Feature Stories | Jan 14 2015
This story was originally published on 8 December 2014. It has now been re-published to make it available outside paying subscribers at FNArena.
By Greg Peel
On November 21, FNArena published China Landing: Not Hard, Not Soft, But Long. The article centred on a trip to China by analysts from investment advisor AllianceBernstein, on which they encountered a growing expectation among the Chinese that Beijing would shortly be forced to make a significant policy shift. The government’s recent strategy of specifically targeted parcels of liquidity injection, offsetting the necessary grind of structural reforms (such as weeding out corruption), was simply not working, many pointed out.
This was evident in China’s September quarter GDP growth rate of an annualised 7.3%, below Beijing’s 7.5% target. There seemed little chance the December quarter would right the ship, given important indicators such as China’s manufacturing PMI (purchasing managers’ index) were continuing to trend down, and property prices were falling. Economists had begun to forecast a final result of 7.0% growth for China in 2014. This implied, to many of those the AllianceBerstein analysts spoke to, Beijing would shortly be forced to roll out another large fiscal stimulus package, as it had done in late 2008.
The analysts did not agree, and indeed no new fiscal package has been forthcoming, but many a global market observer was startled when, coincidently on November 21, the People’s Bank of China announced its first rate cut in two years. Clearly, as the Chinese economy continued to slow, the political pressure brought to bear on the Chinese government had become too much.
The initial global market response to the rate cut announcement was positive, as all the world wants to see a China in growth mode, and easier monetary policy can help bring that about. But it wasn’t long before commentators were pointing out that if Beijing has been forced to resort to the sort of broad-brush approach to economic stimulus reminiscent of the post-GFC period, the Chinese economy was in a worse position than Beijing had been up to that point prepared to admit. The balancing act of structural reforms and targeted stimulus parcels was not working.
Be afraid, they said.
AllianceBernstein has subsequently agreed Beijing’s rate cut marks “a clear shift in policy stance”. The government’s policy of “selective” easing has not really trickled down into system to lower borrowing costs, and patience at the government level has been wearing thin. The Chinese premier has repeatedly highlighted the need to lower funding costs for China’s small and medium enterprises (SME). Thus Beijing has resorted to the old model of directly ordering state-owned and commercial banks to cut lending rates.
[It is not as if we haven’t seen this movie before. The US Federal Reserve had assumed a zero cash rate and 2009 quantitative easing would be sufficient to ensure US banks would happily lend this “free” money into the wider economy and in so doing, the US economy would recover from the GFC. But instead, the banks, and large US corporations, sat on the cash. Hence QE1 was followed by QE2, QE2.5 and QE3.]
This will not be Beijing’s last rate cut, AllianceBernstein suggests. Following this change of tack, the AB analysts now expect more rate cuts over the next six to nine months, and accompanying cuts to China’s bank reserve requirement ratio (RRR), which currently stands at a “staggering” 19.5%. [Australian banks hold an equivalent 8-9%.] Fiscal stimulus will nevertheless remain restrained, AB believes, unless a more expansionary budget is announced at the People’s Conference early next year.
The investment advisor has set its 2015 GDP growth for China at 6.8%.
Citi agrees more Chinese rate cuts will be necessary. The November rate cut did not materially lower the funding cost of the banking system, Citi attests, and lending rates for new loans will likely remain elevated as banks struggle to hold on to profit margins. More rate cuts will be required to substantially lower the financing cost of the real Chinese economy, alongside RRR cuts to counter capital outflows.
But let’s not panic, says BT Investment Management. BT is surprised by a “remarkable degree of pessimism” surrounding the Chinese rate cut, as if it represents a last throw of the dice to stimulate a collapsing economy.
The BT analysts are not themselves overly positive on the Chinese economy, believing growth will continue to slow in 2015. Construction demand remains weak, which is not promising for Australian miners, but this does not mean the entire Chinese economy is doomed, BT insists. China’s newly emerging service sectors are performing better than many had expected. The economy is currently producing more jobs per unit of GDP growth than it has in the past.
This means the government is not facing the same sort of pressure to stimulate the economy as it did in 2008. Beijing is attempting to balance sufficient growth to keep the population content while driving crucial structural reforms which are deflationary in the short term. The near-term trick, says BT, is to let growth decelerate but not to let it stall. The end result should be slower but more stable growth.
Lower inflation and a stronger currency have made a rate cut necessary, BT suggests. Lower inflation increases “real” interest rates, while the renminbi’s tie to the US dollar has resulted in appreciation alongside the greenback, particularly as the yen has been aggressively devalued. A rate cut will counter these impacts and help keep the economy running above stall speed.
