How Weak Is China?
  • Tue, 04/03/2012 - 23:01

4/03/2012 @ 12:31PM

This Sunday, Chinese authorities released its purchase managers index survey showing the fourth straight month of gains. Good news. But on the same day, HSBC released its own set of PMI data, showing the third straight month of declines. Is that bad news? It’s surely was conflicting data points.

Something is happening in China, and thanks to its largely closed society, what that is remains anybody’s guess.

On the non-economic front, Chinese censors moved to limit what people could say on popular microblogging sites like Tencent’s QQ and Sina’s Weibo following rumors about the firing of top Chinese communist party member Bo Xiali last month and the growing perception that there is a leadership rift in the forbidden city.

After the Tiananmen Square fiasco of 1989, China’s leaders have been trying to show a unified Beijing. But today, with social network sites and an abundance of news, Chinese locals know there are problems at the top.

Conflicting data, missing politicians, changing leadership in Bejing and a slowing economy set to fall below 8% growth for the first time in more than a decade all have investors wondering if China has had its day, and that day is done.

While politics plays a role in economics, especially in China, investors are most concerned with the tangible evidence. They are asking whether or not China’s slowdown means a hard landing or a soft landing. The country is going through a transition and is clearly in the process of decelerating. It is already becoming more of a middle income country in terms of per capita income compared to other Asian nations, and it is unlikely that Chinese consumption can make up for the decline in exports to Europe, something many investors are hoping for. As it is, China consumer spending accounts for a little over 8% of GDP; a healthy number by any standard.

“At this point a hard landing in China is being defined as a mere disappointment. Fund managers see a hard landing as growth of 7% or less. That’s not necessarily a hard landing, but it is definitely a disappointment,” said Ruchir Sharma, managing director of emerging markets at Morgan Stanley in New York.

Chinese growth started to slow in the first quarter of this year. Despite renewed pessimism among a handful of investors and consultants like Nouriel Roubini, the current trends are consistent with the market’s consensus case call for a soft landing.

“I think the Chinese economy is a lot more stable than the investing public give it credit for,” said Edmund Harriss, a portfolio manager at Guinness Atkinson in London. “I think for a real economic crisis to occur you need short term debt about to come due and that is not an issue in China. China is not Greece. China is not even the U.S. in 2008.”

Although some investors claim that the state of China’s economy is worse than in 2008, nearly all macro- and industry-level indicators show that the economy is in much better shape today than three years ago.

The Dragon Has Landed

The government has been repeatedly issuing lower growth targets. Wen Jiabao, China’s Premier, forecast 7.5% growth in 2011. The economy grew over 9%. China is adopting monetary and fiscal policy expansion, including lower reserve requirement ratios at the big four state owned banks like the Agricultural Bank of China, in an effort to facilitate lending down market and keep the economy moving. Beijing also reiterated it would continue the restrictions on housing purchases in an effort to curb real estate hyper-inflation. All told, most officials do not seem very worried about the risks of a hard landing, but they are all aware that the Chinese fire breathing super dragon of the 2000s has finally landed.

Several factors contribute to investor disappointment on China, as Barclays Capital’s emerging markets research team led by Yiping Huang in Hong Kong noted in an 11 page report on China weakness on Tuesday. “Landing”, whether soft or hard, is likely to be negative for investor sentiment, although a slowdown could be positive for growth sustainability. Some investors are disappointed that the government has not announced an aggressive stimulus policy. In fact, the government is unwinding its massive trillion yuan stimulus from 2008 and has said that no new stimulus measures in size or scope would take it place.  Europe and maybe even the U.S. need life support, but China does not.

Certain sectors could experience downsizing adjustments even under a soft landing scenario and corporate earnings, which matter more for investors than politics, tend to correct more sharply than real activity during economic downturns.

Why has the Chinese economy slowed from double digit growth to single digit growth so fast, even as U.S. imports of Made in China goods continue to rise? Throughout half of 2010 and all of 2011, China’s Central Bank raised interest rates to fight inflation of more than 6%. All emerging markets were in the same boat, and China’s equity market actually performed better in those circumstances than equity indices in India, Russia and Brazil.

The iShares FTSE China Xinhua 25 (FXI) exchange traded fund declined by 19.07% in 2011, beating the MSCI Emerging Markets index which fell 20.35%.

The Chinese economy has also slowed down because of the European debt crisis hurting demand for Chinese exports. China exports more to Europe than it does to the U.S. and a U.S. increase in China purchases was clearly not enough to pick up the slack. Moreover, restrictions on housing purchases caused a decline in housing sales, falling housing prices and a serious decline in new housing starts.

In short, China is largely slowing by design. As Barclays Capital notes, policymakers have reached a consensus view that it was time to tolerate slower growth to improve the sustainability of growth.

“There are some similarities between the causes of the economic slowdown in late 2008 and early 2012,” writes Huang and his colleagues. “Both were driven by a combination of weakening of external demand and tighter domestic policy. Relative to the situation in late 2008, however, domestic policies played a greater role this time around. While it is possible that some firm-level data may support the ‘worse than 2008′ impression, we find no credible evidence at the macroeconomic or industrial levels.”

China’s biggest problems now are internal. It is going through a change in leadership in Beijing that occurs once every 10 years. Those changes could affect policy and Beijing’s ability to act quickly.

“It is not in the Chinese government’s interest to not have things go smoothly and hurt the economy,” Clark Li, global research director of Balentine in Atlanta said in a recent interview.

On the policy front, the biggest concern is how the government will react to China’s overheated housing market. The ongoing correction there is affecting developers, but Barclays Capital thinks its affects will not be hard felt overall. For instance, of total property investment, which is about a quarter of total fixed asset investment, roughly 30% is in commercial property (which is still growing rapidly), another 30% in social housing (which is supported by government policy), and the remaining is the private residential market that is being cut off at the pass. This last portion can also be divided between large-developers and small-developers. Small property developers are the most vulnerable in the face of housing restrictions. More importantly, if housing risks endanger the soft landing scenario, the government should be able to reverse the restrictions quickly.

As political risk increases in China, overall sentiment will undoubtedly worsen. Maybe China is not as weak as some say, but it appears bound to disappoint.

“Government officials’ confidence actually makes some investors nervous,” Huang wrote. “But are the officials unaware of the problems that worry investors? Our answer is ‘unlikely’. Over the past 30 years, the government has established a good track record in maintaining stable economic growth,” Huang said.

For Edmund Harriss’ China view from London, China is weaker, but not weak.

“I find all this hard landing talk hard to deal with now. It comes and goes. Investors have to get used to China not growing 10% anymore. That’s behind us,” Harriss said. “But that is not a surprise.”