Squalls on the horizon

For international investors, getting a clear sense of the economic status quo and forward prospects for China - which increasingly set the tone for other Asian countries and indeed the world - can be difficult. Partly that is because of the complexity of the variables and the accuracy, or otherwise, of the figures. But, it is made even hazier by the lack of consensus in expert opinion.

Nevertheless, as evidenced by the sharp upturn seen in 2010 in M&A and private equity activity, China remains a key focal point in an intensifying wave of inbound and outbound investment. So some noted economists' views of the Chinese economy, and its evolving global interlock, provide interesting food for thought for investors.

The upside: steady as she goes

Inflation is one item at the top of their lists, the differentiators being how big the issue is or may become, and how deep its roots run. According to Andy Rothman, the Shanghai-based China macro market strategist with CLSA Asia-Pacific markets, the current inflation question marks are a passing weather system, literally.

Acknowledging the 5.1% year-on-year consumer price index rise reported in November 2010, he concludes in a recently released note, that 74% of it was a result of an aberrant spike in vegetable and fruit prices driven by shortages caused by bad weather. These have subsequently subsided by about 19%, he says. "China will have to become accustomed to a slightly higher level of structural inflation in the coming years. But rapid growth in income and GDP means a crisis in the CPI is not looming."

Rather he projects that the Chinese economy will remain steady this year, as will its impact on global commodities. GDP growth will slacken somewhat to 9.5% in 2011 compared to 10.2% last year. He estimates that nominal investment growth - the key driver of raw materials demand - will repeat its YoY performance in the 25% range. And he further predicts that such inflation as there is will peak by spring and average 4.5% over the year, low enough to allow a monetary policy that is ‘mildly accomodative'.

The counter argument

On the other side of the coin is noted American economist Paul Krugman, who in a January 20 editorial in the New York Times, strongly disagreed. "China has stumbled into a monetary muddle that's getting worse with each passing month. Furthermore, the Chinese government's response to the problem - with policy seemingly paralyzed by deference to special interest groups, lack of intellectual clarity and a resort to blame games - belies any notion that China's leaders can be counted on to act decisively and effectively."

How bad will it get? Warnings from some analysts that China could trigger a global crisis seem overblown. But the fact that these rumors are even circulating is an indication of how out of control the situation looks to some at the moment. Krugman also cites an interesting factoid relative to the CPI number quoted above, namely that PRC interest rates on bank deposits are limited to 2.75%.

Longtime Hong Kong-based independent economist Jim Walker offers some interesting wider context which contends that the short range ‘steady as she goes' view may be misleading, given, among other things, the extra-national links in the policy chain that is determining the global economy's future as well as China's now integral place within it.

Inflation (in this story's context) is the increase in money and credit in the system. "What has happened in this part of the world over the past two years, with policies like those adopted by the US in particular, is that there has been tremendous monetary accommodation region-wide," he told AVCJ. "Asian countries have tended to follow relatively fixed exchange rate policies against the USD. So when US monetary policy is very loose, they all more or less adopt a similar policy even when their domestic economic conditions are nowhere near as bad as they are in America."

In China's case specifically, he says, interest rates have sunk to very low levels, negative in real terms relative to the Chinese CPI. And in being held down, they amount to another form of monetary easing. Capital flows spurred by current policies in the US and elsewhere, are reflected in significant portfolio investment inflows in China, and to a lesser extent other countries in the region. This has also boosted domestic money supply.

The collective result is much broader inflationary pressures than those caused by the weather and its effect on food prices. It would seem the Chinese government itself is concerned, as evidenced by recent policy announcements which make it clear interest rate hikes, even those these look gradual, are now on the cards along with other measures intended to tighten monetary conditions.

Global ramifications

But Walker's bigger point is that the loose policy that has been in place in the East and the West for the past couple of years is making the global economy bi-polar. In the US and Europe, where central bank actions authored the approach, the scale of the private sector de-leveraging is now well underway. Equally, the paying down of debt is overwhelming the inflation these actions would normally have generated. But for China and the other Asian countries that rebounded so impressively post-GFC, these same loose ‘accommodative' monetary policies are fanning serious inflationary flames.

This is a real and present danger, Walker believes, "...since a lot of the incremental growth in the global economy has been coming from places like China and India (with reverberations keenly felt across the Asian region, and in other emerging economies further afield). Meaning it's a fairly serious threat to overall global economic health. And, ironically, the country farthest behind the curve in terms of tackling their inflation policy is China. They're beginning to crank up the monetary action just now, but it's going to get much nastier as the year goes on, probably resulting in much lower growth rates."

Another prominent Asian economist, Andy Xie, more or less agrees, adding, "China has announced their highest inflation figures for three years. As well there is G20 acrimony and threats of currency war in the wind. These things actually reflect the consequences of deep structural forces at play in the world."

The most significant is inflation, Xie believes, his basic point being that while it takes a long time to get it rolling, it can take just as long or longer to effectively resolve: his guess is that China - and the world - will be dealing with the fallout for a decade to come.

