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Swedbank Asia Analysis - November 21, 2012

Swedbank Asia Analysis - November 21, 2012

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Published by Swedbank AB (publ)

Swedbank Asia Analysis - November 21, 2012: China’s strained economy – the new political leaders should focus on reforms rather than stimulus

Swedbank Asia Analysis - November 21, 2012: China’s strained economy – the new political leaders should focus on reforms rather than stimulus

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Published by: Swedbank AB (publ) on Dec 04, 2012
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Swedbank Asia Analysis
No. 14
21 November 2012
 Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740e-mail: ek.sekr@swedbank.com Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720.Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897
China’s strained economy – the new political leaders shouldfocus on reforms rather than stimulus
After a massive stimulus through the banks in 2008-2010, China is struggling withovercapacity and bad loans. The situation in the financial sector seems worse thanstatistics indicate. Many lenders are rolling over loans and hoping that the Chinesecentral bank again opens the spigot. In recent years China has borrowed from thefuture, and the question is whether it will choose the easy route with newinfrastructure investment or whether it will accept slower growth driven more byhousehold consumption. If the investment fervor continues, there will be a hardlanding down the road.
The economic turnaround now being talked about is based on meager gains andhopes of a new stimulus. A bottom may have been reached, but the recovery willbe cautious and vulnerable. We are revising our GDP growth forecast downwardfrom 7.9 percent to 7.7 percent this year and still expect it to stay below 8 percentin 2013 and 2014, in line with China’s goal of 7–7.5 percent in the coming decade.
The new political leadership is facing major challenges: corruption, a rebalancingof China's growth model from investments to consumption, a shrinking workforceand concerns about a middle income trap in the absence of innovation. Energyand the environment, urbanization and demographics, and international relations(including maritime conflicts) are also challenging the party and the military.
China’s leaders should show some backbone and reform rather than resort tomore stimulus. The question is whether the new leaders have enough interest inreforming or whether special interests will be allowed to maintain control andprotect the status quo. This applies especially to the continued deregulation of thefinancial sector. This report reviews why it is important and what could preventfurther development.
The global economy would benefit if Chinese growth were lower and moresustainable and if financial deregulation were fully implemented. Countries andcompanies that are stuck in the old business model will face increasing difficulty,while others could benefit from increased demand from China’s consumers asthey place greater value on quality and other long-term considerations.
Contents PageChina’s critical questions 2China’s economic outlook just hopes? 3Challenges facing the new political leadership 7Deregulation of the financial sector: Why, why not and how? 12Consequences for the global economy 19
 Swedbank Asia Analysis No. 14 21 November 2012 
1. China’s critical questions
It is easy to presume that China’s economic position is strong andthat the outlook is good, since GDP growth is relatively high (despitefalling from 9-10 percent to 7-8 percent in the last year). It also has alow debt level (reportedly about 30 percent of GDP) and hugecurrency reserves (USD 3 300 billion). However, the situation isprobably much worse than most analysts in the West realize.First of all, it can be difficult to interpret Chinese data, if they are evenavailable. The economy has probably grown more weakly or shrunkof late, and after the massive stimulus in 2008-2010 bad loans areprobably closer to 15-20 percent of outstanding bank loans than the 1percent reported. Now property companies, local governments andstate-owned enterprises have to be rescued and their debtsassumed. Companies aren’t getting paid and lenders are rolling overcredits, which hides the bad loans for a while longer. In the wake ofstrong credit growth, the shadow banking system has grown. In theabsence of transparency, there is a risk of Ponzi schemes.Secondly, it is common to say that China, with its low inflation, cannow pump new liquidity into the system to reinvigorate demand. TheChinese central bank will not repeat the mistakes from 2008-2010,which led to overcapacity and financial instability. The problem isn’tconsumer prices. It’s the debt buildup and bad loans owing to thedeclining quality of the lending and underlying assets.Thirdly, China borrowed from the future and built too much capacity.The construction industry is reporting that some production hasincreased so much that nothing more has to be built for the next 7-8years to keep pace with demand. This will restrict growth in comingyears.Fourthly, China's economy has been painted into a corner. Whenloans are rolled over, resources aren't available for new investment.By starting the printing presses and pumping in new liquidity,investment will increase more and more, which is a must to generatethe same growth as before. At the same time China’s leadership hadplanned to rebalance to lower, more sustainable and greener growthdriven more by consumption than investment. A new recession in therest of the world may force China to return to its proven recipe.Infrastructure investments are already in the pipeline – not as large asin 2008-2009, but still just over 2 percent of GDP in the next four-yearperiod.Instead of stimulating and driving the economy through moreinvestment, China needs reforms. This report focuses on the financialsector’s deregulation as a key to a better functioning economy. Itwould reduce corruption and the influence of state-owned enterprisesand would facilitate a rebalancing in favor of household-drivengrowth. Other important reforms involve fiscal policy (taxes, socialinsurance), the hukou system for migrant workers and corruptionfighting. Challenges also include demographics, urbanization andrelations with the rest of the world, especially as conflicts with Asianneighbors grow. A huge agenda for the new political leadership!
Lies, damned lies, and statistics! Lower inflation is no reason to open the spigots China has borrowed from its future China has to find the courage not to take the easy way out: new investments Less stimulus, more reforms! 
Swedbank Asia Analysis No. 14 21 November 2012 
2. China’s economic outlook – just hopes?
Still no clear trend in economic data 
In 2012 the Chinese economy slowed significantly, probably morethan statistics indicate. The reasons for the slowdown can be found inweaker global demand, which has impacted China’s export outlook,but primarily in its own austerity policies, which followed the majorstimulus in connection with the global financial crisis and recession in2008-2009. Credit growth peaked at 30 percent in November 2009and contributed to an overheating, which authorities today regret andwant to avoid repeating.
Inflation and monetary policy
When inflation rose significantly (at most to 6.5 percent in July 2011)after authorities stimulated demand through state-owned banks’lending, it launched a period of higher reserve requirements andlending rates in 2010-2011, which slowed credit growth.About a year ago the central bank began to loosen monetary policyby cutting cash requirements, but by then the effects on land andproperty sales and prices were already clearly negative, and worriesabout an economic hard landing had increased. In China’s situation, itwould be enough for GDP growth to fall below 6-7 percent to causeeconomic and political instability.A hard landing can be generated by tightening economic policy duringan overheating, but can also happen if capacity in the economycontinues to expand, the financial and real estate sectors becomemore unstable, and demand fails to keep pace. The first reason is themain concern at this point, but in a few years the bigger risk is thatoverinvestment will lead to excessive capacity, which could latercreate a financial and real economic hard landing.
The question domestic and foreign experts are now asking is whether the Chinese economy has hit bottom and a turnaround has begun? External and internal reasons for China’s slowdown Monetary policy has been eased to avoid a hard landing 

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