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9 Januar y, 2012

Ben Simpfendorfer

The 2012 outlook (a story of state-rms and low-margins)

The chances of a hard landing in 2012 are low: China isnt Europe and has room to borrow in the event of another global crisis. But further policy stimulus will only aggravate existing imbalances. The housing sector is a case in point: more public housing is needed, but not the state-owned companies that build it at low-margins. It is instead time to revitalize the private sector.
The Chairman of MCC Engineering, a state-owned Chinese firm, recently had this to say about the outlook for public housing construction in 2012: The government is satisfied. The people are happy. And the banks all benefit, as the company will not lose money. Its nice to hear some bullish thoughts about the next 12 months, especially when they relate to China, the worlds last major growth driver. But when the boss of one of the countrys largest state-firms is bullish, should we be pleased or worried? Theres certainly reason to be pleased: I expect no hard landing in 2012. Sure, the data will deteriorate. Exports, for example, are likely to fall -5% in 2012, only marginally less than their -16% decline in 2009

as global growth cracked. The PMI is likely to average around 50, or only marginally in expansion territory, against its average 52 in 2009. However, China still has plenty of policy firepower and can support growth through a difficult period. Thats why Zou Honglu, the Chairman of MCC Engineering, is so bullish about his firms opportunities next year: the government could crank up spending on public housing construction, a policy that would certainly keep lowincome households happy. And yet pumping further stimulus into the economy will only worsen structural imbalances, especially the states rising share of activity. Indeed, the economy was ironically better balanced in 2007, or prior to the last round of stimulus. And thats reason to worry about yet another round of the same. What is needed instead is a combination of fiscal easing and policy reform. In short, the 2012 outlook should be about preventing a cyclical hard landing while simultaneously tackling structural rebalancing.

Chinas debt verus Europe and the United States (including financial sector debt)
% of GDP


United States










Source: CEIC, Eurostat, IMF, US Federal Reserve and SRA calculations

China isnt Europe. More debt, please.

When discussing risks of a hard landing in 2012, comparisons between rising debt levels in China and Europe are inevitable. But China has scope to borrow more in the face of a slowdown. My colleague, Mike Every, recently published Part I in a series of three notes looking at global debt. His final note, to be published at the end of the month, will look at Asias debt levels relative to those in Europe and the United States. Its a simple message: Asia both can, and must, borrow more to support global growth. This applies equally to China. For all the concerns about rising debt levels, Chinas household and government debt were worth only 28% and 58% of GDP at end2010. Households could leverage up significantly, while even the government, after accounting for contingent liabilities such as bond issuance by local governments, has room to continue borrowing. Admittedly, the non-financial corporate sector looks more stretched: its total borrowing is worth 91% of GDP and thats not accounting for borrowing from the shadow banking sector. But the figures nonetheless compare favourable with those in Europe (125%), and not far from those in the United States (76%). In short, corporate borrowing is high, but not explosive.

Add to that the fact the PBOC has over 16 trillion yuan ($2.5 trillion) locked up in required reserve deposits. Thats a vast amount of liquidity the central bank could flush into the system in the event of a major, and unexpected, growth slowdown. (The PBOC currently requires commercial banks to place 21% of their total deposits with the PBOC). The upshot is that China could afford to go on another debt binge in the event that the economy appears to slow abruptly. Sure, it has implications for mediumterm growth (and Ill get to that in a moment), but the ability to continue borrowing, or further relax fiscal and monetary policy, does rule out the risks of a hard landing in 2012.

Who pays for the dumb investments?

More debt will inevitably result in more bad debts (and there are plenty of those to judge by some of the speculative investments by local governments). Isnt that a risk to the outlook? Possibly. But its worth keeping in mind the fact that governments never really pay off their debt: they either default or, as often, grow their way out of it. Take the United States experience post-World War II. Federal debt was worth around 120% of GDP in the mid-1940s. Yet by the late-1950s, the figure had fallen to just 60%. Ironically, the country only actively paid off its debts between 1945 and 1948. Instead, average 6% nominal GDP growth after this period meant the country was

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Chinas required reserve deposits are three times the size of the U.S. TARP bail-out
$ billion
3,000 2,500 2,000 1,500 1,000 500 0 China's required reserve deposits China's 2009 China's 2009 credit fiscal stimulus stimulus U.S. TARP Europe's bail-out EFSF program

going to state-owned agencies given the banks traditional reluctance to lend to private SMEs. Sure, private firms might be borrowing from the expanding shadow banking system, but loan tenors tend to be a shorter 1-6 months, while interest rates can be significantly higher (anywhere from 20% to 100%) discouraging firms from borrowing to buy capital machinery (but not from making speculative bets in the commodity or property markets). (More anecdotally, the fact China National Radios economic programs have recently started with a public announcement claiming that the state sector is neither advancing () or retreating () at the expense of private sector, but rather that the two exist together in balance is just one more indication of how the issue is capturing attention).

