Monetary Policy

China Forgets Inflation and Goes for Growth


China has just pulled off one big U-turn. After months of battling inflation, the government in Beijing has decided its new priority is faltering economic growth. The central bank announced on Nov. 30 it would cut reserve requirements for banks, freeing up 350 billion yuan ($55 billion) to lend in the coming months. “This is a big signal—a very public shift for Beijing,” says Stephen Green, regional head of research for Greater China at Standard Chartered Bank. He predicts four more reserve requirement cuts next year, while both Goldman Sachs (GS) and HSBC (HBC) have said interest rate cuts could follow.

The world has changed a great deal since last July, when Chinese inflation hit a peak of 6.5 percent. The People’s Bank of China, the country’s central bank, had raised benchmark rates four times and reserve requirements seven times over the last 12 months to stifle inflation, which was triggered by rising food prices and ambitious public spending to contain the economic spillover from the U.S. downturn. Since summer’s end, inflation has started to drop, and the euro crisis has pushed Europe—China’s largest overseas market for toys, textiles, machinery, and electronics—closer to outright recession. In October, European orders for Chinese goods fell 22 percent from September, according to China Customs. “The euro zone is looking more perilous by the day, and [the Chinese] know how exposed they are to jolts in global growth,” says Alistair Thornton, a China economist with IHS Global Insight (IHS). On Dec. 1, Beijing announced the first contraction since 2009 of its manufacturing sector, which officially makes up about 50 percent of gross domestic product.

China’s real estate sector is starting to fall back to earth, too, spurring fears of a knock-on effect for steel and other construction-related industries. Steel profits dropped 82.6 percent in October from the month before, according to the China Iron & Steel Assn. Real estate prices fell for the third consecutive month in November in China’s 10 biggest cities as well as in smaller locales. Property prices are reaching a “turning point” as developers face tighter credit conditions, the central bank warned on its website on Dec. 2. “The bigger concern that banks and companies have is whether a 20 percent fall in home prices might induce panic selling,” it said in its statement.

Releasing billions of dollars of new loans to build more housing, as well as bridges, roads, and subways, will likely complicate any effort to clean up problems generated by the last splurge. Powered by double-digit annual growth in lending, China pumped up investment in infrastructure and factories 24 percent to 30 percent a year for the last three years. The country thus managed to avoid the slowdown that plagued most of the world.

Yet much of that loose credit leaked into the usurious shadow banking sector, estimated to total 10 trillion yuan by June 2011, according to Jianjun Li, a professor of finance at the Central University of Finance and Economics in Beijing. That’s about one-fifth of total lending. Those loans, at annualized rates of 40 percent or more and largely beyond regulators’ reach, are hammering small businesses that borrowed from the informal banks.

The easy credit unleashed in 2009 and 2010 also helped propel a rise in local government debt, officially estimated at 10.7 trillion yuan at the end of 2010 and held by more than 6,500 financing vehicles (local governments are largely banned from borrowing directly in China). Shen Minggao, head of China research at Citigroup (C) in Hong Kong, says many of the investments made by local governments may show little return, which could lead to a surge in nonperforming loans. “Local government loans are the largest risk” facing China’s economy, he says. “If the economy suffers a serious downturn, the banks are in deep trouble.” As much as 30 percent of China’s total loans could go sour, Fitch Ratings predicted in April.

The renewal of easy credit could further slow down the government’s reform plans. Policymakers say they want a balanced economy where private enterprise plays a larger role and Chinese families consume more, which would reduce the country’s dependence on exports and investment. The reform effort would also lessen the power of state monopolies in telecoms, utilities, banking, and insurance. Such moves over the long run would make the economy more diverse and less exposed to destabilizing forces. Yet they also take time and commitment from the top to work. Today Chinese are encouraged to save instead of consume. As a result, personal consumption’s share of GDP has actually shrunk since the 1980s and is still less than 40 percent.

Now with another crisis at hand it’s simpler to fall back on the tried and true methods of nurturing growth, whatever their risks. Arthur Kroeber, managing director of Beijing-based economic analysis firm Gavekal-Dragonomics points out that as a new leadership prepares to take charge next fall, most officials are loath to rock the boat.

The go-slow approach to reform reflects the clout of economic conservatives, according to Tsinghua University professor Patrick Chovanec. While the central bank has been viewed as generally reformist under Governor Zhou Xiaochuan, “they don’t have much power,” Chovanec says. That contrasts with state planners who still believe that supporting the manufacturing and infrastructure work often done by government-owned companies is the best way to ward off a recession.

That’s not a balanced view of development, yet top officials express little concern as they contemplate a fresh bout of global economic turmoil. “An unbalanced recovery would be better than a balanced recession,” Vice-Premier Wang Qishan told U.S. trade officials in Chengdu on Nov. 21. There’s another way to look at the situation, though. “At some point it doesn’t make sense to keep on building,” says Chovanec. “China has built tomorrow’s infrastructure and housing today. So what is it going to build tomorrow?”

The bottom line: China’s banks could soon be lending more than $55 billion to finance more infrastructure and real estate, risking a bubble in the process.

With Henry Sanderson
Dexter_roberts
Roberts is Bloomberg Businessweek's Asia News Editor and China bureau chief. Follow him on Twitter @dtiffroberts.

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