Markets Insight

Last updated: August 13, 2012 5:01 pm

Risks must not hide positive China trends

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Much depends on how Beijing tackles variety of hazards it faces

With Europe imploding and the US stagnating, one of the big concerns is whether emerging economies will continue to drive global growth as they have in recent years.

Much depends on China. Thus there is constant focus on the risks facing it. Three areas stand out: avoiding a hard landing; rebalancing the economy; and China’s institutional shortfalls.

Over the past year China’s economy, not immune to problems in the west, has cooled. The bulk of the cooling, though, is the result of a deliberate and successful policy to curb inflation. Now, with price rises low, the authorities are easing to avoid a hard landing.

The outlook for any economy depends on the interaction between the fundamentals, policy and confidence. China is fortunate to have plenty of room for policy manoeuvre.

As policy stimulus takes effect, a soft landing is likely this year followed by a rebound in growth next, with investment projects increasing and bank loans rising.

Real estate, often a bellwether of any economy, appears to be stabilising. We have conducted a sixth survey of a large group of developers across China. The results suggest rising apartment sales in many cities.

In the big tier-one cities the froth has come off the market as policy has squeezed speculators out. Elsewhere, affordability has improved with prices falling and wages rising at double-digit rates.

Although financial markets are focused on whether a hard landing can be avoided, within China the issue is more whether a rebound avoids the shortcomings associated with the recovery after the global recession, such as property bubbles, local government financial difficulties and wasteful infrastructure. That feeds directly into China’s bigger challenges.

China’s second risk is its imbalanced growth. This most probably means that a temporary setback is inevitable at some stage in coming years.

Investment is about 48 per cent of GDP versus a global average of 24 per cent. China wants to lower its ratio to about 38 per cent, with this still high figure justified by urbanisation and industrialisation.

When investment is so high, even a small correction can hit growth. This is complicated by the need for China to increase its ratio of private plus public consumption from under 50 per cent of gross domestic product to about 75 per cent. This is a huge but necessary change if China is to move from a middle to high income country.

Last year’s 12th five-year plan highlighted ways to rebalance, including seven strategic industries that China wanted to excel in. Then, this year, a World Bank report suggested China needed to innovate.

This, plus an ageing population, justifies China investing overseas, buying intellectual property rights and brands, to add to the previous clamour for energy and resources.

China’s third risk is its institutional infrastructure. As the economy grows this needs to change. There are many facets to this such as the rule of law, property rights, the need to prevent corruption, institutional independence and effective policy tools. It is also reflected in the way economic data are collected.

Policy tools have worked so far, with the focus on infrastructure spending, reserve requirement ratios and setting targets for bank lending.

Like other countries, China has seen the balance sheet of its central bank balloon. Also, China’s broad M2 measure of money supply accounted for 52 per cent of M2’s global growth in 2011.

Unlike more capital-focused western financial systems, China’s is bank dominated. This goes hand in hand with China’s repressed financial situation, where interest rates are regulated and bank lending is a key policy tool.

As the economy grows, these policy tools may become less effective. The key message is the need for reform. Beijing still tries to run the economy from the centre, despite the growing private sector and increasing importance of the regions.

Achieving domestically driven demand will be helped by further encouraging the private sector, by effective social safety nets and deepening and broadening China’s financial markets.

Greater currency flexibility, too, is a necessity and perhaps this is now happening. This year has seen the end of an era of one-way currency bets as the renminbi has seen its first sustained depreciation since being depegged in July 2005.

One facet of greater flexibility is an expanded offshore currency market, with more trade settled in renminbi. Multinationals recognise that renminbi invoicing can strengthen relationships with onshore clients and help price negotiations. All this is helping the liquidity essential for development of the offshore market.

Like its currency’s recent performance, China is not a one-way bet. There are risks in China but these need to be kept in context. The trend in China’s economy is up, as its pace and scale of change is dramatic, but one should expect setbacks along the way.

Gerard Lyons is chief economist at Standard Chartered

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