There’s an unusually cool breeze blowing from across the Pacific as spring gives way to an uneasy summer. China’s stringent government efforts to reign in a clearly overheating economy initially marked a welcome pause in the hottest growth story of the century. The depths of the slowdown, however point to a less manageable set of problems after years of state-led economic development.
Based on recent accounts of U.S. firms including GM, Starbucks and Apple, which are experiencing stellar growth in China, domestic consumers appear to be driving growth. Actually they have taken a back seat in a fast car for much of China’s rise. Their share of gross domestic product has fallen from about 50% in 1980 to under 40% three decades later (consumers account for roughly 70% of the U.S. economy.)
Certainly the average household has more purchasing power today than they did before Deng’s momentous reforms. Salaries are outpacing inflation and mandated minimum wages are on the rise. Beneath the glassy exteriors of newly minted malls and dark tinted sedans in major urban centers lies a harder truth. The much anticipated transition to a consumer-driven economy may be harder to accomplish than most expect.
By the numbers the slowdown appears widespread and deep. April imports dropped dramatically to a mere 0.3% from an expected 11%. Purchasing by the 100 million or so presumed middle class consumers certainly hasn’t kept pace with the largely “on sale” products of an outside world still struggling with recovery.
Exports have been faltering as well and mid-term prospects look bleak. The EU, China's largest export market, confronts the specter of a wider economic crisis spreading from Greece and Italy to Spain, Portugal and perhaps even France. The U.S. faces an extended period of anemic growth with new employment numbers slipping and a housing market still under the cloud of foreclosures and falling prices. HSBC’s Purchasing Manager’s Index has been at contractionary levels for the past seven months. Electricity and rail cargo shipments appear weak as well.
Investors have become increasingly wary. While the Dow Jones Industrial Average has bounced back to near pre-crisis highs, off 11% since 2007, the Shanghai composite index has lost 60% of its value. Foreign direct investment has dropped for the past six months running. Recent turmoil in Europe contributes to this slump, but government policies curtailing foreign control of their own firms may be having a substantial chilling effect as well. The Ministry of Finance’s decision to severely restrict ownership and management of foreign accounting firm’s local subsidiaries will only increase investor concerns. This comes after several corporate scandals have damaged investments in Chinese companies.
Financial concerns continue to gather momentum. In a curious move several banks are going back to the markets to raise fresh capital even after reporting substantial profits and a drop in lending. With so much cash supposedly on hand it is a curious case to make for selling more shares. The banks true debt loads remain obscured by risky side transactions made to avoid government restrictions. These risks are hard to quantify, much as the private U.S. collateralized debt and derivatives markets were (and still are considering JPMorgan Chase's recent $2 billion trading loss). Risks of moral hazard can’t be easily dismissed.
Part of the slowdown was expected after implementing prudent policy to cool the housing market and get inflation under control. Prices continue declining in major markets and inflation has dropped below 4.5%, the latest government target (up substantially from the original 3%, but still well below historical highs.) Now talk has turned back to stimulus. With the beginning of quantitative easing state-controlled banks can now lower their reserve ratios and free up more money for lending. The key question remains, what type of lending?
Some of the previous state-led development has certainly been useful and will likely lead to growth in the future. New low cost housing projects benefiting the poor keeps construction workers employed. Connecting large coastal cities to the interior via new roads provides an important route for manufacturers seeking to lower wages. Garment factories have already begun shifting operations to places like Vietnam and Bangladesh.
Many projects won't give the economy the longer-term boost it needs. While the high speed rail line from Shanghai to Beijing remains a popular route, many of the other lines are priced out of reach for the average traveler. The Ministry of Railways recently announced a plan to attract private investment after posting a $1 billion loss for the first quarter of 2012 after amassing $384 billion in debt.
In tough economic times such as these the private sector takes the hardest hit. They have far less access to capital compared to state-owned enterprises. If debt servicing becomes a problem banks are far less likely to roll over their loans or adjust terms as they do under government supervision. Absent reform China risks hollowing out its dynamic private sector just as the domestic economy begins adjusting to slower days ahead.
The next few months will reveal whether the central government can really turn the growth taps on and off at will. Quality now matters far more than quantity alone. Following through on much needed and talked about reforms to spur domestic consumption will create a more stable environment. Maintaining the status quo will not. Either way, China's economy is changing and so is the world outside.
Brian P. Klein is global macroeconomic and geopolitical strategist. He can be reached at www.brianpklein.com.