My thoughts on China's economy

[American Turtle]

It is estimated that fixed investment will comprise of 50% of GDP this year. Some big components are real estate (24% of total FAI), manufacturing (28%), Utilities (10%) and transportation (11%). Up to July 2005, the total fixed asset investment grew by 27% yoy. I see above average growth in coal, power, oil, and transportation which were once bottleneck sectors. In my opinion, it is a matter of time these sectors (Oil and transportation are the excecption here) will face overcapacity. Growth remained very strong in manufacturing industries which is also my big concern.

To better understand how this investment frenzy will go forward I have to look into what happened in last investment-boom cycle. The last investment-led boom cycle started in 1991 and ended in 1993. The percentage FAI as a pecentage of GDP shot up from 35% to 44%. It peaked in year 1993. The ratio thereafter fell down to 36% (almost the same percentage when it started) in year 2000. Correspondingly, growth rate of GDP fell from 13% in 1993 to 7.8% in 1999 and picked up to 8% in 2000. Another way to look at this is to see the growth path of Taiwan and Korea. Neither country has ever touched 50% level and never consectuively remained above 40% for three years.

My take-aways from last cycles and current concerns are folllowing:

1. The investment will go more slowly behind GDP growth to bring down the ratio to a more sustainable level.

How long and how severe the investment growth will go down this time? Basically the hard-landing or soft-landing question.

I think the investment growth will decelerate at a slow pace unless there is a severe global economic recession. The real estate sector will remain at strong growth. Some big trends such as urbanization and housing upgrade will keep the momentum over there. There is overheating in a few georgraphic locations but not over the whole country. The export-driven investment will also remain strong. This is also the most healthy and constructive investment in China, the blend of foreign know-how with cheap labor. The trouble part as Andy Xie mentioned is "state financial system monopolizing the financial capital for fixed investment." Some of these investment went into the Steel, Auto, cement, coal and etc. It will take years to unload the overcapacity we have here. In last cycle, it takes 6 years. The government has a good memory hence reacts early this time. My bet is 2 to 3 years drag-down.

2. Other components of GDP mainly private consumption, net export and government did not pick up the slack caused by slowdown of investment during last cycle.

Will it pick up this time?

China already ran a record current account surplus and already faced a lot of pressure from US and EU. A more accelerated growth above the current level will be much harder to achieve.

The wide wealth disparity restrcits domestic consumption. The saving rate on the top 25% of higher income is 47%. Unless government has successfully spread the wealth (which they may never do that), the consumption extra-contribution would be limited.

I agree with you that Chinese government is more worried about a cooling economy than a over-heating one. We are going to see aggressive fiscal policies if biz investment falls down sharply. They did it in last time and no doubt they will do it again when necessary.

3. The increased bank lending in the last cycle piled up as NPLs. The ratio on incremental lending arguabbly is as high as 40% last time.
How Chinese banks are positioned this time?

Up to July, the total FAI is 4,115 Billion RMB of which 28% goes to manufacturing. If we assumes a 93% bank financing ratio (2004 average) and 3% NPL ratio, it will bring it out 115 Billion NPLs. The overall reported NPL up to July is 30 bil. I expect to see a big increase of NPLs in the next two year.

In a nutshell, the economy will slow down to bring investment back to a sustainable level. Export sector will keep its momentum and government spending will greatly make up the loss in the next two years. China's political system inhibits the spread of wealth. Hence, do not count too much on consumption. The longer they stayed on this investment frenzy, the more severe and longer the downturn will be. Last time, it takes them 6 years to get back the growth momentum. I would not surprise to see 2 to 3 years this time. My estimate is 8% growth rate next year and 7% the year after next. Anything below 6% is a diaster and government will not let it happen which includes distorting the numbers when necessary

[HenryTo]

AT,

On the subject of real estate, it is important to keep in mind that a real estate boom in any country is typically defined by only a few certain markets, and not all over the whole country. Here in the States, we have California, Florida, Arizona, NY, and Hawaii. In China, we have Shanghai, Beijing, Hong Kong, Macau, and so forth. Think of it as where the money is heading.

I am looking at some numbers right now and they are telling me the following:

* Shanghai and Macau property prices are already down 20% from their highs; along with a significant decline of real estate transactions in all core markets (Shanghai, Beijing, Hong Kong, etc.).

* The cost of borrowing U.S. dollars (remember, many real estate developers have loans denominated in U.S. dollars) is now above rental yields

* China is adding one billion square feet of new commerical space every four months (the equivalent of all commerical space in Manhattan). Can this be sustained? I notice that Richard Russell of Dow Theory Letters (a bear for the last six years) is now caught up with the China frenzy and the Chinese real estate frenzy as well.

There is no need for real estate prices to "crash" for the economy to slow significantly. If the cost of U.S. capital continues to go up - and at the same time, accompanied by a overcapacity of real estate space, then construction can literally stop overnight. If so, then the headline GDP can come down (to the 6% level you're discussing) very quickly.

[pete richardson]

AT --

Good post. The Hu/Wen "golden harmony" policy laid out at the recent
plenum puts stress on geographic diversification, increased consumption
and a nod to the environment. It was met cooly by many of the top guys who are on the mercantilist kick.

For strategic and security reasons, not too many more moons will pass before the US and EU will begin to lean very hard on China. These guys
have gone ga-ga with the exports and are diverting huge sums to defense.

At some point there will be a defining confrontation for both sides.

Best,
PR