Source: CEIC; SRA calculations

able to grow its way out of the problem (see The debt debate [1], 28 December). Ive earlier argued that China did much the same in the late 1990s as a means of reducing its bad debteven as Japan did the oppositeand it can do the same over the coming decade so long as nominal GDP continues to average above 10%. (For the record, reported nominal GDP growth averaged 15% over the past 10 years and 19% over the past 20 years).

Its politics, not just economics.

That said, the property sector best illustrates why it is tempting for China to nonetheless permit the statesector to advance at the expense of the private. The events of the past year, in China and abroad, underscore that the global crisis is no longer only about economics: it is also increasingly about politics. The Chinese states growing intervention in the market, for example, is driven largely by concerns about the worsening income inequality that stemmed from the two decades of freemarket reforms.1 To its credit, China is (again) ahead of the curve. The government recognizes that its failure to provide public housing is a major political challenge: after the liberalization of the property market in the late-1990s, public housing was largely overlooked until 2007, when it was realized that the market wasnt allocating enough housing to low-income households. It is a challenge faced by emerging markets across the world, from New Delhi to Riyadh, and it will become a serious social issue in the coming years, especially as growing urbanization puts sustained pressure on the environment. Fortunately, China is one of the few govern1. We expect to see similar political challenges across the rest of the world: its hard to overlook the social implications of 49.6% youth unemployment in Spain, even as the Euro crisis only just gets underway; or the risks of devaluation in Egypts currency and the knock-on effects for food inflation; or real and perceived growing income inequality in the United States.

More policy easing isnt always a healthy thing

Yet, for all my confidence that China will avoid a hard landing in 2012, the more fiscal easing is needed, the worse the medium-outlook appears. Part of Chinas success in dodging the global crisis was its ability to call on the state-owned banks, stateowned firms, and local governments to channel credit to largely infrastructure and other capital-intensive projects. The problem is that stimulus has raised the publicsectors share of economic activity at the expense of the more dynamic private-sector. More fiscal easing in 2012, either in response to a deepening global recession or property collapse, would have the same effect. Its difficult to show the states rising share of activity owing to the absence of decent data. However, one good illustration is the fact that the share of medium- to long-term loans made by the state banks has risen from 52% to 63% of total loans since 2007most of that is

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ments to be aggressively dealing with the situation, albeit not always successfully. But there are a number of problems with public housing; most relate to the fact public housing is a lowmargin and unproductive asset. Consider this: China plans to build an average 7 million public housing units annually over the next 5 years (2011-15). Its a huge increase on the annual average 3 million units built between 2008-10 (figures before 2008 are difficult to obtain). Its also far higher than the annual average 5 million units built by the private sector in the same period. Yet the economics are unpleasant. Five large stateowned firms dominate public housing construction. Furthermore, they are earning profits margins of only around 8%, according to a research unit of Soufun, a leading real estate data provider. That compares to the 15% to 25% profit margins for the private residential developers in recent years. In effect, the shift towards construction of more public housing implies that state-owned firms, operating at smaller margins, will capture an ever larger share of economic activity. Another problem is that public housing requires public funding to administer and so is another drain on already stressed local government finances (see Octobers edition of China Insider). I wrote in February last year about the southern city of Dali in Yunan provincethe city has a successful public housing program but faced some big questions: Who determines the allocation of units? What happens when residents dont pay their rents? How to set rents relative to income levels? In the private market, these questions are dealt with by market forces. In the public market, they require adding thousands of public service workers and expanding the responsibilities of local public housing departments. (The reports on Dali indicate that public housing departments are often understaffed and, even then, only staffed by part-time workers). A further problem is that public housing isnt a productive investment, at least not in the same way as is a factory buying new capital equipment. It might ease political risks by tackling social inequality, but it doesnt lay the foundations for sustainable long-term growth,

other than by freeing up income for spending on other goods and services.2

What are the risks of a collapse?

The degree to which China will have to rely on public housing, and other state spending, in 2012 depends largely on whether the private housing market crashes. The private market faces some challenges. National home prices have largely stalled over the last year, according to official data, and are falling on a monthly basis. Individual cities have even seen large declines. Floorspace under construction and floorspace starts (a proxy for housing starts) have also slowed to single-digit growth rates. So what follows is a brave statement; it was a sub-title in an editorial piece published by the Chinese-edition of the Peoples Daily last Tuesday: The fall in property prices is due to the governments intervention, not a change in supply and demand. Why brave? Because investors may account for up to 40% of demand, based on the limited company data available, so there is a big difference in whether the Peoples Daily was talking about real demand or real + speculative demand: theres always the chance that Chinas public housing construction is in the midst of a major, but much needed, boost
Million units
12 10 8 6 4 2 0 1999 2001 2003 2005 2007 2009 2011 2013 2015 Private Public

Source: CEIC, Soufun, SRA calculations

2. However, as my colleague Mike Every would argue, having a large homeless population; or one that has no disposable income after paying the rent; or that is squeezed into so small a space that they cant have kids, is hardly productive either!

