China's Challenge - 10 September 2012
Beijing has announced another big stimulus plan – but will it deliver...?
THE UPCOMING generational change in the leadership of the Chinese Communist Party (CCP) is probably contributing to some of the mixed signals coming out of China, writes Dan Denning in the Daily Reckoning Australia.
Nobody knows yet what the incoming members of the Politburo's Standing Committee will do.
What we do know is that China announced about $150 billion of new spending last week. The spending includes 60 new (and some previously announced) projects. The National Development and Reform Commission (NDRC), China's central planning body, announced a bevy of agriculture, energy, railway and road projects. China's long-term aim is to build at least 7,000 kilometres of rail and subway lines.
Australian investors would be keenly interested anytime China opens its wallet. The 4 trillion Yuan stimulus in 2009 was around 6% of GDP, and lit a fire under iron ore and coal prices. It kept Australia's terms of trade near a 140-year high and supported the Aussie Dollar. It wasn't bad for stocks either.
The most recent plans announced by President Hu Jintao amount to around 2% of Chinese GDP. And Hu's weekend announcement gave bears reason to cavort. Before the APEC meeting in Vladivostok, Hu said the following to a business conference:
The world economy today is recovering slowly, and there are still some destabilising factors and uncertainties. The underlying impact of the international financial crisis is far from over...We will work to maintain the balance between keeping steady and robust growth, adjusting the economic structure and managing inflation expectations. We will boost domestic demand and maintain steady and robust growth as well as basic price stability.
Nothing like setting yourself a task. He may as well have added: cure cancer, walk on the moon, send a manned spacecraft to Mars, and create limitless cheap energy from table top cold fusion in a jar. China has a difficult challenge.
The challenge is that any stimulus spending is going to reinflate the property bubble. That bubble has deflated slowly for the last six months. But if China lowers reserve requirement ratios at banks, or simply spends more money, it could leak into house prices. In fact, sales of residential floor space were up 13.3% year-over-year in August, according to the Wall Street Journal. That kind of inflation is socially destabilising, which is the exact opposite of what the CCP wants.
When the government spends money (fiscal policy) it can more or less use it like a fire hose, targeting spending in specific industries. But when you manipulate the price of credit (monetary policy) you can't really control where the money goes. And it almost never goes where you expect it. This is how bubbles are born.
China's official statistics bureau reported on Friday that consumer price inflation is only around 2% per year. It's almost certainly higher than this. And in the event, it's higher than 1.8% reported last time. Food prices were up 3.4%. Food prices up, producer prices down, quandary present and correct!
The real root of the problem is, well, the whole model that puts politics before profits. You can't allocate scarce resources, capital, and labour to meet purely political goals. Not only is it unfree, in philosophical terms, it suppresses the natural price signals that tell producers what to produce based on what people want and need.
An article in today's FT reports that 574 Chinese companies had negative cash flow from operating activities in the June quarter, according to data from S&P Capital IQ. It's hard to run a business if you have more money going out than coming in. The only way to do it is to borrow money.
Data from Mike Werner of Bernstein Research in Hong Kong shows that non-performing loans at China's banks are up just 1% in the first half of the year. No crisis yet, right? Maybe. Werner reports that over-due loans, as reported by the banks, are up 29%.
Extend and pretend, baby!
When you don't have enough cash to make interest payments on your debt, you obviously have a problem. China's borrowers have a big problem. But like any sizeable debt outstanding, the borrower's problem quickly becomes the lender's problems. China's banks have a problem.
The original problem is that local government borrowers were given loans for projects that may never deliver cash flows sufficient to repay the original loan, much less pay the interest on it. But ignoring that problem for a second, you can push it out in time restructuring the terms of the loan. You accept smaller payments and delay the maturity of the loan for a few years.
All of this is perfectly legal and incredibly opaque. Not recognising a loss is the key for any bank sitting on a pile of bad loans and hoping to stay in business. But there are at least two obvious consequences when a central government uses its banks as a tool for political policy.
First, foreign investors tend to withdraw money the less transparent bank balance sheets get. Remember, foreign direct investment in China was down 8.7% year-over-year, according to China's Ministry of Commerce. You wouldn't want to have more money locked up in Chinese assets if it was possible those assets were going to be revalued...a lot lower.
The second obvious consequence to using the banks as a political tool is that the banks become less effective tools. A bank can extend and pretend about asset quality as much as it likes. But the larger the pile of non-performing loans gets, the harder it is for the bank to extend new credit. New credit is exactly what's required for any large new infrastructure plans. The banks may simply not be in the position to loan as much money to local governments as they did in 2009.