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Beijing Preps for a Soft Landing

Tighter credit over the past year has cooled property prices without undermining growth, setting the stage for fresh easing.

In the midst of the global financial crisis that followed the collapse of Lehman Brothers Holdings in 2008, China embarked on one of the world’s largest stimulus packages, injecting 4 trillion yuan ($630 billion) into its economy through a massive bank lending program. The policy succeeded brilliantly, boosting growth to a rate of more than 9 percent in 2009 and more than 10 percent in 2010. The stimulus spending also reignited China’s red-hot property market, leading real estate prices in some major cities to triple over the past three years and driving consumer price inflation up to a three-year high of 6.5 percent in July. To prevent a destabilizing inflationary outburst, the People’s Bank of China tightened policy aggressively in the past year, raising interest rates three times in 2011 and lifting bank reserve requirements six times. The reverberations have been felt throughout China as banks have pulled in credit lines, forcing some companies into bankruptcy.

Now the authorities stand at a critical juncture. Their tightening efforts have combined with weakness in China’s main export markets, Europe and the U.S., to raise the threat of an economic hard landing, with sharply slower growth and rising unemployment. That’s a chilling prospect for the global economy at a time when Western countries are struggling under a mountain of debt. Can Chinese policymakers fine-tune their economy to avoid a downturn and maintain growth at a strong and sustainable rate?

Most analysts are confident that Beijing can avoid a crash. They point to the unexpected easing by the central bank, which cut reserve requirements at the start of December in the first such move since 2008, as evidence that the authorities are aware of the risks to growth and have sufficient means to respond.

“The Chinese government still has multiple tools to deal with any liquidity or illiquidity issue,” says Victor Shih, an associate professor of political science at Northwestern University, in Evanston, Illinois, who warned about the borrowing binge unleashed by the stimulus program. “Up until now they have reacted in a timely manner.”

Paul Schulte, Hong Kong–based global head of financial strategy and Asia banks research at CCB International Securities, a subsidiary of China Construction Bank Corp., estimates that in the past 12 months Chinese regulators have removed 4.4 trillion yuan in liquidity from the financial system—well in excess of the original stimulus spending—through tightening; he predicts that they are about ready to reverse course and ease. “Credit growth is running at about 6 percent, while nominal growth is running at about 18 percent,” he says. “This is clearly unsustainable.”

Beijing still faces tough challenges ahead, though. The 2009 stimulus may have succeeded in the short term, but it did so only by increasing the economy’s reliance on government-driven investment. Policymakers need to reduce that dependency and encourage more private sector growth and consumer spending to sustain a durable expansion in the long run, analysts say.

“If China fails to transform its development pattern over the next five years, then the risks of a major crisis could increase exponentially,” says Huang Yiping, Hong Kong–based chief economist for emerging Asia at Barclays Capital. Until now the government has always stretched the financial and fiscal systems to contain near-term downside risks, Huang says, but there is a limit to how much longer policymakers can take this approach. After the Asian financial crisis of 1997–’98, for instance, it took several years for China to reduce banks’ nonperforming loans and the government’s contingent fiscal liabilities. “But China may not always have the luxury of a long adjustment period to deal with such problems,” he says.

Indeed, there are still a number of bears who think the economy is headed for a harsh downturn. James Chanos, founder of New York–based hedge fund firm Kynikos Associates, believes that much of the stimulus borrowing went to finance dubious speculative real estate projects. Chanos says he is shorting Chinese property and banking stocks because both sectors are headed for a crash. “We see a history of horrible lending,” Chanos said at the Delivering Alpha conference in New York, sponsored by Institutional Investor and CNBC in September.

A sharp slowdown in China is the last thing global investors want to see, considering that Europe is flirting with recession because of its debt crisis and the U.S. recovery remains weak and vulnerable to global turmoil. The mainland economy had been the greatest source of strength at a time of troubles in the West, says Shane Oliver, Sydney-based head of investment strategy and chief economist at AMP Capital, which has A$97 billion ($99 billion) in assets under management. “China worries have escalated recently because of anecdotal evidence of slower growth, indications of a credit crunch in some parts of the economy and increasing pressure on property developers,” he says.

