Streetwise Professor

For months I have been extremely skeptical about the Chinese economy.  I am not alone.

In the aftermath of China’s release of its GDP numbers, indicating 3Q growth of 8.9 percent, many voices–including those from within China–are expressing doubts about the sustainability of the government’s frenzied stimulus policies. From the FT:

Most fiscal rescue packages stimulated consumption of tradable goods. China, however, has gone the other way. It has been frantically  building roads and power plants.

That approach was based on the assumption that a collapse in exports would be a blip – one that could be offset by state-sponsored splurges on fixed assets. Itsthird-quarter gross domestic product numbers showed that the strategy had been a success, on its own terms. Over the first nine months, the economy grew 7.7 per cent. Of that, investment accounted for 7.3 percentage points and consumption 4 percentage points. The decline in net exports lopped off 3.6 percentage points.

But what if that assumption was wrong? The decline in exports was slowing, yes, but shipments in September were still 15 per cent worse than they were in the month of Lehman’s demise – the 11th straight month of falls, and not much better than the 17 per cent fall in the darkest days of March. The longer they remain sluggish, the longer fixed-asset investment will have to compensate, raising the risk of growth being hit by an investment-led slump.

With unusual frankness, the statement from the National Bureau of Statistics noted that the export picture was “severe”. Otherwise, the gap between rhetoric and reality keeps widening. While regulators and sundry bank executives keep popping up to warn about the  risks piling up in financing new assets, for example, the banks keep lending. September’s total of Rmb517bn of new loans was a quarter bigger than August’s. M2, a measure of money supply, grew a record 29 per cent year-on-year. A gentle contraction from here, as policymakers seem to be indicating, would take years to bring M2 growth down to its long-run average.

A temporary fix is developing more than a whiff of permanence.

Qin Xiao, Chairman of the Chinese Merchant’s Group and the Asian Business Council is alarmed:

While consumer prices are mostly under control, asset price bubbles are growing rapidly because of huge liquidity injections by governments around the world. Globally, there does not seem to be an exit strategy in place to drain this liquidity from the system. Certainly, in China, stock and property bubbles are a concern.

While we have avoided the worst recession since the Great Depression, we are probably  heading for another asset bubble and more financial turbulence. What can we do? Compared with pouring money into the economy, draining money from the economy is a much tougher job for central banks. The dilemma is this: if we tighten monetary policy, there is a high possibility of a “second dip” next year; and if we continue the loose policy, another asset bubble might be not far away.

I do not believe a quick, steep bounce driven by fiscal fixed investment is a good thing for China. Nor is a moderate slowdown anything to be afraid of. Monetary policy must not neglect asset-price movements. Therefore, it is urgent that China shifts from a loose monetary policy stance to a neutral one.

I am also worried about the role of governments after the crisis. There are some who say that this is a crisis of the market economy. It is not; nor is it a time to turn our backs on markets. There have been failures of regulation and oversight, particularly in the west. In China we are still developing our regulatory system. It is a time to strengthen oversight, improve governance and push for freer and more efficient markets in China and abroad.

However, there is growing concern, especially in China, that the temporary stimulus programme might evolve into permanent government control of the economy. The Chinese government should continue to loosen its grip. Prices, especially of energy but including water and food, need to be freed further. The currency needs to be liberalised. Privatisation needs to move ahead. China needs freer markets, not more state control.

FTAlphaville provides some additional background:

And lo and behold — China’s third-quarter GDP  statistics have just been released, and they show an 8.9 per cent growth compared with the same period last year.

Make no mistake, however. This is a growth almost entirely driven by government policies and stimulus packages.

Fixed asset investment, China’s main measure of capital spending, jumped a massive (and probably still  questionable) 33 per cent. At the same time, however, exports are still contracting, falling 15.2 per cent in September, and 23.4 per cent in August. The trade surplus narrowed $45.5bn to $135.5bn.

China’s seems to be a Michael Jackson economy.  Its apparent vigor is the product of a regimen of drugs prescribed to mask organic weaknesses (in China’s case, a massive fiscal and monetary stimulus intended to offset the effect of a collapse in exports)–and to treat the side-effects of previous drug regimens. This putatively therapeutic approach can permit apparently normal function–and even result in seemingly superhuman performance–for some time, but the cumulative effects are ultimately destructive.  In many cases, the denouement is catastrophic–as with Michael Jackson.

China’s Enron-like GDP management seems to be attempting to buy domestic peace by engaging in vast infrastructure investments until such time as export demand picks up, thereby permitting a reversion to the previous model of export-driven growth.  Timing is everything here.  The deleterious effects of the drug regimen cumulate at an increasing rate.  Larger doses need be given in order to achieve the same effect.  The risk of a brutal popping of myriad asset price bubbles, with the consequent shock to the financial system and the real economy, grows with the duration of the fiscal and monetary imbalances.  Unless exports turn around rather quickly, the imbalances in the Chinese economy are highly likely to result in a huge bust.

To the extent that markets outside of China have been bouyed by the ripple effects of that country’s massive stimulus, such a bust would erode asset values and economic growth in said markets.  And nowhere would the effects be more pronounced than in the commodity markets–and commodity-intensive countries.  It is hard–nigh on to impossible, IMHO–to ascribe the robust performance in commodity prices (in the face of persistently high and sometimes ballooning stocks) to anything but the effects of China’s natural resource-intensive stimulus spending, commodity hoarding encouraged by cheap credit, and (arguably) Chinese government stockpiling.  A messy end to the Chinese stimulus would translate into an extremely bloody fallout in primary commodity producing nations.

And that means you, Russia.  In bailing out itself, China has almost certainly saved Russia from an absolute economic catastrophe.  Not that things are rosy in Russia, by any means, but the current situation would be immeasurably worse without China’s stimulus-fueled commodity binge supporting prices. (And it must be noted that Helicopter Ben has pitched in too. I wonder if Putin has sent him a thank you note?)

I am not predicting an inevitable collapse in China, followed by fallout elsewhere.  It is possible that the huge Chinese bet on exports recovering before the baleful effects of the stimulus regimen take hold may pay off.  But the nature of the stimulus does create a significant downside risk in the Chinese economy, and in the world economy, especially in primary resource producing nations.