Where is China's slowdown?

The long-predicted slowdown did not occur in the first half. But slowing credit growth points to some painful months ahead.

News that China's economy grew at 9.5% year-on-year in the first half, some 0.2% lower than at the same point last year, has caused consternation and optimism in equal amounts among China observers and businessmen Most were expecting, and perhaps fearing, a marked slowdown after the government announced, at the National People's Congress in March 2005, that it was proceeding to slam the brakes on sectors experiencing hyper growth such as real estate, cement, steel and cars and intended to bring growth down to 8% for the year. Instead, the rate of growth continues at the psychologically important rate of above 9%.

China's growth rates are rarely free from controversy. When it is not growth rates being willfully overstated, as during the last cyclical slowdown in the late 1990s, it is because information gathering processing is subject to revision. Most recently, it appears as if the National Bureau of Statistics overstated growth rates during SARS in 2003. That means that subsequent growth rates were off too high a base and may be re-stated at a lower level.

China's economy is exceptional in terms of the important role played by urban fixed asset investment. FAI comprises anything that results in a capital asset, defined as an asset which is fixed and long term, comprising infrastructure and housing as well as real estate. In China, FAI comprises 59% of GDP. That is an unusually high level, and perhaps only occurred previously in the days of the command economy of the Soviet Union, and in Europe proper in the war economies of 1914-1918 and 1939-1945.

FAI is generated by companies and by the government. Direct government investments amount to about 10% of GDP. Companies drive the rest, often financed out of retained earnings since there is no dividend policy at state-owned enterprises.

FAI was possibly the biggest surprise in the first half, rising 27.7% yoy, compared to 28.8% in June and 28.3% in May. But there was a good reason for that, namely de-bottlenecking those sectors of the economy which have not kept up with rapid growth, notably power. Thus, investment in coal mining and electricity surged 83% yoy and 35% yoy. Investment in transport has also surged.

Yet Chinese companies are also seeing a general decline in profitability growth according to the World Bank, down from 38% in the first half of 2004, to 19% in the first half of 2005. The reason companies are nevertheless continuing with expansion is because they are concerned with the government's plans for wide-ranging consolidation.

In the steel industry, for example, the Chinese authorities have already vowed to consolidate the industry into ten major players. The government hopes these players will subsequently be able to take on the biggest Western multinationals. But the reaction from Chinese steel makers is to expand as fast as possible to ensure they will be picked as one of the lucky survivors.

Most economists do not approve of growth based heavily on one or two drivers. Balanced contributions to growth are preferable. If Chinese domestic consumption is not strong enough to absorb the products of increased FAI, profits go down, price wars ensue, companies go out of business and Chinese banks get more bad loan on their books. Alternatively, if capacity is aimed at exports, trade frictions can break out and the economy becomes vulnerable to international trade flows, which are expected to weaken this year, from 12% grown in global trade last year to slightly over half that rate for the full year 2005.

So far, exports have held up, and contributed to China's sustained growth, rising 32.7% yoy for the first half. Imports went up just 14% for the same period, ensuring that net exports (exports minus imports) made a strong contribution to first half GDP growth.

By some estimates, 40% of the first half's GDP growth came from net imports. The import collapse is a striking reversal of the first half of 2004, when China ran a small trade deficit. This may be evidence Chinese manufacturers are using all that excess capacity to take over market share from importers.

Bank loans are an important indicator of economic dynamism in a country where the stock and bond markets contribute so little to total corporate capital raised. Indeed, China's credit to GDP ratio is 130%.

The key to a pending slowdown could be here. Growth in narrow money (M1, money held by the public) dropped 11.2% yoy in June to 11% in July, while loan growth slowed from 13.2% yoy to 13% in the same period.

Total outstanding loans declined by Rmb 32 billion in July compared with the Rmb546 billion increase in June - a significant month-on-month reduction. For the second quarter as a whole, the total amount of loans outstanding rose by less than 10% for the first time since 2001 on the same period last year, while the amount of new loans has declined for five of the last eight quarters, according to China's central bank.

Loan growth has also been affected by the central bank's directive to the state banks to focus on getting their capital adequacy levels up to 8% by the 2007 deadline. Instead of lending to companies, which they have to capitalize at a 100%, banks have been buying up central bank bills, bills which the government has been issuing during its numerous sterilization operations.

It is clear that with credit growth slowing to that level, the implications to the economy are serious. While the first half has been kept strong through FAI and exports, expect a sharp shakeout in the second half, as profitability is ground down through price cutting and high raw material prices.

How the shakeout will affect China Construction Bank and Bank of China, who may have IPOs coming up early next year and later this year respectively, will no doubt be watched with interest.

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