China: The deceleration continues Global Economic Outlook, Q3 2016

Data related to industrial production, manufacturing, electricity output, and retail sales all indicate that the Chinese economy continues to decelerate. Growing debt is also a cause for concern. There are warnings that unless China takes up serious reforms, the expansion of debt could lead to a financial crisis, low economic growth, or both.

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The latest data indicate that the Chinese economy continues to decelerate.1 Data on Chinese trade indicate continued weakness in exports but a slower pace of decline for imports. First, dollar-denominated exports fell 4.1 percent in May versus a year earlier, sharper than the 1.8 percent drop in the previous month. This reflected weak demand in both Europe and the United States. In local currency terms, exports were actually up slightly. The difference between dollar- and renminbi-denominated exports reflects the depreciation of the renminbi over the past year. Part of the problem for China, however, is that, although its currency has fallen in value, it has fallen far less than that of other emerging countries. Thus China’s exports have lost competitiveness versus other countries. Indeed some manufacturing capacity has departed from China, heading to other low-wage emerging markets. Meanwhile, the Chinese central bank continues to sell foreign currency reserves in order to stabilize the currency and prevent a sharper depreciation.

Part of the problem for China, however, is that, although its currency has fallen in value, it has fallen far less than that of other emerging countries. Thus China’s exports have lost competitiveness versus other countries.

Imports, which have been consistently falling for some time, fell only 0.4 percent in May versus a year earlier. This was a far smaller decline than the 10.9 percent drop in April. There were some special circumstances, however. First, the rise in commodity prices has boosted the import bill. Second, imports from Hong Kong increased 242.6 percent from a year earlier, possibly meaning that investors engaged in fake invoicing in order to move funds out of the country. Specifically, importers can invoice amounts far larger than the actual cost of the imported goods. This makes it appear that imports were much greater than was actually the case. Yet it enables the importer to send money out of the country without appearing to violate the government’s controls on capital movements. Thus underlying imports were likely quite weak, probably reflecting weak domestic demand. Moreover, many Chinese exports rely on imported inputs. Weakening exports have the effect of weakening imports as well.

Fixed asset investment in China was up 9.6 percent in the first five months of 2016 compared with a year earlier. This was the slowest rate of investment growth in 16 years. Interestingly, private sector investment was up only 3.9 percent, while investment by state-owned enterprises (SOEs) was up 23.3 percent. The latter figure might be of concern, given that there is considerable excess capacity in the state-run sector, producer prices for SOEs are declining, and SOEs are disproportionately laden with debt. The significant slowdown in private sector investment might also be alarming, and could bode poorly for growth. Finally, investment in real estate was up 6.6 percent from a year earlier, a considerable slowdown from before. Excessive investment in property has been one of the hallmarks of China’s economy lately. Thus slower growth of property investment is surely welcome. The challenge for China will be to shift away from investment-led growth and toward consumer-led growth. In addition, it would be helpful if investment by the private sector increases as a share of the total. This is clearly not happening now.

Chinese industrial production increased 6.0 percent in May versus a year earlier. This was in line with growth over the past year. Manufacturing output was up 7.2 percent, while that of electricity, gas, and water was up only 2.4 percent. Mining output declined 2.3 percent. The weak growth of electricity output will be seen by some as a proxy for the state of the overall economy. In addition, output of cement and steel rose modestly, and that of coal dropped sharply. Meanwhile, Chinese retail sales were up 10.0 percent in May versus a year earlier. This was the slowest rate of expansion in quite some time. All of these data suggest an economy that continues to decelerate.

Consumer price inflation in China decelerated in May. Prices were up 2.0 percent from a year earlier, less than the 2.3 percent inflation recorded in April. The central bank’s target rate of inflation is 3.0 percent. The weakening of inflation, despite a modest depreciation of the currency in the past year, suggests weakness of domestic demand. As such, it may presage further efforts by the government to stimulate the economy, either through monetary or fiscal policy. Meanwhile, the producer price index fell 2.8 percent in May versus a year earlier. This is less than the 3.4 percent decline in April. Producer prices have been consistently falling for a long time, driven by excess capacity. The fact that producer price deflation has abated may have to do with the recent rise in commodity prices. Still, as producer prices continue to fall, it will exacerbate the difficulties some companies may face in servicing their large debts.

In May, foreign direct investment (FDI) into China was down 1.0 percent from a year earlier. For the first five months of 2016, FDI was up 3.8 percent from the same period a year earlier. In that five-month period, investment in manufacturing was down 3.2 percent, while investment in service industries was up 7.0 percent. Investment in services accounted for 70 percent of the total.

Debating debt

The International Monetary Fund (IMF) has entered into the debate about China’s growing debt. The deputy managing director of the IMF, David Lipton, said that “corporate debt remains a serious—and growing—problem that must be addressed immediately and with a commitment to serious reforms.” He pointed out that corporate debt is now about 145 percent of GDP, which is “very high by any measure.” He warned that, if unchecked, the expansion of debt could lead to a financial crisis, low economic growth, or both. He also said that the measures taken so far by Chinese authorities are inadequate. These include securitization of debt as well as debt-for-equity swaps. The problem with such measures is that they don’t address the underlying problem of poor performance of the debtor companies, especially SOEs. Lipton noted that, while SOEs account for about 22 percent of economic output, they account for about 55 percent of corporate debt in China. Many of them are “essentially on life support.”2

China appears to face the risk of something akin to what happened in Japan in the 1990s, when banks rolled over bad loans to poorly performing companies. The result was a plethora of poorly performing companies being propped up by troubled banks.

Critics of China’s policies say that such enterprises must be reformed or shut down. Debt-for-equity swaps simply allow banks to own shares in these companies. Such measures do little to improve the performance of these companies. Banks are left with little incentive to force these companies to fail. Critics also say that it would make more sense for the Chinese authorities to simply allow banks to let companies default, and then establish a vehicle to clean up bank balance sheets. Such a policy would lead to the bankruptcy and possible closure of some unprofitable and highly inefficient companies. While this might be painful in the short run, it would boost long-term productivity and enable the economy to restructure away from loss-making businesses.

Interestingly, the deputy governor of China’s central bank, Zhang Tao, says, “Any industry that lacks the mechanism to elevate winners and eliminate losers can’t develop in a healthy and sustainable way.” This suggests a willingness to let failing companies fail—although this has not yet happened. He also addressed the issue of banks that hold bad debts, saying “We will permit financial institutions to go bankrupt in an orderly way, restructure those that need restructuring, shut those that need to be shut, and strengthen market discipline.”3 Meanwhile, debt continues to expand. Lipton noted that “in a setting of slower economic growth, the combination of declining earnings and rising indebtedness is undermining the ability of companies to pay suppliers or service their debts. Banks are holding more and more nonperforming loans, and the past year’s credit boom is just extending the problem.”4 Some observers have raised the specter of a crisis for China in which a large financial institution fails due to excessive bad assets. Yet this seems unlikely. Rather, China appears to face the risk of something akin to what happened in Japan in the 1990s, when banks rolled over bad loans to poorly performing companies. The result was a plethora of poorly performing companies being propped up by troubled banks. This led to limited credit creation, no economic growth, excess capacity, and deflation.