Can China Avoid a Post-Olympic Economic Downturn?

Economic analysis indicates that countries that host the Olympic Games typically suffer from economic decline and currency depreciation in the months following its conclusion. The "so-called ‘Valley Effect’ is mainly caused by a dramatic increase in investment in the pre-Olympics stage, accompanied by a boom in consumption and revenues, [but] investment and consumption shrink in the post-Olympic stage." On the surface, China fits this mould, as it spent upwards of $40 Billion building venues and upgrading infrastructure in preparation for the Games. At the same time, most economists agreed that the Chinese economy was both more robust and more diverse than previous hosts, and could even receive an economic boost from the Games, as a result of increased media exposure and tourism.

The first bump in the road came in the form of a tainted products scandal, which led to the recall of dozens of items, including toys, medicines, and most recently, dairy products. Then came the credit crisis, which exploded in the US and quickly spread to the rest of the world. While the implications for China are not entirely clear (for reasons that will be discussed below), it seems almost certain that the economy will take a hit. In which case, it probably won’t be possible to disentangle the (negative) economic impact associated with the Olympics from the general economic downturn, but I don’t imagine this is of much concern to investors, anyway. Given the rising prominence of China within the framework of the global economy, analysts are watching with baited breath to see if and how China can avoid a dreaded economic downturn.

Falling Exports

The structure of China’s economy is such that exports (and investment in fixed assets to produce those exports) represent the most important component of GDP- as much as 40%, according to one estimate. Unfortunately, as a result of the worldwide economic downturn, global private consumption is "expected to rise by 2-4 per cent this year. That compares with an 11 per cent jump in 2007, and contrasts sharply with the boom in personal spending this decade." The effect on the Chinese economy has been, and will continue to be devastating. In November, overall exports fell for the first time in seven years, and declined by a whopping 6.1% with its most important trade partner, the US. One analyst noted: "Many analysts had anticipated that the monthly trade figures would show China’s export machine slowing along with the global economy, but few had expected it to slip into reverse."

The decline of exports has already begun to ripple down through the economy. By no coincidence, Chinese industrial output is also growing at the slowest pace in seven years. In fact, "with five back-to-back purchasing index readings signaling contraction, ‘the manufacturing sector, which accounts for 43 percent of the Chinese economy, is close to technical recession." Meanwhile, China’s codependent trade partner, Hong Kong, has witnessed its benchmark purchasing managers’ index fall to the lowest level since the 2003 SARS outbreak.

Factory Closures

"A sharp deceleration in industrial activity is being amplified by stock build up…many steel factories and other factories may just as well close down because they have enough inventories to provide customers without producing anything." In other words, the next link in the economic chain, the factories themselves, is beginning to buckle. The numbers are staggering; China’s Pearl River Delta manufacturing base has already seen 7,000 factories close in the first nine months of 2008. As if the economic recession wasn’t punishment enough, Chinese factories must cope with an increasingly harsh business environment, since "raw materials cost more, labor and environmental laws have grown stricter, exporters are getting fewer tax breaks, and a string of product recalls have raised questions about Chinese quality." Economists estimate that altogether, 100,000 factories will close in China in 2008. The actual number could be even higher, due to the unreliability of Chinese statistics and the opacity of Chinese bankruptcy laws. Factories that remain open will be forced to consolidate their operations with those of rival companies, and/or retool in response to a decline in business. In short, millions of workers are becoming redundant. The official employment statistics show that 6.7 million workers have already lost their jobs. Given that the economic boom of the last decade drove over 130 million migrant workers to cities in search of work, the level of joblessness could climb quickly.

At this point, it seems that only Chinese government economists are delusional enough to believe the economy will continue to expand by the 10%+ rate that has characterized its growth for the last 30 years. Private-sector economists are much less optimistic; Goldman Sachs, for example, forecasts 2009 GDP growth of only 6%. In the words of one economist: "It is not a recession, but it will feel like one to the average citizen and will feel like a depression to the 100 million or so migrant workers, many of whom are out of a job and stranded far from home."

Slowing Inflation

Price stability represents perhaps the sole bright spot in this morass of bad news. Thanks to precipitous declines in oil and energy prices, as well as fruitful initiatives aimed at boosting domestic food production, consumer inflation has retreated from dangerous highs. According to a Reuters poll, "The consumer price index, is expected to have risen 3.0 percent from a year earlier, a marked reduction from a near 12-year high in February of 8.7 percent." The decline in producer prices has been equally dramatic. Economists caution, however, that this is a double-edged sword: "Gargantuan consumer of commodities that it is, China benefits from material costs deflation in a way that slower growing developed economies don’t. But deflation in China would become a problem…[since] consumers who expect prices to carry on falling are more likely to keep hold of their cash."

Weakened Financial Sector

The collapse in real estate prices that is at the heart of the global credit crisis has not spared China. National statistics are difficult to come by, but anecdotal reports paint an unambiguous picture. Shenzhen, previously the country’s hottest property market, has witnessed sharp declines in prices, with developers offering deep discounts on new projects. In Beijing, "the number of residential properties sold during the [October] weeklong national-day holiday…was down by 72% compared with the holiday in 2007." Publicly-traded shares of Chinese real estate companies have declined proportionately, due to bleak projections for the immediate future. The government has been slow to react, unsure whether it should appease aspiring homeowners, or tread cautiously in order to minimize the detrimental impact of a decline in construction on economic growth. Ultimately, "18 cities, including Hangzhou and Shanghai, have introduced measures to prop up the market. These include cuts in transaction taxes and even subsidies for homebuyers." Unfortunately, counters one analyst, "The government’s latest real estate policies aimed at boosting home purchases won’t change peoples’ expectations that property prices will fall further."

