Sunday, May 29, 2011

Not when but if China slows down

THE International Monetary Fund projects that within five years, China will overtake the United States to become the world's biggest economy. Yet investors are nervous that long before then the world's most astonishing growth engine might run off the rails.

In consecutive falls since the middle of last week the Shanghai Composite Index shrank by 4.75 per cent in six days, amid fears that the People's Bank of China might overreach in its campaign to rein in inflation.

The index is now more than 10 per cent below its peak, mainly because China's inflation rate climbed to 5.4 per cent in March (BHP and Rio, take a bow) and in just seven months, the central bank has tightened quantitative controls eight times and raised interest rates four times.

So it should be no surprise that recent figures have shown growth in manufacturing output slowing, or that analysts such as Goldman Sachs are edging down their forecasts of China's 2011 growth (in Goldman's case, just from 10 per cent to 9.4 per cent), or that Standard & Poor's should highlight the possibility that in a worst case scenario, 10 per cent of loans by Chinese banks could be non-performing within three years.

Does that mean China's extraordinary run is ending? And what are the risks for us if our main customer should stumble? Like most of us, I'm no China expert. But over the years, we've all seen warning after warning that China's record growth is about to end. So far it hasn't, and the institutional wisdom is that it won't.

This year the IMF estimates China's GDP will be 20 times what it was in 1980. That's right: twenty times. Australians think we've done pretty well, yet our GDP is only 2.7 times the size it was then.

On the IMF's figures, China has gone in just 30 years from being one of the world's poorest countries to being its biggest middle-income country. For 30 years it has averaged growth of 10 per cent a year. Not even Japan or South Korea have matched that.

Nonetheless, China has got there with an economic model that owes far more to its Asian neighbours than to standard Western economics. In Western economics, the consumer is king, and the goal of economic policy is to maximise consumer welfare. In Chinese economics, the producer is king, and the goal of economic policy is to make Chinese producers the most competitive in the world.

Its policy mix is quite different from that used by Japan and Korea in their rise. They relied essentially on protecting their domestic market by shutting out foreign investment and imports alike, and developing a highly effective culture of innovation by imitation and kaizen (continuous improvement) to develop world-class industries behind their protective walls. The walls came down only when they were already globally competitive.

By contrast, in the 1990s, the West forced China to lower its protection dramatically as its entry fee for joining the World Trade Organisation. That forced China to rely on weapons the WTO could not control: a heavily undervalued currency that makes its exports more competitive, and imports into China less competitive; a host of behind-the-border controls; and a culture of ruthless piracy of Western innovations.

Many argue that this cannot last. To keep its exchange rate low despite its explosive growth, for instance, China acquired more than $1 trillion of US Treasury bonds exposing itself to the risk of huge losses if its de facto currency peg collapses. But as the US dollar has slid since 2009, the People's Bank has managed to juggle its conflicting goals: at first going down with the US, then allowing the yuan to creep up by 5 per cent against the $US, but continuing to slide against other currencies.

It is gradually moving out of US Treasuries, instead using its huge current account surpluses to buy up companies and resources in direct investments around the globe. Federal Reserve data suggests China bought just $51 billion of Treasury bonds in 2010, and has been a net seller this year.

The fears of investors are not shared by the international financial authorities. The IMF's latest Outlook last month projected that China's growth would slow only marginally, from an average of 10 per cent a year since 1980 to 9.5 per cent over the coming decade. Here in Australia, Treasury's forecasts are broadly similar.

If it is wrong, the consequences for Australia could be dramatic although more for individual companies than for the economy overall. Australia's currency has soared largely because of the high commodity prices created by China's booming demand for iron ore and coal. If China stumbles, the first casualties here would be high commodity prices and the high dollar.

The effects of that could be complex. Mining companies gain from high prices, but lose from the high dollar. The new mines opening up are cost efficient and a lower dollar could see them offset lost sales in China by gaining new markets elsewhere. But the dislocation would be severe.

Mining investment would slow sharply. But other globally exposed industries such as manufacturing, tourism and agriculture would benefit if the high dollar disappeared.

The Reserve Bank too would face conflicting pressures. The high dollar has helped it by lowering import prices and slowing the rest of the economy: the transition to a low dollar would imply higher import prices, pushing up inflation. But the Reserve's prime fear is that the resources boom could lead to a wage-price spiral. If China stumbled, that boom would deflate, and the fear with it.

But will China stumble? Before you join the bears, remember: China is a country that lives well within its means. The IMF estimates its savings rate at an astonishing 54.3 per cent of GDP. And its current account is running a surplus of 5.7 per cent of GDP. Just as Australia is bound by its low savings rate and current account deficit, China's high savings rate and surplus gives it the freedom to flick the switch to consuming whenever it needs to.