Monday, November 14, 2011

Fears of China Economic Hard Landing

Recently China GDP growth is slowing down over a tighter monetary policy and weaker global demands, triggering market fear that the second-largest economy in the world may start to slide towards an economic hard landing.

As you may also expect, any China economic hard landing can be bad news for global commodity markets. When the prices of industrial metals (e.g.: copper) fall on weaker Chinese demands, it will induce a domino effect in agricultural commodities such as wheat, cotton and soy beans etc. This kind of commodity market crash will also result in weaker commodity currencies like the Australian dollar (AUD), the New Zealand dollar (NZD) and, to a smaller degree, the Canadian dollar (CAD).

An economic hard landing, by definition, is usually referred to an economy falls rapidly into recession, and can happen if a central bank aggressively tightens its policy to curb inflation pressure or if an economy suffers from sharp external or internal impacts.

One of the major problem in China is that People's Bank of China (PBoC) keeps trying to delay raising interest rates (reference: Important 2010 Internal Review). It has started to form a really bad impression to the market that PBoC is unwilling to raise interest rates against inflation. In fact, PBoC can just temporarily let the market to speculate in a way that although it does not raise interest rates by now, it is going to do so soon. Maybe it is a strategy to control market expectations, however, history tells us that it is highly risky to control in this way. This policy impression to allow excessive real negative deposit rate (now it still has 3.5% - 5.5% = -2% in October) simply forces Chinese savers to provide more subsidies to borrowers, and thus encourages Chinese savers to look for better places to put their money and has escalated the risk of asset bubbles forming. Everything will be too late when the Chinese central government is forced to introduce extraordinary heavy measures to squeeze an asset bubble. Historically PBoC might overdo the tightening process, and it would just end up an uncontrollable bubble burst (hence an economic hard landing). That is why inflation is always a concern in China, not really because of the inflation itself but the fears of market crash it might eventually result in.

To avoid this, People's Bank of China (PBoC) should better give an impression to the market that it will be more decisive to raise interest rates, not just to raise reserve requirement ratio (RRR), whenever necessary.

It is also true to say that a potential collapse of China property market and the bad loans in Chinese banking sector are the two key internal contributors that could seriously hurt the national economy and might induce an economic hard landing.

(1) China property market: In China, a significant drop in property prices may induce severe wealth destruction. It is because the mainland Chinese people basically have only three main investment options, namely bank accounts, property market and equity market. Because real deposit rates have become negative since February 2010, a lot of Chinese people have then drawn their money out of bank accounts and put them into equity and property markets. Since the equity market in the mainland China is still not mature enough (i.e.: just a good place for large companies to raise funds and hence not a good place for small investors), many Chinese people have no choice but to put their money into property market. That is why the China property prices are easy to soar, and this problem has always been a concern of the central government. As the measures of New National Eight have been implemented step-by-step to cool China property market, the potential risk of property market collapse is now contained.

(2) Bad loans in Chinese banking sector: please refer to our separate article Possible Solutions for LGFV Debts that mentioned the risk of bad loans in Chinese banking sector is contained and should be manageable.

As the risks from the above two internal factors are now contained, we believe China can likely engineer an economic soft landing. Fears of an economic hard landing can be relieved but, of course, external factors such as European debt crisis and US weak economy outlook, though are out of China's own control, still can hardly be ignored as they may have adverse impacts on emerging economies in the years to come.


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