A prolonged period of declines in prices for real estate and other assets wouldn’t take long to find its way into the country’s still fragile financial sector. Only a few years ago, the Central government attempted to head off an inevitable crisis as a result of non-performing loans, by injecting hundreds of billions of dollars directly into banks with the most unstable balance sheets. Unfortunately, the last few years have witnessed a flurry of new politically-motivated (and probably unprofitable) lending activity, which could become painfully exposed as a result of the slowing economy and then exacerbated by new loans that will be required to fund the government’s recently announced stimulus plan (to be discussed below). One analyst warns: "Chinese banks are likely counting large amounts of questionable loans as good assets on their books. No one knows the extent of the problems in these financial institutions, but the central government’s statistics showing single-digit nonperforming-loan ratios have a too-good-to-be-true quality to them." This pessimistic outlook is shared by another analyst, who estimates the NPL ratio at 20-40% of GDP.

Sagging Stock Market

All of the bad news (and then some) has already been priced into Chinese share prices, which have retreated sharply after rising 500% over a two-year period. Despite a whopping 50% decline in 2008 alone and valuations that some analyst would consider attractive, it could be a long time before prices recover. The government’s response has been contradictory: on the one hand, it has offered incentives to investors (in the form of lower margin rates and taxes) as well as attempting to prop up the market by purchasing shares directly. On the other hand, it is requiring companies to pay out higher proportions of net income to shareholders in the form of dividends, which could come at the expense of new factories and spending on R&D. Despite the grim outlook, one analyst remains optimistic that "just as the big fall in our [US] share market was led by the Shanghai index so the current rise has also been led by Shanghai."

Will the Chinese RMB Appreciate?

The Chinese RMB remains the wild card in an environment where virtually all prices and indicators are trending downward. In a related article, I noted that in late 2008, "investors had made significant bets that China would reverse its official policy of RMB appreciation. Futures prices indicated that investors collectively expected the currency to depreciate over 7% against the Dollar over the next year, as part of a comprehensive Chinese policy to boost the faltering economy. Since then, however, the RMB recorded its biggest one-day rise since the currency peg was abandoned three years ago, and investors subsequently scaled back their bets. While it’s unclear what caused the sudden change in sentiment, there are a few factors which probably contributed. First is Treasury Secretary Henry Paulson’s recent visit to China, in which he encouraged China to continue to permit the the Yuan to appreciate. In addition, high-ranking Chinese economic policy-makers have indicated that market forces will increasingly determine the valuation of the Yuan. Finally, there is the recent election of Barack Obama, a long-standing critic of what he believes to be the undervalued RMB."

The issue of China’s currency has important macroeconomic implications because of the pile of foreign exchange reserves maintained by its Central Bank. These reserves, currently estimated at $1.9 Trillion, recently fell for the first time in seven years. Despite the insistence of some economists that the nature of China’s economy is such that it will continue to purchase US government bonds, statistics and common sense suggest that this is very much in doubt, due to lower Chinese tax revenues and plans for higher domestic spending; "All the key drivers of China’s Treasury purchases are disappearing; there’s a waning appetite for dollars and a waning appetite for Treasuries." This will affect the US by making it more difficult for the Obama administration to finance its own economic stimulus plans, as well as increasing long-term interest rates at every level of borrowing, from institutions down to individual homeowners.

Government Stimulus and Economic Restructuring

Naturally, the government of China is not sitting by idly as the economy flounders. It recently "announced a four trillion yuan ($586 billion) stimulus package, the largest in the country’s history….the two-year spending initiative will inject funds into ten sectors, including health care, education, low-income housing, environmental protection, schemes to promote technological innovation, and transport and other infrastructure projects." This will be supplemented by tax cuts and monetary policy initiatives, as well as specific plans (discussed above) aimed at combating sagging property and equity markets. In addition, local governments will chip in 20 Trillion yuan of their own to fund smaller-scale projects. While skeptics note that the true amount will probably be substantially less (since some of plan will no doubt overlap with spending already earmarked in the budget), the consensus opinion is that it is a most welcome measure. The only concern, remarkably, is whether it will be enough to stimulate an economy that is increasingly sprawling and complex. Accordingly, both the Premier of China as well as independent analysts have suggested that another stimulus plan could be unveiled as soon as early 2009.

The stimulus plan must be implemented as part of a broader structural change in China’s economy, whereby growth comes not from exports but from domestic consumption. China’s citizens are among the notorious savers in the world, due both to cultural factors and to a gradual elimination of state social programs, such that education, health care, and retirement costs are increasingly born by individuals. Fortunately, "there is significant room for a more rapid expansion of consumption; China’s household consumption-to-GDP ratio (35.4 percent in 2007) is one of the lowest in the world, the country’s fiscal situation is strong and the economy is only lightly leveraged." The only thing preventing domestic Chinese companies from devoting more attention to the domestic Chinese market is ironically the government, itself. The official economic strategy remains focused around exports, which are promoted through import substitution, tax incentives, and a cheap currency. If anything, the government has become more steadfast in recent months, halting the appreciation of the RMB and increasing tax rebates for export-oriented companies.

If not for its obstinacy and sheer misguidedness, the Chinese government is well poised to implement such a shift. "Previous prudence has left plenty of room for a stimulus: the budget surplus stands at 1-2% of GDP (depending on how you measure it) and total public-sector debt at less than 20% of GDP, one of the smallest of any large economy." In addition, the absence of democracy means the government can act swiftly and efficiently when carrying out policy, without having to worry about normal checks and balances that would inhibit such a process in an industrialized country. Finally, China’s growing middle class has proven not only willing, but eager to become more avid consumers, as retail sales continue to rise by a steady clip despite the economic downturn. In short, while the next couple years will probably see diminished growth, responsible planning could mitigate the painful transition by rewarding China in the period that follows.