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Multinationals’ profits are falling, foreign direct investment (FDI) is falling, deflation looms. In sum, China enters 2006 showing every sign that the economic cycle is headed south.

Net income of foreign-invested enterprises in China, compared year-on-year, has been dropping since the first months of 2005. Data from the National Bureau of Statistics (NBS) indicate that foreigners’ earnings from direct investment declined around 5 per cent last year (final numbers are not yet available). Accounts filed by affiliates of US corporations with the American government show earnings falling 8 to 9 per cent year-on-year.

The trend is one of accelerating income erosion. It would be a great surprise if foreigners’ profits were not falling at a double-digit rate, year-on-year, by mid-2006.

The market appears to anticipate this because foreign investment in China – which ought to fall when returns do – is also declining. Utilised FDI dropped 12 percent in the first half of 2005, according to the NBS.

Slowing FDI is being accompanied by a brisk reduction in speculative foreign capital inflows into China. For more than two years, international speculators bet heavily on the proposition that the Chinese government would significantly revalue the renminbi – making it stronger relative to the US dollar. A belated recognition that this is a pipe dream is seeing China’s foreign exchange accumulation plummet.

Net foreign exchange inflows into China in November, the latest month for which data are available, were just over US$9bn, or less than one-third of the year earlier figure.

Infinitely more important than the currency revaluation fantasy is China’s trajectory back to deflation, which last pummelled the economy between 1997 and 2002.

The standard consumer price inflation (CPI) measure peaked at just under 5 per cent in mid-2004. Thereafter, ever-increasing overcapacity in the economy saw the CPI number retreat. By November, it was at a year-on-year level of 1.3 per cent and falling.

In 2006, the Chinese government will roll out its artillery in an effort to prevent a return to falling prices. Fuel and utility charges will likely be increased, as will other costs that are included in the inflation basket and over which the state still has pricing power.

But people are not stupid. They know when most prices are falling – as they already are for the vast majority of manufactured goods from cars to washing machines – and they wait for them to fall further. The result, in a country that does not allow the market to price investment capital, will be accelerating deflation.

That is good news for consumers everywhere, bad news for profits in China’s domestic economy, bad news for Chinese banks that fund industrial investment in the hope of being repaid, and good news for international traders that buy ever-cheaper goods in China in order to resell them in rich countries.

Overall, foreigners should be more sanguine about 2006 than Chinese citizens. Foreigners have very limited investment exposure to China’s domestic economy (particularly when calculated on a per capita basis), even less to its banking system. And they benefit enormously from low-cost Chinese exports that will have a headline value around US$850bn this year.

Chinese consumers also benefit from falling prices. But most of their money is at risk in insolvent Chinese banks while Chinese corporations have only swift and bruising profit erosion to look forward to.

This will likely be the big economic story of 2006. Through 2005, Chinese companies continued to report profit growth in double digits. This is because, unlike more disciplined foreign firms, they reacted to falling demand by offering ever-more generous credit terms to their clients and by increasing their inventory. Thus they were able to book increased paper profits (matched by higher receivables).

This will be the year in which economic gravity belatedly asserts itself. If the 1994-95 slowdown is any guide, many Chinese companies will simply run out of cash to pay their workers as they make sales for which they do not receive payment. At some point, one of the most popular expressions of mid-1990s media coverage will reappear – san jiao zhai or ‘three-cornered debt’ – meaning that company A cannot pay company B because it is waiting on a payment from company C.

San jiao zhai makes it sound like business has caught a strange disease that is nobody’s fault. That suits politicians. But the reality is that China’s economy is running into trouble because the latest boom, like those before it, has been too much about investment and too little about deregulation.

The China Economic Quarterly is an independent newsletter devoted to analysis of the Chinese economy and business environment since 1997. It draws on the 25 years of combined experience of its editors, veteran financial journalists Joe Studwell and Arthur Kroeber, and also publishes articles by leading China-focused economists and journalists. This column appears exclusively on FT.com on alternate Mondays.

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