China Targets 8% Growth

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By Greg Peel

In 1989 the Japanese economic miracle, which had begun in the post-war ruins and culminated in Japan dominating the global car and electronic goods markets, peaked. Despite the global impact of the 1987 Wall Street crash, by 1989 Japan's stock market had surged to dizzy heights and its property market even dizzier heights. Famously, the grounds owned by the Emperor in Tokyo at one point was afforded greater value than the entire state of California.

In retrospect, the Japanese government was soon to rue the fact it did little to stop the dangerously expanding asset price bubbles. Because they burst in 1989, and the world's second largest economy has suffered from entrenched deflation ever since. Over twenty years later, the Japanese stock index is still nowhere near what it reached at that peak.

In those last two decades, China has been emerging from its communist shadow into a highly successful, quasi-capitalist economy that has shouldered aside the big economies of Germany and Japan. But it has not been a smooth ride. With little experience in monetary policy management, China watched its stock and property markets violently bubble and bust several times before it settled into its true “miracle” trend from 2004 to 2008.

Having watched its “Asian Tiger” economic neighbours suffer the Currency Crisis of 1997, China elected to peg its currency to the US dollar rather than let it float, as the Tigers had done to their detriment without sufficient inflation controls. While loose post 9/11 monetary policy, subprime mortgages, complex derivatives and rampant investment bank leverage in the US are easy targets of GFC blame, the imbalance of surplus and deficit created by China's pegged currency, and the willingness of US consumers to buy ever more cheap Chinese goods on credit, remains very much a contributing factor.

Within that imbalance lay another significant contributing factor in the relative weakness of China's domestic consumption compared to its enormous export industry. When the GFC hit, China all but lost its export customers. In order to get them back, China realised its best bet was to stimulate its domestic economy first and so to apply a defibrillator to the global commodities market. Thus the government released a vast amount of fiscal stimulus into the economy via the banks and told them to lend with their ears pinned back, particularly on infrastructure investment. This inspired a sudden surge in commodities imports, which is one of the reasons Australia barely noticed there had been a GFC.

Stimulating the domestic economy is not as simple as it sounds, despite the vast foreign reserve surplus China can draw upon to fund its renminbi hand-outs. China may well have turned its GDP growth around from an anaemic near 6% post GFC back to double-digit boom numbers, at a time when consumer price inflation remains low, but the side effect is asset price inflation.

Chinese banks are not particularly experienced, not particularly well controlled, and still very much open to old-school Communist party influence of the few over the many. Thus while fiscal stimulus did indeed make its way into infrastructure projects, it also found its way into stock and property market speculation by fair means and foul. As a result, China's stock market is up over 50% from its 2008 low but more worryingly, the Chinese property market is beginning to look a lot like Japan's in the eighties.

It is not lost on the Chinese authorities that this is not a comfortable situation to be in.

In recent months, the Chinese authorities have moved to tick up interest rates and incrementally increase bank reserve ratio requirements in order to stymie uncontrolled lending, to prevent economic growth running away too quickly (as it did in the previous boom) and to try and ease the bubbles. This has led economists to suggest China's GDP growth will pull back to around 9% rather than the 10-11% of recent quarters. But in his Friday address to the annual National People's Congress, premier Wen Jiabao outlined his intentions to get even tougher.

Wen warned that China should not interpret the GDP growth recovery back to double digits as being representative of a fundamental improvement in economic conditions. There is still “insufficient” internal impetus driving the growth, he noted, implying that while fiscal stimulus has provided the oxygen needed, the patient is not yet breathing comfortably on its own. But stimulus is causing the economy to overheat, he suggested.

One risk is that infrastructure spending has not just made its way into improving transport systems and providing better housing, but into increasing productive capacity. China has long had a problem with an oversupply of factories running on paper-thin profit margins and that problem has been further exacerbated recently by even further factory construction alongside a speculative build-up of commodity stockpiles. At the same time, the economies of Western export customers (particularly the US and Europe) are still struggling to recover, suggesting any return to the glory days of the Chinese manufacturing and export industries is a long way off, if ever demand regains such dizzy heights as in the previous boom.

