Holding back the hand that feeds China

China's slowing manufacturing index represents a dilemma for Beijing, which will be wary of stimulating the economy too far, for fear of reinflating a huge property bubble.

Fears over the faltering Chinese economy will cast a shadow over global markets this week, after the release of figures on the weekend showed that the country’s giant manufacturing sector is battling a slump in export orders.

China’s official purchasing managers’ index dropped to 50.2 last month, down from 50.4 in May, and its lowest level in seven months. Some economists now estimate that the China’s growth rate fell below 8 per cent in the first half of the year as demand for Chinese exports, the main driver of the Chinese economic miracle, has been dented by the growing economic woes in Europe and the United States.

Beijing will now face increasing pressure to cut interest rates and to boost spending on infrastructure in a bid to boost economic activity. Already China’s central bank has been reducing the level of deposits that banks must hold in reserve, and last month it cut interest rates for the first time in more than three years (Worries in the quarries as China cuts, June 8).

But Beijing will be wary of cutting interest rates too far, for fear of reinflating the country’s huge real estate bubble. And it will also be cautious when it comes to another massive spending spree because the last one – undertaken in the wake of the global financial crisis in 2008 – left the country littered with countless ill-advised infrastructure and real estate investment projects that are now clogging up the balance sheets of the country’s state-controlled banks.

Indeed, some analysts warn that China is yet to feel the full brunt of its massive real estate frenzy, which continued to run into 2011. Last year, residential construction accounted for a massive 9.2 per cent of Chinese GDP – well above the 6 per cent of GDP that the US saw in 2006 at the peak of its housing boom. Indeed, the only country that has hit that level is Spain, immediately before its own real estate bubble burst.

They point out that the current decline in real estate prices (average new home prices in 70 major Chinese cities have fallen in the eight months to May) will lead to even weaker Chinese economic activity, because a slowdown in real estate construction will mean less demand for constructions materials, such as steel, cement and copper.

What’s more, many affluent Chinese have ploughed their money into real estate, and a sharp drop in prices will have a huge negative wealth effect, forcing them to cut back on spending.

The finances of Chinese regional governments will also be hard hit by a sharp slide in real estate prices, as local governments typically raise between 30 to 40 per cent of their revenue by selling off land. If their revenues fall, local governments will have even less money to spend on running their local operations and on building new infrastructure.

Chinese banks will also feel the pain, as local government financing vehicles used property as the main collateral when they borrowed money to finance new infrastructure projects. The banks have an additional exposure because in recent years many state-owned enterprises have been using their bank loans to engage in real estate speculation.

Beijing’s policymakers face a tough period ahead as they brace for a slowdown in exports, at a time when the country’s cooling property market is likely to prove a drag on domestic activity. They will be wary of providing too much stimulus, for fear of exacerbating the already dangerous imbalances in the Chinese economy. On the other hand, they will be fearful of allowing economic activity to slow too sharply for fear of unleashing a fresh round of widespread social unrest.