TCS Daily

China's Economic Rollercoaster

By Alan Oxley - February 17, 2004 12:00 AM

China has created the third wave of Asian growth. When it collapses, as it must, will it bring down the world economy? This will depend on how successful foreign enterprises are at managing risk. The problem is that no one knows just what the risk is.

China has generated one of the greatest booms in history. We don't make more of it because this it is almost what we expect from Asia. Japan created one of the biggest booms when its prolonged growth made it an economic titan. Then the Asian tigers followed. For nearly two decades, economic growth between eight and ten percent per annum was the norm in Asia while the rest of the world grew at three percent.

China took up the mantle after Japan ground to a halt and the Asian currency crisis popped bubbles in three Asian economies in 1997. Last year China's economy grew nine percent. It is now a significant driver in the world economy. Morgan Stanley economist Andy Xie reports that China now accounts for over one-fifth of global growth in trade.

China is now a major global market. Its share of world imports was 4.4 percent last year, making it the fifth biggest market the world, just behind Japan at 4.9 percent. (The US is the world's biggest market, importing nearly eleven percent of the world's trade last year.) China's share of world imports has soared from 1.5 percent in 1990. China is now propping up growth in other Asian economies and is leading global demand for commodities.

Deutsche Bank economists report China's demand for commodities had increased by about 50 percent in three years. Last year, of world consumption of metals, it took 21 percent of alumina, 19 percent of copper, 21 percent of zinc, 27 percent of iron ore, 28 percent of crude steel, 11 percent of nickel and 37 percent of cement. Iron ore, coal and steel producers around the world are gearing to meet a projected increase in demand of 25 percent next year. Once an exporter of oil, its demand for energy seems almost insatiable.

Last year China generated five percent of the world's exports. (The US share was 10.7 percent, Germany's 9.5 percent). In 1990, China's share was only 1.8 percent. China is set to overtake Japan as the third largest exporter in the world. Its increase in exports this year is equal to its total exports in 1990. US producers complain China's pegged currency gives it unfair advantage. Those who do business in China face the real risks.

Individual companies are becoming exposed to risk in China. Some 14% of Motorola's sales, or $3.7 billion, came from China in 2002. The country accounted for virtually all Volkswagen's sales growth in the same year. Like all foreign corporations they face a dilemma. Can they afford not to be in China? Can they afford to be exposed to China's markets?

The problem is the state of China's finances. The recent abrupt government takeover of the Shenzhen brokerage, China Southern Securities, and the $45 billion bailout of two state banks announced in January once again highlight the fragility of China's financial system. It is awash with debt. Total national debt, including foreign loans, stands at 176% of GDP according to estimates from Morgan Stanley.

The measure of the importance of debt is how affordable is the cost of servicing it and what sort of debt is it. While China's growth rockets, it can afford a lot of debt. But the poor quality of the debt is the worry. A bigger worry is no one knows just how much there is. Official figures are no guide. Estimates by independent analysts vary widely.

CLSA, a brokerage house with extensive China experience, reported in 2002 in Banking in China, that total non-performing loans (NPLs) in the banking system were around US$450 billion, or 37 per cent of gross domestic product. Losses from these loans were forecast at US$360 billion, or 30 per cent of GDP. Others say things are worse. Standard and Poors estimate that bad debt could be as high as 45% of outstanding loans, and a full bailout could cost about $600 billion, or some 40% of last year's GDP. James Kynge reported in the Financial Times in 2002 that independent economists have put the level of NPLs at around 50 per cent of GDP.

The rate of foreign investment in China is very high. Under normal circumstances, that can be regarded as an effective source of finance, although the flow is directly linked to optimism about growth. However, those familiar with investment in China have warned for years that most "foreign investment" in China is in fact money recycled out of China, much of it from state owned enterprises that are technically bankrupt.Ho

Recent analysts draw parallels with conditions in China today and the situation in Asia on the eve of the currency crisis. Some saw the collapses in Southeast Asia as a classic property boom and bust. China certainly looks like that. Donald Straszheim, an independent economist who is generally bullish on China, sees parallels with the Japanese system, where politically-influenced loans led to over-spending on infrastructure projects: "China's financial system is heading for a Japan-style quagmire."

The difference between Japan and the Asian currency crisis economies was that Japan had vast savings to dip into. Rather than crash, it ground to halt. China has savings, but how do they compare to the debt, how much debt is there and has it got the system to manage a crash?

Andy Rothman, China strategist at CLSA identifies the primary problem as misallocation of resources. "Five years after it began steps to recapitalise its state banking system, China still suffers from an increasing stock of non-performing loans, widespread capital misallocation and manifold structural inefficiencies" Rothman said.

Few economists think a financial meltdown is imminent, but all are warning about the level of debt. We have to remember one thing about economists. They generally get it right, but can never tell us the timing. All, however, recognize what the impact of financial failure in China could be on the world economy.

China has become an important contributor to global growth, the major global consumer of commodities, a prop economy for much of the rest of Asia and an important source of earnings for major global corporations. We got a small taste of the impact of economic correction a decade ago.

In 1993 the Chinese government slammed the brakes on growth to stifle inflation, creating a sharp drop in both economic activity and demand for products from abroad. Steel imports, for example, fell to 22.8 million tons in 1994 from 33.5 million tons in 1993. The stakes today are far higher. Morgan Stanley has predicted that even if Chinese growth were to slow to 8%, commodity prices could fall by 15%. Imagine the impact of a full scale recession.

China has not had the normal cycle of growth and recession. Desperate to maintain growth to generate jobs, China's leadership has managed the economy to keep growth. We know its instruments of control are crude. The financial system is weak. The challenges facing the Chinese leadership would defeat most politicians in most countries. They are good, but they would have to be miracle workers to prevent a crash.

Alan Oxley is the host of TCS Asia-Pacific. He last wrote for the site about trade between India and Pakistan.


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