The backstory, he says, is that inflation first became a major market concern back in 2007, to the point where it had prompted countries to increase interest rates, right up until the subprime crisis erupted. "Suddenly everybody started talking about deflation and in the ensuing panic we saw government policy going into reverse and dramatically increasing money supply."

Xie estimates that China's money supply has expanded by 70-80% since the crisis, with India's growing slightly less at about 70%. That's a result, he says, of a policy mistake, opting to print money on a grand scale as the best means of cushioning the crunch, when there wasn't much of a crunch at all.

The result? While China reports a roughly 4.5-5% inflation rate, the reality is probably closer to double digits, Xie speculates. India is in a similar position at the retail level, though it's more opaque because of different metrics.

"The point is interest rates are far too low. And usually, if you have high inflation and low interest rates, you have instability and currency depreciation," he said.

Impact on the home front

As to how this impacts China domestically, CLSA's Andy Rothman again takes a more or less benign view. While local consumption won't replace investment as the primary growth driver in 2011, he says it will still make up an estimated 42% of GDP growth. And last year, retail sales were up about 18% in nominal terms, 15% in real terms. He does acknowledge, however, that this number slipped to 13.4% in November and is expected to dip even further in 2011.

Still, he believes that "consumer spending will be supported by another year of double-digit wage growth, moderate inflation and tax cuts for low- and middle-income families."

Walker, however, believes the problem with that "is that the areas that the growth is being concentrated in are mostly unproductive, and even empty, property investments, and local government infrastructure programs. There really hasn't been a re-balancing of the Chinese economy away from the old model of investments in exports."

And with the latter subdued over the last 2-3 years, the unproductive sector investment has become the main growth driver. "How they're going to unwind that balance is anybody's guess. I just can't see where the areas are that are going to pump up growth over the next 2-3 years," he says. "There's a lot of shakeout of bank capital required in China, and a very real increase in the price of capital needed in order to try and direct investment flows into the higher return areas of the economy. But that means slowing growth pretty dramatically, and that's not a game the Chinese play particularly well. Moreover the fact that all this is being played out in an increasingly inflationary environment just makes the problems more pointed."

Andy Xie takes this thesis to its ultimate extension: the net effect of present trends, left unchecked, will be increasingly skewed income distribution, a by-product of both globalization - because capital is mobile where labor is not - and financial speculation.

"All these money supply issues are creating financial speculation bubbles, which are really just another kind of income concentration. And as this intensifies - the rich vs poor gap - political and social problems will erupt, east and west," he postulates. "China's household income is only 40% of GDP, among the lowest in the world," he says. "In the US, by comparison, 1% has 25% of the income and 40% of the wealth. These two sets of numbers underscore the challenges that lie ahead, and suggest the amount of instability we could see. That's something investors have to keep in mind: instability is here to stay."

Walker adds another obscured reality. The Chinese, he says, don't have many companies that actually make a lot of money. In fact, their return on equity is one of the worst in Asia, despite having one of the highest growth rates.

"If capital were priced properly the country would be lucky if it was growing at all," he told AVCJ. "The question is whether capital is going to become more expensive. And the Chinese (authorities) haven't shown an appetite for that sort of painful measure yet. But I'd say the growing inflation pressures are forcing their hand."

Xie also sees this as the basic solution. "China needs to raise interest rates by at least 3 percentage points over the next 2 years," he says baldly. "And the quicker they raise them, the better. The problem, however, is that there are too many powerful vested groups that want to keep the stock market up, the property market up. They worry raising rates will cause these markets to drop. That's why we're only seeing incremental moves. But when interest rates are raised 25 basis points, what is that? China's average growth rate is 4x the US. So it doesn't help if you do what's needed in such a small, protracted way. You have to sort of move it 1% at one go."

The currency war threat: real or red herring?

In terms of the threat of currency issues and conflicts, if not outright wars, Walker tends to see these as real. "As I've said to a number of our clients, the real battleground will be the emerging markets because of the (US-linked) policy positioning that they've tended to adopt, and with it their essential accommodation of inflation."

At the same time, however, another side effect of the cheap US and European money has been the build-up in commodity prices, driven as much by these financial flows as by real demand. What that means, given that emerging markets are much more commodity-intensive than places like the US or Canada or Europe, is that there is real destruction of consumer buying power in such markets.

To Andy Xie, on the other hand, the much-touted currency war threat is more of a red herring, diverting attention away from the much more real and impacted inflation-rooted problems mentioned above.

"All this currency war unease is causing financial markets to support unstable situations like big country deficits and negative interest rates. China and Russia, for example, are sustainable because they have huge current account surpluses. So when they eventually move back from their loose monetary policy, you may have an implosion, eg domestic asset prices coming down. But you will not have an explosion, such as capital flight and currency devaluation.

"On the other hand, if you look at Brazil and India, they run huge economic deficits and negative interest rates. And historically, this combination over time always leads to a crisis. But nobody wants to look at that. Instead they want to watch the dollar, the threat of currency war. I think this is quite dangerous for investors. But that's the kind of world we're in."

The end point he sees is when the US treasury market collapses, because the US, in a low interest environment, is addicted to printing money. And it will continue to do so until an event of this magnitude happens to stop it.

 

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• Greater China