CDT Money: Time to Call the Bottom?

A breeze of cautious optimism wafted into the Chinese economy this week despite a seventh consecutive quarter of slowing GDP growth, as better-than-expected September data signaled that the world’s second largest economy may have begun to stabilize heading into next month’s 18th Party Congress. Overseas shipments for the month rose nearly twice as much as expected, the money supply grew at its fastest pace since mid-2011, and inflation cooled to its lowest level in two years. Steel and oil output also increased in September.

More importantly, as The Economist points out, consumption (55%) topped investment as the country’s biggest driver of growth during the first three quarters of 2012. While it remains to be seen whether such a trend is sustainable, The Financial Times’ Simon Rabinovitch puts that data point into perspective:

This is exactly what everyone from Wen Jiabao, China’s premier, to the World Bank has said is necessary to make for a more sustainable economic model. In recent years, investment has accounted for nearly half of China’s total economic output, a record for a major economy in peacetime.

The ghost cities, empty apartment buildings and unused convention centres that dot the country are the physical manifestations of this excessive investment, and investors remain concerned that much of it will translate into bad debts for the banking sector.

So increasing consumption is unambiguously good news for China.

Nevermind that September’s manufacturing purchasing managers index (PMI) remained in contractionary territory, or that non-manufacturing PMI fell nearly 3 points, or that growth in electricity consumption slowed for a second consecutive month. The balance of positive news boosted Asian stocks, according to Bloomberg, and Reuters reports that ’s benchmark index neared its 2012 high. Chinese stocks extended their rally into today, rising to a six week high, and even the much-maligned cohort of U.S.-listed Chinese companies saw their longest stretch of gains since April. Today, ratings firm Fitch issued a report claiming that China’s economy would avoid a hard landing.

The People’s Bank of China also reversed course during the past week, according to The Wall Street Journal, withdrawing approximately US$35 billion from the banking system after injecting funds for three straight weeks. The move suggests that the central bank sees a smoother road ahead, one paved with sufficient liquidity and a more stable growth trajectory. The China Daily reported that premier Wen Jiabao took part in economic talks last weekend and similarly expressed confidence that China would achieve its full-year economic goals, but he also warned that the effects of the global financial crisis had yet to subside and reiterated his call for reforms to facilitate balanced growth.

As The Wall Street Journal’s Tom Orlik and Bob Davis write, however, China’s incoming leaders face a dilemma over whether to “take a risky political bet on reforms” that may create more pain in the short term:

The traditional methods of kick-starting growth—cutting interest rates and boosting investment—would risk exacerbating economic imbalances, increasing investment returns at the expense of salaries and spending money for households.

Spreading the gains from China’s growth means challenging some of the most powerful groups in the country’s body politic: local officials who benefit when their governments flip land bought on the cheap from farmers, and state-owned enterprises whose low taxes translate into less money for welfare programs. The winners in such a gamble would be China’s lower and middle-income households, which are increasingly looked to as the source of future growth.

Revamping the state-owned sector so the firms operate in a more commercial fashion could cost as many as four million jobs as the companies slim down and shed political tasks and subsidies, said Minxin Pei, a China expert at Claremont McKenna College. “It wouldn’t be privatization; it would be departyization,” Mr. Pei said.

Despite the risks, will the new leaders heed Wen’s advice? Reuters reports that the State Council has tasked policy think-tanks to draft “their most ambitious economic reform proposals in decades” and spoke to five policy advisers involved in the process. According to their sources, policy priorities include curbing the privileges of state-owned enterprises, overhauling China’s tax code, and moving towards a more market-based system of lending and resource allocation.

Domestic companies have long felt squeezed out by massive state-owned enterprises, but lately foreign companies have also grown increasingly frustrated with their lack of fair access to the Chinese market. Earlier this month, The Economist explored the foreign pressure mounting on the Chinese government to level the playing field:

One of the biggest complaints lodged by the multinationals is that they are largely frozen out of government procurement—a market estimated to be $1.3 trillion in size. China promises to join WTO accession protocols that would bring its rules in this area in line with global norms, but has been dragging its feet for years. Strikingly, the EU Chamber has issued a thinly veiled threat on reciprocity: if China does not open up soon, the relatively free access its firms enjoy to the EU’s market may become “untenable”.

The American Chamber of Commerce is more diplomatic, but its political system is not. A congressional committee is investigating Huawei and ZTE, two Chinese telecoms firms, for alleged links to the Chinese army (its conclusion is due on October 8th), and President Obama has just upheld a ban on a Chinese firm owning wind farms in America on security grounds.

It is revealing that the heavyweights of global business have chosen this moment to speak out on reform. One reason, to be sure, is to play to domestic audiences: China-bashing is always popular during American elections, and the euro crisis has turned Europeans sour on China too. But China also gets new leaders soon, and making noise is sure to get their attention.

A broad consensus for reform may exist within the Chinese government, but it remains to be seen who will push any such changes through after China’s next generation of leaders takes the helm following the 18th Party Congress. And while the Party’s power brokers may have agreed on the expected promotions for vice-president Xi Jinping and vice-premier Li Keqiang, the other members of the Politburo Standing Committee will have a large say about what shape any reforms will take. The New York Times reported today that Wang Qishan, a favorite of the international community and the man probably most qualified to have day-to-day control over China’s economy, may have to settle for a lesser role on the Standing Committee and cede the reins of economic policy to the younger and less experienced Li.

Capital Flight – Fact or Fiction?

China does not report on capital inflows and outflows, but that has not stopped some analysts from trying to piece together a picture of its fund flows from available information. A closer look at the investment data, both into China from abroad and by the Chinese elsewhere, seems to support claims that China is suffering from capital flight. The China Daily reported on Saturday that foreign direct investment dropped in September for the 10th time in the last 11 months, declining nearly 7 percent year-on-year as investors shied away from rising costs and a shrinking number of opportunities. On the flipside, The China Daily also reported that investment from China into the United States reached a record high through the first nine months of this year:

During this year’s first three quarters, Chinese businesses invested $6.3 billion in the US, according to a report released on Thursday by New York-based Rhodium Group, which tracks Chinese investments.

The deal pipeline is strong, with major acquisitions pending in the aviation, auto parts and energy sectors, according to Thilo Hanemann, Rhodium Group’s research director.

“While energy and advanced manufacturing continue to land the most investment dollars, 2012 deal flow suggests that Chinese investors are increasingly interested in US service firms, including entertainment, hospitality, finance and information technology,” he said.

The Wall Street Journal also looked at the case of Yan Shuling, who was convicted of money laundering in 2009 and later exonerated, as an example of how Hong Kong has become the gateway for Chinese looking to dance around the mainland’s capital restrictions and move their money abroad. One data trend that does not mesh with the theory of capital flight, however is the recent performance of the yuan against the dollar. The Financial Times’ David Keohane notes that China’s currency has nearly completely rebounded from its summertime plunge, and questions whether any perceived capital outflow has already reversed.

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