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confidence in the governments intervention collapses and speculative demand vanishes in turn. That noted, they are also offsetting factors that cant be overlooked and argue against a nation-wide collapse in prices (or loss of confidence). First, the relative absence of leverage means local demand and supply conditions, as well as local household balance sheets, will play a more important role than it did in the US. (Mortgage debt accounts for 13% of GDP versus some 66% in the United States). The recent restrictions on non-residents buying in city limits further emphasizes the importance of local conditions. Second, cities will enforce the recent tightening restrictions with varying degrees of strictness. Their reliance on land sales as their main source of funding for infrastructure and other public spending (on average 40% of total revenues) will encourage many to only loosely enforce restrictions, or ease them significantly given the first sign of softening in the central governments stance. A look at major city-clusters around the country shows that property sales have collapsed in areas centred on Beijing, Shanghai, and Hangzhou, even as they remain steady in places such as Chongqing, Hefei, and Shenyang. (Ill be looking more closely at these city-clusters in next months report: but, in brief, its increasingly important to look at Chinas regional growth, rather than national). My own experience, travelling through near a dozen second-tier cities over the past six months, echoes the data, with some cities clearly about to suffer a horrible property crash even as others look more balanced owing to less supply, but also a stronger local domestic economy (typically the coastal provinces) that is less reliant on fiscal stimulus.

Zhujis overbuilding
A city in the coastal Zhejiang province

Source: Authors picture

Xiamens overbuilding
A city in the coastal Fujian province

Source: Authors picture

Reform must accompany stimulus

Whether because of chances that a property crash is limited to certain parts of the country, or because of Chinas ability to pump more credit into the economy, the odds are that 2012 turns out to be surprisingly dull, with the economy slowing, but still growing at above an 8% rate (not bad for even an emerging market economy!). But what really matters is the extent to which China is relying on policy stimulus, such as public housing construction, to drive growth in 2012.

In that event, fiscal stimulus must be accompanied by economic reforms: such as further liberalization of the services sector; improving the availability of credit for SMEs; better protection of IPR; greater spending on secondary education; and, raising incomes relative to corporate profits, to name a few. If not, then the economy risks becoming increasingly characterised by state-firms operating at low-margins, and while 2012 might look ok, the medium-term outlook (2013-15) will start to worsen. The problem is that economic reform is tough at any time, but its especially tough in an election year, with Chinas senior leadership due to be changed in late 2012.

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Inflation worries are still real

If theres any good news, its the likelihood that inflation will ease in 2012, if only for cyclical reasons as the global and domestic economy slows Slower global growth is likely to ease commodity price, while slower domestic growth, especially in the export sector, should ease pressure on both production costs and goods prices. The governments efforts to reduce transport costs for fruit and vegetablesthe major constituents of the consumer baskethave also helped ease inflation. I remain hawkish on inflation over the medium-term owing to structural shortfalls of production inputs, especially the countrys ageing labor force. (The average Chinese is 10-years older than the average Korean or Japanese at the same point in their development). Environmental constraints related to land and pollution is another inflation pressure. Nonetheless, slowing inflation should help bolster incomes and profits, especially among non-commodity related sectors.

What does it mean for the world?

Positives? Global financial markets can largely ignore China in 2012 and limit to their concerns to Euros possible collapse or a US recession, as the odds of a China hard landing remain small. Moreover, slower growth at 8% might result in lower commodity prices: a benefit to all economies. Negatives? China might have contributed to a global recovery over the past two years, but it also shares some of the blame for global imbalances. Indeed, the economy was relatively more balanced in 2008, or before the crisis, and a failure to accelerate reform will raise medium-term growth risks. Worsening imbalances in China means the country will not be as powerful a global growth driver over the medium-term. Surprises? The more likely surprise in that case is the chance that economic growth slows below 8%, perhaps as low as 5%. That isnt necessarily bad news for a country with population growth of just 1%, but it will remove the last remaining global growth driver and financial markets will not take the news well. Best regards, Ben Simpfendorfer

What does it mean for China?

Positives? The risks of a hard landing in 2012 are low. Debt levels are relatively low, in spite of worries about bad debts, while banks have plenty of liquidity if needed, and so China has plenty of fiscal stimulus to respond to either a depending global crisis or worsening property market correction. Negatives? More policy stimulus risks worsening existing imbalances. Fiscal and monetary easing will benefit large state-owned firms at the expense of their small private-owned competitors unless accompanied by more serious economic reform. The medium-term growth outlook will worsen as a result. Surprises? The government loses control of the property market, and prices crash as investors lose confidence. Public housing can only partly offset the loss of private housing demand and state infrastructure spending would bear the burden of supporting growth through a difficult period.

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