to improve the underlying reality. The second way is just to fake the numbers. According to a Tuesday article in the People’s Daily:

A Shaanxi graduate said his university gave him a bogus work contract to inflate its post-study employment figures. The former student said the contract was for a job at a local company which did not exist and carried the signature of his tutor.

“I had no idea that I already had a job,” the student, who had been hunting for work, wrote anonymously on a website. In order to ensure a high employment rate and deliver a satisfactory work report during the global financial crisis, some Chinese universities have been faking work contracts or employment agreement for graduates, Southern Metropolis Daily reported yesterday.

“Faking employment rates is not an isolated case and it has existed for years in China,” an education expert, who wanted to remain anonymous, told China Daily. Due to fierce competition among universities, especially secondary-tier ones, the performance and reputation of a school largely depends on its employment rate after graduation, he said.

According to unwritten rules at many universities, students cannot graduate if they do not find a job, the report said. This means many unemployed students have to buy a fake job contract or employment agreement from small companies so that they can get their certificates.

This kind of thing will mean that the college employment numbers, a very useful figure for understanding the effect of economic growth in China, are now much less useful. Already the People’s Daily article cites differences between the Ministry of Education numbers and a private firm’s numbers.

The Ministry of Education said that nearly two thirds of them [2009 college graduates] had already secured jobs before graduation in early July. But this figure differs widely with an employment report from an independent consulting firm on higher education. A report from MyCOS HR Digital Information Co said 58 percent of prospective graduates had not signed job contracts by the end of June and that 2 percent had contracts cancelled.

By the way the article has an interesting graph on the number of college graduates over the past eight years, for those who are interested. The total number of university graduates has surged from 1.45 million in 2002 to 5.59 million in 2008 and 6.10 million this year. The intervening years saw 2.12, 2.80, 3.38, 4.13, and 4.95 million graduates.

My third comment is about the great article in today’s Wall Street Journal on the explosive development of the Beijing music scene, a subject that all my friends know is one dear to my heart. Anyone who is interested in knowing more about this scene should read it.

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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