China Economics: Two Types of Overtightening

Two types of overtightening

Baseline scenario of ‘imported soft landing’: A recap
Amid tremendous uncertainties about the outlook for China’s external demand and the domestic policy stance, we use the metaphor of four seasons of the year to characterize the potential scenarios for 2008: Autumn features ‘an imported soft landing’, summer features ‘overheating’, spring features ‘a policy-induced soft landing’, and winter features ‘an outright hard landing’ (see China Economics – Journey into Autumn: An Imported Soft Landing in ’08, December 4, 2007).

Our baseline scenario is an ‘imported soft landing’. Under this scenario, we forecast China’s GDP growth to decline from 11.5% in 2007 to 10% in 2008 and CPI inflation from 4.5% to 4.0%. Our forecasts envisage a modest rebalancing in growth drivers in 2008: relatively weak exports to be offset by sustained strong domestic demand. Consequently, the current account surplus (as a percentage of GDP) will narrow, as import growth outpaces export growth, albeit both at lower levels.

Under the ‘imported soft landing’ in 2008, the policy-makers’ intention to implement aggressive tightening measures is unlikely to be followed through. Specifically, the welcome downturn in external demand and its attendant cooling-off effect should be able to provide a breathing period for the authorities and ease the urgency to take aggressive policy actions with blunt policy tools.

We therefore expect a continued muddling-through approach in policy implementation in 2008, featuring ‘three No’s’: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate, and no aggressive rate hikes. We expect the policy stance will remain tight through 1Q or 1H and then turn neutral or ease in the remainder of the year, depending on the pace of the US economy sliding into recession and its attendant impact on China. In short, we think that the authorities’ macro controls will be frontloaded.

Under our baseline scenario of an imported soft landing, the Chinese economy – in adapting to a weak external environment – will likely be able to realize a welcome rebalancing (away from external to domestic demand) that would otherwise be unachievable, thus boding well for a sustained and robust expansion over the medium term. While this growth rebalancing should be positive for the equity market over the medium term (i.e., 1-3 years), the stock market performance will likely be moderately negative in the near term (i.e., 6-9 months). Specifically, low-valued and low-margin export-oriented sectors (e.g., textiles) may be hard-hit. At the same time, domestic market-oriented sectors should do relatively well.

Credit tightening in 2008 shapes up
The most important aspect of the authorities’ tightening policy package is administrative credit tightening. The authorities have reportedly set the indicative target of bank loan growth at 13-14% – which is substantially lower than the 16% growth rate that we estimated for 2007 – and specified loan growth targets for each of the four quarters in 2008 for major state-controlled banks by following a general guideline: 35% of annual quota for 1Q, 30% for 2Q, 25% for 3Q and 10% for 4Q.

If the credit tightening, together with other macro-control measures (e.g., tighter scrutiny over approval of investment projects), is consistently implemented, it will likely result in a significant slowdown in real activity. Taking the 2004-05 round of macro controls for example: as bank loan growth was brought down sharply from 24% in 3Q03 to only about 13% in 1Q05, fixed-asset investment growth plunged from 43% in 1Q04 to 23% in 1Q05.

However, the credit tightening in 2004-05 did not do much ‘damage’ to industrial production. Despite a sharp drop in bank loan growth, the growth of industrial value-added did not slow much. One key reason is that export growth during the same period was extraordinarily strong (i.e., nearly 35%Y), having effectively offset the cooling-off impact of tight domestic credit conditions.

Risk of overtightening due to policy mistakes
An increasing number of clients have recently registered their concerns about the risk of overtightening in 2008. In particular, investors fear that were the authorities to carry out the aforementioned austerity measures despite a recession in the US and the attendant synchronized global downturn, the Chinese economy would suffer a serious double-whammy impact and the negative implications to the market would be broad-based: domestic demand- and export-oriented sectors would be equally affected.

Indeed, if export growth were to decline sharply from 26% in 2007 to 16% in 2008 as we envisage, and at the same time, the credit tightening were to be carried out, both investment and industrial production would likely suffer a significant slowdown. The overall impact of the upcoming round of tightening may well be as large as – if not larger than – that in 2004-05.

While this concern about overtightening is not entirely unwarranted, we attach a very small probability to this scenario. This is essentially an overtightening due to policy mistakes: here the policy makers underestimate the negative impact of US recession on the Chinese economy. However, since delivering high growth and job creation is still of paramount political priority, we do not believe that the authorities would tolerate a sharp slowdown in growth, which would have serious political and social consequences. We therefore caution against overreacting to the authorities’ rhetoric to take tough measures to cool off the economy and believe that the authorities will not take any signs of external slowdown lightly and will stand ready to reverse the course of tightening policies.

Risk of overtightening due to policy constraint
We, instead, would like to draw clients’ attention to a different type of overtightening: if there is no meaningful slowdown in the US economy and China’s external demand and the authorities continue to be reluctant to allow a much faster appreciation of the renminbi exchange rate in 2008, the tightening measures needed to cool off the economy will have to be more austere than otherwise, resulting in a much deeper recession in domestic output.