According to official figures, about 1 percent of the 53.5 trillion yuan in loans held by the Chinese banking system are currently nonperforming. Most analysts believe the real number is higher—or soon will be. May Yan, a Hong Kong–based banking analyst at Barclays Capital, forecasts that the NPL rate will rise to between 3 and 4 percent in the next year or two. “With any rapid growth there is potential of an asset bubble,” says Yan. She estimates that licensed banks may have made as much as 5 trillion yuan worth of loans—many of dubious quality—in excess of the official stimulus program since 2009. Underground banks such as credit cooperatives and microlenders, many of which borrow at low interest rates from the state banks and lend to private businesses at much higher rates, may have extended an additional 9 billion yuan in questionable loans. The easy money fueled a dramatic rise in property prices and financed countless speculative real estate projects, primarily residential housing in major cities.

The government responded by squeezing liquidity out of both the formal banking system, which is dominated by the Big Four state-controlled banks, and the informal system, which involves everything from unlicensed banks to credit cooperatives to virtual loan-shark operations. The central bank increased its policy lending rate three times in 2011, taking it up to 6.56 percent. Even more important, the central bank raised reserve requirements 11 times since 2009 to a record high of 21.5 percent, effectively limiting the amount of customer deposits that banks can lend out.

The tightening has had a dramatic impact on conditions in Wenzhou, a city of 9 million people in Zhejiang province, south of Shanghai, that is a major hub of private entrepreneurial activity, much of it financed by informal lending. Since April more than 80 major businessmen have disappeared, committed suicide or declared bankruptcy to avoid repaying debts to informal lenders, China’s official Xinhua News Agency has reported.

“Entrepreneurs were hit when export orders dried up,” says Yeo Lin, director of the Industrial Development Research Center at Zhejiang University’s School of Management. “Now the excess funds in China’s underground banks are drying up.”

Premier Wen Jiabao visited Wenzhou in October and pledged to aid small and medium-size enterprises. Also that month, China’s ruling State Council issued a series of measures ordering state banks to shift their lending from state-owned enterprises to private entrepreneurs. In November, Wenzhou officials established a 1 billion-yuan fund to provide bridge loans to small businesses, many of which can’t get loans from state-run banks and often resort to paying interest rates as high as 30 percent from underground lenders.

Those measures are inadequate to meet the needs of the country’s small businesses, says Shen Minggao, Citigroup’s Hong Kong–based chief economist for greater China. Most banks still prefer lending to big state-owned enterprises because those companies have political connections and long-standing relationships with their lenders. To spread the flow of credit, China needs to fully privatize the giant state-controlled banks, give banks the freedom to set interest rates and legalize underground banks, Shen contends. “There is much more to do,” he says.

The central bank eased policy in early December after China’s Purchasing Managers’ Index fell to 49.0 percent in November from 50.4 percent in October. A reading below 50 percent suggests the economy may be slowing below its trend rate of growth. The central bank move, which lowered the reserve requirement by a half point, to 21 percent, should release some 350 billion to 400 billion yuan of fresh lending capacity, analysts estimate. For now, however, the impact of the past year’s tight money policies dominates the economy.

That tightening is helping the government win its war against property speculators. Housing prices are likely to fall by 10 percent by the end of 2011 and another 10 percent in 2012, says Du Jinsong, a Hong Kong–based property analyst with Credit Suisse. “Some small developers—unlisted ones—already defaulted,” he says.

Putting overleveraged property developers out of business would actually be good for China, says Andy Xie, a Shanghai-based independent economist who formerly worked as Morgan Stanley’s chief economist for Asia ex-Japan. He believes property prices will fall as much as 25 percent in 2012 and another 25 percent by 2015.

“Too many businesses adopt the strategy of holding the government and bank hostage for profit,” Xie says. “When one borrows enough, the government and the bank must keep them alive. So many businesses behave in such a way the government could be forced to bail out indebted businesses again and again by printing money. Such an economy inevitably ends with hyperinflation.”

