Orient Express

China represents both the greatest opportunities and the greatest risks for the Asia region as a whole. The high levels of growth are real; whereas the government used to talk about 8% growth as being sustainable, that level now seems to be moving closer to 9% or 9.5% long-term trend growth.

Some observers argue that China is probably experiencing total factor productivity growth in the vicinity of 6-7%, as rapid liberalisation has included: the near elimination of (merchandise) trade barriers; increased domestic labour mobility, albeit informal; the privatisation of at least half of the productive capacity of the economy; the restructuring and recapitalisation of the banking system; and the introduction of a domestic financial market.

Since China initiated its reform process in the late 1980s, the incidence of poverty has fallen from 50% to single digits, although with GDP per capita is still only US$1,700.

In Beijing, the host city for the Olympic Games in 2008, no expense is being spared to put on a world class event. The anecdotes are of power plants being moved and millions of trees planted so as to lessen the smog in the city; of armies of university students being trained in English to act as volunteer tour guides for the Games; and of the International Olympics Committee telling the Chinese to slow down on their construction projects so that buildings are not completed too far in advance of the Games. For those who don’t believe in miracles, there is an Achilles’ heel to China’s high growth. Most importantly from an macroeconomic point of view, the composition of growth is skewed to investment. This has led to concerns about the pace of credit expansion and credit quality. Loan growth peaked at 24% in late 2003 and slowed to around 13% in mid- 2005, but has accelerated again to above 16%.

Historically, China has been plagued by cycles of excessive investment that have brought about a massive pile-up of NPLs (non-performing loans) when the boom eventually went bust. The concern in Beijing is that, although many things have changed in China, the banking sector may not yet have changed enough to avoid repeating this history.

There is a political element to the recent upturn in credit growth and fixed asset investment, as we are currently in the Chinese equivalent of an election campaign. This year is the first year of the 11th Five Year Plan, when new projects were organized and signed off. Next year in October 2007 is the Communist Party plenum – the 17th Congress of the CCP – at which leadership positions are chosen and then voted upon by the National People’s Congress in March 2008. As the current leadership serves two five-year terms, the plenum designates the leaders who will comprise the Politburo from 2012.

As such, provincial officials are keen to promote their job creation credentials, and the easiest way to meet growth targets is to fund a project. Thus, despite a number of measures announced in the past six months to cool investment, urban fixed asset investment growth remains around 30% per annum. Many of the thousands of public demonstrations reported by the government over the past year have been by peasants expressing their anger at provincial-level takeovers of land to undertake massive works projects.

If the main driver of the present high rates of investment is the October 2007 plenum, then it seems unlikely that investment will decline considerably in the next 6-9 months. As such, a number of commentators have expressed concern about credit quality amongst some Chinese banks, particularly the second or third tier banks in provincial regions. NPL levels are presently low, but may rise again in the event of an eventual economic slowdown. At the same time, there is no data to indicate whether the concerns are valid.

The authorities acknowledge that the US$60 billion used to recapitalise the banking sector thus far is unlikely to be sufficient, and that further funds will be required. Using other OECD countries such as Mexico and Korea that experienced a banking crisis and eventual cleanup, an eventual cost of 25% of GDP – some of which was realised and some of which was not – does not seem unreasonable. In China, that amounts to US$600 billion.

Observers in Beijing suggested that government debt levels could easily rise from less than 30% of GDP at present to 70-90% of GDP if explicit and contingent liabilities related to the indebtedness of provincial governments and defaulted loans held by government-backed asset management companies (AMCs) were brought on to the balance sheet. The likelihood of substantial off balance sheet liabilities combined with concerns about present-day asset quality introduces the spectre of a domestic banking sector crisis over the medium term. Few believe that such a crisis is imminent, or certain. If the banks sufficiently manage their balance sheets and China grows into its expanding capacity, the debt burden will gradually fall. Yet, the ingredients for a crisis are present despite reforms of the past several years.

One obvious conclusion to reach from all of this is that a more “flexible” RMB (Renminbi – the Chinese currency) exchange rate regime is unlikely to eventuate or to have a very significant effect if it did so.

In the 14 months since the RMB was revalued, the authorities have put in place a functioning onshore domestic foreign exchange (FX) market that includes an interbank spot market, a trading platform and market makers; a growing FX forwards market; and a nascent interest rate swap market. The existing exchange rate regime already has as much flexibility as is required for the RMB to fluctuate dramatically; since parity is reset each morning, in theory the RMB can open the trading day at any value. The fact that the RMB does not fluctuate dramatically is not a function of the foreign exchange regime, but rather the PBOC approach to managing the currency. Given the lack of domestic experience in hedging currency risk, it can be argued that allowing greater currency volatility at this stage would be foolish.

Moreover, few believe that a 5-10% appreciation of the currency – which is at the upper limit of what the stability-seeking authorities are likely to allow – will substantially slow China’s export growth or reduce its trade surplus with the United States. As an example, the RMB appreciated by 15% against the EUR in 2005 and during this period Chinese exports to the EU rose by 31%. Rather, interest rates are key. The main area of economic overheating is in investment, driven by a banking sector that is flush with cash following recapitalisation and by government officials keen to graduate to higher office.

Under this scenario, surely the most efficient way to cool investment would be to further raise interest rates. The authorities have raised the official lending rate twice in the past six months, but market-based interest rates that are more indicative of the levels of liquidity are low; the 7-day RMB rate is around 2.2% versus 5% for US$ LIBOR. Ironically, one of the benefits of higher interest rates would be that banks would have greater incentive to invest their cash in more liquid assets, rather than piling into long-term loans to the real estate and manufacturing sectors.

Going forward, we expect China to experience high rates of investment and growth, and to avoid substantially altering the pace of currency appreciation. The ongoing strength of China puts the Asian region as a whole in a good position as the global economic cycle turns down. At the same time, limited local financial market development leaves the region more vulnerable than it needs to be to US market sentiment. Finally, tensions around China’s trade surplus and energy security are likely to remain on the agenda of global leaders for some time to come.

Amy Auster is the Head of International Economics at ANZ Bank