While austere tightening measures (e.g., administrative credit and investment curbs) would help moderate aggregate demand and thus ease inflationary pressures (i.e., ‘expenditure-reducing effect’), appreciation of the renminbi exchange rate can also effectively ease inflationary pressures by shifting demand away from domestic goods to foreign goods (i.e., ‘expenditure-switching effect’). In the absence of a significant renminbi appreciation, the tightening measures would have to be much tougher in order to achieve the objective of easing inflationary pressures than under the scenario where exchange rate appreciation is an important part of the tightening policy package.

We believe that this is what happened during the 2004-05 round of macro-tightening, which was aggressive and effective in bringing down inflation in a relatively short period of time. However, the real activity adjustment was equally sharp, as reflected in the plunge in the growth rates of investment and imports. This constitutes the ‘overtightening due to policy constraint’, in our view, for had significant renminbi appreciation been employed in the policy package, the tightening measures may not have been so austere and the slowdown in domestic demand may not have been so sharp.

On the other hand, had the external demand been much weaker in 2004-05, there would have been no need for strong macro controls as were implemented in order to achieve the same policy objectives.

We are afraid that if in the current round of macro tightening, allowing a much faster appreciation of the exchange rate (e.g., 20% renminbi appreciation), is ruled out as a policy option, the administrative tightening measures will have to do the heavy lifting: to cool off the economy and ease inflationary pressures entails more austere measures that could render a much deeper recession in domestic output than otherwise. In this context, the austerity measures announced by the authorities will be followed through and even made tougher if inflation does not come down fast enough.

An unintended consequence of overtightening due to policy constraint
The Chinese economy is experiencing two imbalances: internal (i.e., high inflation) and external (i.e., large trade surplus). The current policy package that features administrative curbs on bank lending and investment can help correct internal imbalances (e.g., inflation). However, these tightening measures will also exacerbate the external imbalances: tight bank credit and investment controls will weaken domestic demand and subsequently imports, contributing to even wider trade surpluses, especially when there is no meaningful slowdown in the US economy to ensure continued robust export growth. With persistent large trade surpluses getting even larger, there will be even more FX reserve accumulation and attendant liquidity creation.

If tightening policies are able to help lower expectations of future CPI inflation by bringing down current inflation, headline CPI inflation may stay stable despite excess liquidity. In this context, persistent excess liquidity may manifest itself in the form of asset price inflation to the extent that investors’ confidence is not destroyed by the austerity measures. Chinese investors may become more interested in offshore investment opportunities (e.g., through QDII, QDRI schemes).

Market impact of credit tightening
Distinguishing between the two types of overtightening is important for understanding the broad market implications. Overtightening due to policy mistakes would likely result in a hard landing of the economy, and its negative market impact would be serious and broad-based. On the other hand, overtightening due to policy constraint would have a disproportionately large negative impact on domestic demand-oriented sectors, while export-oriented sectors would be less affected. Therefore, the market implications under the scenario of overtightening due to policy constraint will likely be exactly opposite to our baseline scenario of an ‘imported soft landing’.

Administrative credit tightening is expected to play a key role in the tightening policy package. In this policy environment, different enterprises in different sectors will be affected differently, depending on how dependent they are on financing provided by the banking system.

We have two general observations based on experiences from the past macro tightening. First, sectors with relatively high debt-asset ratios tend to be more adversely affected. We compared the debt-asset ratio with the magnitude of decline in the fixed-asset investment rate during the 2004-05 tightening and found that sectors with higher debt-asset ratios tend to experience larger declines in fixed-asset investment growth after credit tightening is imposed. We looked at the most recent debt-asset ratios for 42 industries. Several sectors including the coal mining and other mining, construction, retail and wholesales and real estate have high debt-asset ratios. Among the manufacturing sectors, heavy industries (e.g., machinery & equipment, metals) tend to have higher debt-asset ratios than light industries (e.g., textile, food). These sectors of high debt-asset ratios would likely be – other things being equal – vulnerable to credit tightening.

Second, small- and medium-sized enterprises are generally at a disadvantage relative to large ones in the event of credit tightening. This is mainly because administrative tightening inevitably involves some degree of credit rationing. Large enterprises tend to have close and long-standing ties to banks and greater lobbying power with policy makers, thus providing easier access to bank credit and policy makers’ approval of investment projects. In this context, macro tightening tends to lead to industrial consolidation, with large enterprises taking over small ones or the latter simply exiting the market.

We also think that the direct impact on publicly listed companies tends to be smaller than that on non-listed companies for two reasons: a) publicly listed companies – especially those that have gone public recently – tend to have strong cash positions; and b) it is much easier for publicly listed companies to tap alternative sources of financing, including the placement of corporate bonds. On the latter, despite macro tightening, the authorities have indicated that the development of a corporate bond market will be encouraged in 2008. In fact, since August 2007, publicly listed companies have been allowed to issue corporate bonds under a more streamlined procedure than before.

By Qing Wang Hong Kong
Morgan Stanley
January 7, 2008