For now, however, runaway inflation doesn’t appear to be a threat. Consumer price inflation eased to a rate of 4.2 percent in November from 5.5 percent  in October as a result of the government’s tightening measures, and most analysts expect the rate to fall to about 3 percent in the first quarter of 2012.

Although falling real estate prices are likely to produce a rise in nonperforming loans, the authorities have plenty of firepower to deal with any problems and prevent a banking crisis, analysts say. “The Chinese government can bail out the banks even if nonperforming loans were to rise to 10 percent,” says Barclays Capital’s Yan. “I don’t think it will be as bad as some people are saying. Chinese banks, at the end of the day, have considerable earning power. In the end it will be a moderate or cyclical rise in NPLs.”

Credit Suisse’s Du also believes the banking system can weather an increase in bad loans. “Banking exposure to direct loans to developers and mortgages is less than 20 percent, so there will be pressure, but it won’t be devastating,” he says.

Mortgage loans currently amount to just 14 percent of gross domestic product, well below household savings at 23 percent of GDP, according to Barclays Capital. Total savings, including that of the corporate and government sectors, amounts to 53 percent of GDP, according to official statistics. In addition, China’s public sector debt currently stands at only 45 percent of GDP—18 percent from the central government and 27 percent from local governments—according to Barclays Capital. That’s well below the U.S.’s debt-to-GDP ratio of about 100 percent and the euro area’s rate of almost 90 percent. The People’s Bank of China also has $3.2 trillion in foreign exchange reserves, the highest in the world, some of which can be used to bail out the banks if nonperforming loans were to rise excessively.

Still, investors are worried about the impact on banks of slower growth and China’s credit crackdown. The MSCI China Financials Index fell 43 percent from January to early October 2011, driving its average price-earnings ratio down to a record low of 5.6. The index had rebounded by 30 percent from its lows as of early December, after state-run Central Huijin Investment, the arm of sovereign wealth fund China Investment Corp. that holds the government’s stakes in banks, spent $31 million on the Shanghai Exchange to buy shares of the four biggest Chinese lenders: Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China. The banks, meanwhile, have so far performed well despite tight credit conditions, with net profits in the first nine months of 2011 rising across the board, from 9 percent at Bank of China to 80 percent at China Minsheng Banking Corp., according to Barclays Capital.

Economic growth also appears to be continuing at an enviable clip, although it has slowed from the torrid pace of 2010. “China came into 2011 with GDP growth too strong and monetary policy too loose,” says Michael Buchanan, Hong Kong–based chief economist for Asia at Goldman Sachs Group. He predicts that growth will slow to a rate of 9.2 percent in 2011 from 10.3 percent the previous year and ease further to 8.6 percent in 2012. His estimates are in line with those of multilateral institutions: The Asian Development Bank predicts that Chinese growth will ease to 9.6 percent in 2011 and 9.2 percent in 2012, while the World Bank forecasts rates of 9.3 percent and 8.7 percent, respectively.

China is unlikely to repeat its performance during the precrisis years, when it delivered double-digit growth and inflation below U.S. levels, analysts say. But the prospect of a slowdown along forecast lines raises fewer concerns these days. A decade ago China needed a minimum of 8 percent growth a year just to create enough jobs for the 10 million workers coming into the labor market every year. With the population aging, however, the growth in the labor force has slowed to fewer than 5 million workers a year, meaning that China can tolerate a modest growth slowdown.

The composition of that growth is a potential problem, however. China’s trade partners and outside economists have long criticized the country’s reliance on export-driven growth and its relative shortage of domestic consumer demand. According to the ADB, consumption makes up only 34 percent of China’s GDP, roughly half of that of the U.S. and other developed nations.