The rate cut will also help alleviate pressure on China’s housing industry. Of most concern to BT is not just declining new construction and falling house prices, but the large inventory of unsold housing in China’s second and third tier cities. In extreme cases there is in excess of three years of supply.
While there is unlikely to be a broad rejuvenation of the housing sector, lower interest rates, in conjunction with government’s recent relaxation of mortgage lending rules, should lead to market stabilisation, BT believes. The government has been at pains to prevent a housing bubble, but given the importance of housing to the broader economy and its importance for China’s banking sector, the government would like to see at least a flat rather than declining market.
BT is forecasting 7.0% growth for China in 2015, diminishing thereafter. The investment manager remains negative on commodity prices in the medium term, and thus negative on Australia’s resource sector. It is an inescapable fact that China’s housing construction industry and the global commodities sector are closely connected.
Between 2000 and 2013, annual housing completions in China tripled, notes research group Gavekal Dragonomics. Steel consumption quadrupled. The price of iron ore soared. In the decade to come, China’s housing market will again be a crucial factor for the global economy, Gavekal, suggests, but unfortunately the other way around.
Gavekal expects annual Chinese construction volumes to fall by 15-10% by 2025, or some 2% per annum. Around a third of China’s economy depends directly or indirectly on property and construction. “Commodity producers who have lived high off the Chinese hog for years should prepare for leaner times as prices grind inexorably downward”.
That is not to say China’s housing market is in danger of collapse, Gavekal assures, as some more excitable commentators are suggesting. Rather, it has matured. Total demand for housing peaked in China in 2011 and will likely remain stable at current levels through next year, before entering a steady decline.
Gavekal points out the biggest driver of China’s 2000-13 housing boom was not the migration of farmers into the cities, as most have always assumed. Some 44% of new floor space completed over that period was attributable to existing city-dwellers moving from old crumbling apartments into big new modern ones. The demand for upgrades peaked in 2011 and will shrink by two-thirds by 2025, Gavekal forecasts. Underlying urban migration flow also peaked at that time, but it should remain stable for the next few years before declining modestly.
Beijing will not be able to arrest this decline, but it can smooth the downturn, Gavekal believes. The government’s goal to maintain annual GDP growth at a rate of 7% through to 2020 is nevertheless unrealistic. China’s service sector may have been growing to fill the void, but a more urgent approach to deregulatory reforms is needed if Beijing is to replace the sputtering real estate engine.
Gavekal agrees commodity prices have further yet to fall. While there may be some offset to declining steel demand for housing through greater intensity of steel use (such as building more high-rises) as well as increased auto manufacture and shipbuilding, commodity producers “should be sceptical,” Gavekal warns.
The Conference Board in the US sees things a little more grimly. The Board’s analysts agree Beijing’s “soft landing” goal of 7-8% growth looks rather ambitious, and are forecasting a decline to a mere 4% growth beyond 2020. China’s success of the past 15 years was built on an historically unique development model, but the price of success has been deep-seated risks and imbalances. “The course of China’s growth has always harboured the potential for deceleration at least as rapid as its acceleration,” the Conference Board suggests. “We are beginning to see the signs of this transformation take hold”.
But before we all go and cry into our chicken and sweet corn soup, the Conference Board’s outlook for China is not quite as dour as it first seems.
Those Chinese companies setting their guidance based on 7-8% growth are in for a real shock, the Board warns. But the impending slowdown, and the government and private sector response to it, also presents major opportunities for those ready to seize them. The analysts have outlined four positives for China that should emerge from the negative of slower growth.
China’s talent environment should improve dramatically. China’s best and brightest will stop jumping across to which ever company offers the best deal and will begin to value stability and career development.
Facing shrinking access to capital, Chinese companies are likely to compete more conservatively in order to protect their balance sheets.
As many Chinese firms begin to feel the fallout, opportunities will arise for foreign companies to partner with or acquire struggling Chinese businesses. Foreign M&A deals may even “balloon”.
Similarly, the growing hubris of Chinese officials towards foreign businesses may reverse sharply in some regions as local leaders become more receptive in order to attract needed investment.
In short, the Conference Board does not believe China’s projected slowdown implies a crisis poised to reverse a generation of progress. Even at 4%, China still represents a “huge and dynamic opportunity”. This will nevertheless require both Chinese officials and foreign investors to acknowledge the time has come for structural adjustment.
“Transitioning away from the state-driven, credit-fuelled boom that has amazed the world toward a more sustainable, consumption-centric model will be a long and perilous process that causes much near-term pain,” suggests Conference Board China Center resident economist Andrew Polk. “Ultimately, China has no other choice”.
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