The risk here is that as soon as the West is back on its feet, there will be so much oversupply of Chinese factories and raw materials that China will simply shoot itself in the foot via competition and price deflation – another danger of bust following boom. Still China will need to buy more iron ore and coal to feed its steel factories and building programs so in another case of potentially having shot itself in the foot, China's rampant buying of steel inputs from late 2008 and through 2009 has meant the big producers now expect big contract price increases. Bulk mineral analysts are now forecasting China will have to pay BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Brazil's Vale anywhere from 60% to 80 or even 90% more for iron ore this year, and similar price increases are expected for coking coal. This big jump in price will impact clearly on China's GDP numbers.

But it is the runaway property market which has Wen most concerned. Describing the property markets in some cities as being like a “wild horse”, Wen has pledged to use lending and tax policy tightening to rein in property speculation, while at the same time increasing public spending on low-income housing to redress the balance of the haves and have-nots.

It is private spending which has taken off as a result of government stimulus, leaving direct public spending in its wake. In the first full year of government stimulus last year, public spending grew at a rate of 21%. But this year that growth rate has tailed off to 11%. There is room to move here given China's fiscal budget deficit is running at under 3% (contrast Greece at 13%).

It is thus not Wen's intention to indiscriminately tighten monetary and fiscal policy to rein in runaway economic growth and asset price inflation. It is his intention to redirect policy so as to curb unwanted and potentially very dangerous speculation. While China has been emulating Japan in an earlier era, it doesn't want the story to end the same way.

To that end, Wen is targeting only 8% GDP growth ahead for China. That's lower than the 9% foreign economists were anticipating once expected monetary policy measures were applied. And it's much lower than the double-digit numbers of recent quarters.

It also implies potentially more urgency in China's need to revalue its currency further against the US dollar. China had revalued 5% in the boom times ahead of the GFC, and economists have been predicting another 5% revaluation would occur before this year-end. The only thing holding China back from expedient revaluation is the US government's constant entreaties for China to do exactly that. It is very important to China that the world sees it doing its own thing in its own time, and not because of US pressure.

Wen made no mention of currency – that was left to the governor of the People's Bank of China, speaking to the Congress on the weekend. Governor Zhou suggested that the 2008 pegging of the renminbi at 6.8 to the US dollar was a “special” policy put in place as a response to the GFC emergency. Economists took this as a big hint they're right to assume revaluation in the near future.

There are two questions which arise from China's new 8% growth target. Firstly, can China actually manage such control over its economy? And secondly, how will this lower rate impact on Australia's own little economic “miracle”?

In the past, China has been suspiciously good at announcing a particular target on something and – lo and behold – the numbers come out exactly as such. However, the authorities were simply caught out in the previous boom years when last an 8% target was intended, given GDP growth of 13% was reached. This implied China's softly-softly approach to monetary management had backfired, such that while any bust was prevented the boom still ran out of control. What will be different this time?

As each year has passed over the last couple of decades, the Chinese authorities have moved further and further up the capitalist learning curve. In the beginning they were monetary novices, and paid the price. So backwardly entrenched was China's financial system and banking industry in the old communist ways that volatile boom and bust cycles were inevitable. But as recently as the last couple of months the outside world has been taken by surprise as China has quickly moved to increase bank reserve ratios and generally attempt to cool the overheated economy. The signs are that China is quickly getting better at this game.

So perhaps an 8% target is a lot more realistic this time around.

From Australia' point of view, we don't want to hear 8% now we've once again become used to 10% or more. There is little doubt China's stimulus measures and resultant commodity buying spree has played right in to Australia's hands, such that Australia has virtually stood alone as a sentinel of “Western” economic success post-GFC in comparison to the likes of the US, UK, Europe and Japan (which is also considered more “west” than “east” in economic terms). With GDP returning to trend growth levels and unemployment apparently having peaked, could Australia's success be derailed by Chinese economic tightening?

The answer is that Australia will no doubt feel some impact from the difference between 8% and 10% plus. However, the risk of 10% plus is that it gives way again to a 13% boom or even more, and that a subsequent bust (likely led by a bursting of the Chinese property market bubble) would be followed by an equivalent bust in Australia. So which would Australia prefer?

Would we like to see a couple of years of halcyon days before the inevitable – eat drink and be merry, for tomorrow we may die – or we we like to know China is on a more subdued but steadier path of controlled economic growth, benefiting itself and thus benefiting Australia as result?

It may not be what short-term stock market traders want to hear, but it would surely be a more comfortable investment world for the longer term players.

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