Dr. Doom (aka Nouriel Roubini) is at it again. Can’t this guy shut up for once? The problem is, he is usually right. More than five years ago he predicted that the US would be the next ’emerging market’ crisis. Everybody laughed. They don’t laugh anymore.
He seems to have some kind of crystal ball, in which the future appears more clearly, but most of all, more menacing and bleak than in almost any other vision of the future. Here he is, on China. Bleak as ever, but the logic seems impeccable..
Hard Landing In China?
Nouriel Roubini 11.06.08, 12:01 AM ET
- For the last few years, the global economy has been running on two engines: the U.S. on the consumption side and China on the production side, both lifting the entire global economy. The U.S. has been the consumer of first and last resort, spending more than its income and running large current account deficits, while China has been the producer of first and last resort, spending less than its income and running ever larger current account surpluses.
- For the last few months, the first engine of global growth has effectively shut down. And to add to our worries there are increasing signs that the other main engine of the global economy–China–is also stalling.
- The latest batch of macro data from China are mixed, but all point toward a sharp deceleration of economic growth. Official gross domestic product (GDP) data show growth down to 9% from the 12% of a couple of years ago; spending on consumer durables (autos) is falling sharply; home sales and construction activity are dropping; and leading indicators of the manufacturing sector (the Chinese Purchasing Managers’ Index) show an outright contraction.
- Note that manufacturing, which accounts for 40% of China’s GDP, is slowing based on surveys of manufacturers, matching anecdotal reports of factory closures in China’s southeast coast. Industrial production has slowed to the lowest level in six years, and while the slowdown may have been exacerbated by the Olympics shut-down, it has been on a slowing trend for months. The Federation of Hong Kong Industries predicts that 10% of Hong Kong-run factories in the Pearl River Delta will close this year. And, of course, the Chinese equity bubble has burst big time, with the Shanghai index having fallen over 60% from its bubbly peak.
- Thus, there is a growing risk of a hard landing in China. Let us be clear what we mean by that. In a country with the potential growth of China, a hard landing would occur if the growth rate of the economy were to slow down to 5% to 6%, as China needs a growth rate of 9% to 10% to absorb about 24 million folks joining the labor force every year–it also needs to move about 12 million to 14 million poor rural farmers every year to the modern industrial and manufacturing urban sector.
- The whole social and political legitimacy of the Communist Party’s regime rests on continuing to deliver this high-growth transformation of the economy. Therefore, a slowdown of growth from 12% to 5%-6% would be the equivalent of a recession for China. And now a variety of macro indicators suggest that China is indeed headed toward a hard landing.
- China’s economy is structurally dependent on exports: Net exports (or the trade-balance surplus) are close to 12% of GDP (up from 2% earlier in the decade), and exports represent about 40% of GDP. Real investment in China is about 45% of GDP, and, aside from housing and infrastructure spending, about half of this capital expenditure goes toward the production of new capital goods that produce more exportable goods. So, with the sum of exports and investment representing about 80% of GDP, most Chinese aggregate demand depends on its ability to sustain an export-based economic growth.
- The trouble, however, is that the main outlet of Chinese exports–the U.S. consumer–is collapsing for the first time in two decades. Chinese exports to the U.S. were growing at an annualized rate of over 20% a year ago. The most recent bilateral trade data from the U.S. show that this export growth has now fallen to 0%.
- The worst is still to come in the next few quarters. After an OK second quarter in the U.S. (boosted by the tax rebates), U.S. retailers hoped that the consumer downturn would be minor; they thus placed, over the summer, massive orders for Chinese (and other imported) goods for Q3 and Q4. But now the U.S. holiday season clearly looks to be the worst in decades, and the result will be a huge overhang of unsold Chinese goods. You can therefore expect orders of Chinese goods for Q1 of 2009 and the rest of 2009 to be down drastically, dragging Chinese exports to the U.S. into sharply negative territory.
- And it is not just Chinese exports to the U.S.: Until a few months ago, the U.S. was starting to contract, but other advanced economies (Europe, Canada, Japan and Australia and New Zealand) were growing at a sustained rate, boosting Chinese exports. But there is strong evidence that a severe recession has now started in almost all of the advanced economies. So you can expect Chinese export growth to Europe, Canada, Japan, etc., will sharply decelerate in the next few quarters, adding to the fall in Chinese net exports.