The world should be more worried about the continued low level of consumer demand in China, says Michael Pettis, a former Bear Stearns Cos. banker who is a professor of finance at the Guanghua School of Management at Peking University. “If we get a significant rise in debt and nonperforming loans, which most analysts now agree is very likely to be the case, the debt will be resolved the way it always has been, by transfers from the household sector in the form of repressed interest rates,” says Pettis. “The problem with bad debt in China is not that it leads to a banking crisis but rather that it exacerbates the consumption imbalance.” Such a trend would leave the economy more vulnerable to the weakness in Western economies and threaten to aggravate trade tensions with the U.S. and Europe.

Rebalancing the economy to boost domestic demand is a key plank of the government’s 12th Five-Year Plan, which began in March 2011. The plan aims to slow growth to an annual rate of 7 percent annually and shift the focus of development from China’s overheated coastal cities to secondary cities and rural areas in the country’s interior. The plan also calls for the creation of a national social welfare and health insurance system. The absence of such social protections has encouraged the Chinese to maintain some of the highest savings rates in the world and has put a brake on consumer demand.

The plan’s focus on rural China is smart considering that 50 percent of the nation’s 1.4 billion people live outside the major cities and are clamoring for economic development, says Sam Sio, chairman of China Metro-Rural Holdings, a Hong Kong–based company that builds trade and logistic centers in rural China. The company is developing three such centers, in Heilongjiang, Liaoning and Shandong, three coastal provinces in northeast China where thousands of townships are urbanizing. Fifty percent of China Metro-Rural’s customers pay cash; they don’t need bank financing for retail space that sells for less than 25 percent of prices in China’s major cities.

“From our experience, we can see that China isn’t suffering economic overheating in the rural areas, where demand is growing and supplies are lacking,” says Sio. “It is rural economic development that will drive China’s growth for decades to come.”

Meanwhile, economic reform efforts should get a fresh impetus from the impending change at the top of the government, analysts say. Vice President Xi Jinping is expected to succeed President Hu Jintao as general secretary of the ruling Communist Party in late 2012 and assume the presidency in 2013. Xi is regarded as an advocate of private sector development and a contrast to Hu, whose conservative policies favored state-owned enterprises. Xi served as party secretary of freewheeling Zhejiang province and the city of Shanghai before rising to the vice presidency in 2008.

In advance of the leadership transition, in a move that also favors reform, the government recently reshuffled its top financial regulators, analysts say. In October the State Council appointed Guo Shuqing to take over as chairman of the China Securities Regulatory Commission. He replaces Shang Fulin, who is moving to the China Banking Regulatory Commission to take the job of the retiring Liu Mingkang. The Council also named Xiang Junbo to head up the China Insurance Regulatory Commission, replacing Wu Dingfu. A fluent English speaker and a pro-reform politician-turned-businessman, Guo has served as chairman of China Construction Bank since 2005. Xiang had been chairman of Agricultural Bank of China, where he led a restructuring that culminated in the bank’s $22 billion initial public offering in 2010.

A “financial revolution” is coming to China in the next five to ten years under the new, younger generation of leaders, says Barclays Capital’s Huang. This revolution will include significant liberalization of interest rates, the exchange rate and capital controls, allowing banks rather than the government to become the primary allocators of capital, he contends. “Financial institutions should operate as market entities, maximizing returns and minimizing risks,” Huang says.

The latest liberalization move came in October, when the government announced that it was allowing four local governments to issue bonds. Since then the cities of Shanghai and Shenzhen and the provinces of Zhejiang and Guangdong have sold a total of 22.9 billion yuan of bonds with maturities of three to five years, with the longer maturities yielding between 3.3 percent and 3.47 percent.

Until now local governments have had to rely on bank borrowings or request the central government to issue bonds on their behalf. Some analysts believe that bank loans made to local governments under the 2009 stimulus program will account for a big share of the anticipated rise in nonperforming loans. The shift toward bond market financing should help prevent local government debt from posing a risk to the banking sector, officials believe.

Beijing should expand the experiment to all of China’s provinces as soon as possible, says Northwestern’s Shih. “The bond market will not restrain local behavior until all local governments face much higher yield if they behave in a fiscally irresponsible way,” he says.

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