International | Feb 10 2010
By Andrew Nelson
The last month or so of market turmoil isn't so much about actualities, but rather uncertainty as to what the future holds in store for the recovery unfolding around the world. The outlook for China is at the centre of this uncertainty and while we may turn to the past to help guide future expectations, the question remains: what does recent history actually tell us about China's current road to recovery?
There are two recent periods of Chinese economic distress and recovery that come to mind. 2003-04; when Chinese authorities responded to an overheating economy with campaign-style macro controls in April 2004 that lasted about six months and saw the Chinese economy and stock market show significant resilience. Or 2006-07; when aggressive credit controls imposed in October 2007 contributed to, while not necessarily causing, a hard landing for the nation's the economy.
We have looked to Morgan Stanley economists Qing Wang and Steven Zhang for some insights into these two recent periods, with the pair giving us a fair idea as to the likelihood of either of these past scenarios playing out again.
The situation occurring in 2004 is quite different from what China is facing now, and in hindsight the tightening program imposed at the time now looks completely justified. The team from Morgan Stanley notes the average year-on-year growth rates of some of the major economic variables over the six months leading in to the tightening that kicked off in April 2004 clearly indicated an overheating economy. Fixed asset investment (FAI) increased 37%, exports were also 37% higher, while industrial production (IP) surged 18%, loan growth was at 27% and inflation as measured by the consumer price index (CPI) increased by 2.7%.
The tightening measures to counteract such overheating included strict investment project approval, tight controls over bank lending and a moratorium on developing agricultural land for industrial and/or commercial use. During this period there was only one interest rate hike and that came six months after the tightening began, after headline CPI inflation had peaked and started to decline, while producer prices were yet to peak.
Yet despite the aggressive tightening, the team notes that the Chinese economy remained remarkably resilient, with FAI growth decelerating sharply from the pre-tightening levels of near 40% to about 20% in the months immediately after before stabilising at around 25%. At the same time, IP growth only slowed down marginally, supported by strong export growth throughout the entire tightening cycle.
Given the current cyclical environment is still obviously too weak to justify the same type of aggressive tightening, the team thinks that the only explanation for the current rumbles coming out of China could be a "policy normalization". The pair rate the measures that kicked off last month as just early policy action intended to pre-empt a 2003-04 style economic overheating before it even gets started. Thus, the team thinks that further policy action will be measured, underpinned by improvement in external demand.
The problem is: such an approach could see a repeat of 2003-04, especially if external demand turns out to be much stronger than expected. Such an eventuality could once again trigger an aggressive push of policy tightening, which would in turn slam the brakes on many of the key components of the economy over the short term. But with China increasingly relied upon to help pull the OECD out of its hole, such short-term weakness would not be a welcome sight.
The tightening binge that started in October 2007 was enacted to address stubbornly high inflation, with average year-on-year FAI growth at 27%, exports at 27%, IP at 18%, loan growth of 17% and a CPI growth rate of 4.9%, The program over that period mainly showcased some very tight controls over bank credit, especially in the property sector. Investment growth declined as a result. Industrial production growth also slowed, but the economic weakness this affetced offered little defence against the onset of the GFC in September 2008. Exports collapsed and China landed hard.
While not likely, Wang and Zhang think it is possible we could see a repeat of the 2007-08 tightening experience, but only if Chinese authorities failed to learn the lessons from their mismanagement of the property sector in 2008 and go down a similar policy route again this year. Were both property sales and property construction activity to slow sharply, and if the OECD ends up going though a double-dip rebound, the team thinks China will be right back where it was in the latter half of 2008.
The good news is; neither a repeat performance of property sector blundering, nor a double dip recession in the OECD is likely, say the team from Morgan Stanley. First, it is Morgan Stanley's institutional view that the recent policy initiatives we have seen coming out of China are mainly to discourage speculation, while at the same time attempting to encourage supply. If successful, the two combined would help prevent a too rapid rise in property prices.
In fact, the team doesn't even think that the policy measures implemented back in 2007-08 were the main causes of the ensuing slowdown in the property sector. They lay the blame at the feet of a "buyer's strike" that was brought on by expectations of a broad-based property price decline. Why? With property developers cut off from bank lending, it was widely expected that the credit crunch would force developers to cut property prices in order to maintain sales and thus cash flows. However, the duo from Morgan Stanley thinks Chinese authorities will in no way want to intervene in such a heavy-handed way this time around.
Lastly, while the recent fiscal crisis on Europe's Mediterranean coast may have cast some storm clouds over hopes for a smooth global economic recovery, the way things are panning out are pretty much in-line with the lukewarm recovery that Morgan Stanley's global economics team has been expecting for a while now. So while we're certainly not in for smooth sailing, Morgan Stanley places a low probability on a double-dip recession scenario.