- Once this happens, you can expect a severe drop in capital expenditure in China, as there is already a large excess capacity of exportable goods given the massive overinvestment of the last few years. A sharp fall in net exports and real investment will likely trigger a hard landing in China. Considering the certainty of a recession in advanced economies and the likelihood of a global recession, there is a very high probability that Chinese growth could slow down to 7% or even lower in 2009 (7% is, indeed, now the forecast of a leading bank such as Standard Chartered (other-otc: SCBEF.PK – news – people )); and 7% is just a notch above the 6% that would represent a near-hard landing for China.
- Can aggressive easing of monetary and credit policy prevent this hard landing? Not necessarily.
- First, China has already reduced interest rates three times in the last few months and eased some credit controls. But monetary and credit-policy easing may be ineffective: It will be like pushing on a string, as the overinvestment of the last few years has led to a glut of capital goods. There is already evidence that corporate-loan demands have diminished sharply and that commercial banks have hesitated to lend while choosing to firewall risks. The government can ease money and credit, but it cannot force corporations to spend or banks to lend if loan demand is falling because of low expected returns on investment.
- But could fiscal policy rescue the day?
- The optimists argue yes, pointing out that fiscal deficits and public debt are low in China and that the country has the resources to engineer a rapid fiscal stimulus in a short period of time. But the ability of China to implement a rapid and massive fiscal stimulus is limited for a variety of reasons.
- First, as pointed out by recent research (Global Insight), the combined effects of natural disasters, social strife in western China, and the Olympics have created a large hole in the central-government budget this fiscal year. The Ministry of Finance may have dipped into various stabilization funds to avoid the appearance of running a large deficit. For regional and municipal governments, the decline in turnover in local property markets has reduced the flow of fees and taxes, causing them to delay ambitious industrial development plans in some cases.
- Second, a hard landing in the economy and in investment would lead to a sharp increase in non-performing loans of the–still mostly public–state banks; the implicit liabilities from a serious banking problem would then add to the budget deficits and public debt. Note that the poor quality of the underwriting by Chinese banks–that financed a huge overinvestment in the economy–has been hidden for the last few years by the high growth of the economy. Once net exports go bust and real investment sharply falls, we will see a massive surge in non-performing loans that financed low-return and marginal-investment projects. The ensuing fiscal costs of cleaning up the banking system could be really high.
- Third, as pointed out by Michael Pettis, a leading expert of the Chinese economy, a surge in tax revenues in the last four years has been more than matched by a surge in spending. So if revenue growth diminishes or reverses, it might not be easy to slow spending growth proportionately. Contingent liabilities from non-performing loans could also reduce resources available for a fiscal stimulus.
- Fourth, while a fiscal policy stimulus has already started, its scope and size have been relatively modest. The big question is whether the Chinese government could increase the fiscal stimulus by an order of magnitude larger than the current effort if an abrupt hard landing were to occur. The answer is probably not, as moving a massive amount of economic resources from the tradeable to the non-tradeable sector (infrastructure and government spending on goods and services) will take time and cannot be done quickly. The Chinese government has massive infrastructure projects for the next five to 10 years; but front-loading most of that multi-year spending over the next 12 to 18 months will be close to impossible.
- In conclusion, the risk of a hard landing in China is sharply rising. A deceleration in the Chinese growth rate to 7% in 2009–just a notch above a 6% hard landing–is highly likely, and an even worse outcome cannot be ruled out at this point.
- The global economy is already headed toward a recession. A hard landing in China will have severe effects on growth in emerging market economies in Asia, Africa and Latin America, as Chinese demand for raw materials and intermediate inputs has been a major source of economic growth for emerging markets and commodity exporters. The sharp recent fall in commodity prices and the near collapse of the Baltic Freight index are clear signals that Chinese and global demand for commodities and industrial inputs is sharply falling. Thus, global growth–at market prices–will be close to zero in Q3 of 2008, likely negative in Q4 of 2009 and well into negative territory in 2009. So brace yourself for an ugly and protracted global economic contraction in 2009.
- Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.