China Squeeze: Stephen Roach

Global

February 28, 2007

By Stephen S. Roach | New York

Like nearly everything else in the world these days, it now appears that global stock market corrections are made in China. I have no idea if the rout that began in China was just a brief flash or the start of something big. But I have long felt that something has to give in China. This may well be the beginning of an important venting process.

The basic premise of this story is that China — despite its remarkable successes on the economic development front — now has a seriously unbalanced economy. The main problem is a runaway investment boom. By our estimates, in 2006, fixed asset investment exceeded 45% of Chinese GDP — a record for China and, in fact, a record for any major economy in the world (see accompanying chart). By comparison, Japan’s investment ratio in the 1960s — the period of maximum rebuilding from the destruction of World War II — never exceeded 34% of GDP. China’s annual growth in fixed asset investment has averaged 26% over the past four years. Should the investment boom continue at this pace, the odds of capacity excesses and a deflationary endgame will only increase. That’s the very last thing China wants or needs.

The Chinese government recognizes the perils of just such a possibility. For nearly three years, it has conducted an on-and-off tightening campaign aimed at cooling down its overheated investment sector. Following relatively limited actions first implemented in the spring of 2004, Chinese authorities have upped the ante in the past eight months. The People’s Bank of China has raised its short-term policy rate twice by a total of slightly more than 50 basis points, and beginning in mid-2006 the central bank boosted bank reserve requirements five times in increments of 50 bps from 7.5% to 10% — the last such action taking effect on 25 February.

The problem for China is that it is still very much a blended economy —both state and market driven. As such, market-based policy actions — especially interest rate adjustments — have had only limited success, at best. Two additional factors compound this problem: First, Chinese banks run chronic excess reserve positions; reserves amounted to 14% of total deposits by year-end 2006 — well above the mandated 10% requirement set by the latest policy action. That means, of course, that recent increases in bank reserve ratios are not a binding constraint on the banking system. Second, much of China’s bank lending remains outside the scope of the central control of its monetary authorities; dominated by a vast and highly fragmented system of autonomous local banks, there is only limited traction between monetary policy adjustments and broad trends in Chinese bank lending. In light of that disconnect, together with only limited development of a domestic corporate bond market, Chinese macro officials have had to rely largely on “administrative controls” — namely, a case-by-case project approval mechanism — to rein in the excesses of a runaway investment boom.

The results of this effort have been mixed. Courtesy of the administrative edicts issued by the National Development and Reform Commission — the modern-day counterpart of China’s old central planning bureau — investment growth slowed from near 30% at the start of 2006 to around 14% at the end of the year. Unfortunately, bank lending went the other way — actually accelerating from 13% y-o-y growth in mid-2006, when the latest tightening campaign began in earnest, to 16% by December. That, in a nutshell, could well be the key to this story: China’s central bank has been unable to get traction on bank credit expansion at the same the central planners have succeeded in achieving traction in prompting the investment slowdown. This has resulted in an excess of bank-induced liquidity creation that is undoubtedly spilling over into the financial system. As a doubling of the Shanghai A-share index over the past six months suggests, the Chinese stock market appears to have been a major beneficiary of this mismatch.

Here’s where the story gets especially interesting — and, admittedly, somewhat conjectural. In China, stability is everything. The Chinese leadership believes it cannot afford to lose control of either its real economy or its financial markets. Pure market-based systems can rely on interest rates, currencies, fiscal policies, and other macro stabilization instruments to contain the excesses. A blended Chinese economy does not have that option. The quasi-fixed currency regime compounds the macro control problem — making it difficult for China manage its currency in a tight range without fostering excess liquidity creation. That puts the onus on Chinese policymakers to opt for non-market control tactics. Just as China has moved to bring its central planners into the business of containing the excesses in the real economy through administrative measures, I suspect it now feels compelled to rely on a similar approach in order to deal with excesses in its financial system.

All this puts the onus on China’s financial regulators to face up to the risks inherent in any asset bubble — in the current instance, an equity bubble. That’s especially the case in the weeks just before the annual early March meeting of the National People’s Congress — always a critical and delicate point in the Chinese policy cycle. In that context, there were countless rumors of government intervention in the markets on 27 February. The only such action our China team has been able to verify — and it’s an important one — pertains to State-directed sales of its massive holdings of so-called reformed shares. Apparently, yesterday (27 February) it became public information that various local affiliate holding entities under the SASAC (State-owned Assets and Supervision Administration Commission) have been reducing government stakes in about 15 listed Chinese companies by close to the annual limit of 5% of total outstanding shares. Following the equity market reforms of 2005, these previously unlisted shares have since been classified as market tradable shares — thereby opening the door for actions such as those which became evident on 27 February. The 9% one-day plunge in Chinese A-shares could certainly be interpreted as a sign that “inside sellers” played a key role in sparking the decline — either acting at the explicit request of the government or out of fiduciary conviction that the end was close at hand.

Inside selling or not, the bottom line is that China’s macro control imperatives are a critical ingredient of its overall stability objectives. And in recent years, risks have been multiplying on the control front. Just as China cannot afford an overhang of excess capacity, it cannot afford a major equity bubble. Lacking in market-based mechanisms to address these problems, the administrative option remains a very important tool in the Chinese policy arsenal. So far, that’s mainly been true on the real side of the economy. The near-parabolic increase in the Chinese equity market over the past six months is good reason to believe this strategy is about to be tested on the financial side of the economy.

In the last five years, China has emerged as a major engine on the supply side of the global economy. But with that achievement has come a new set of risks — especially an overheated investment sector and an equity bubble. These two problems are related in that they are both very visible manifestations of China’s control problem. The sharp break of share prices on 27 February may well be symptomatic of China’s increased determination on the macro control front. Ultimately, this is good news for China and the broader global economy — it sets the stage for balanced and sustainable growth. But for those counting on open-ended Chinese growth, any such slowdown could come as a rude awakening. The China squeeze now appears to be on in earnest.