The Real Picture Behind 'China Crisis'

There are basically two groups of investors in their opinion of China's economy. In one camp are those who are optimistic on the economy’s strength and its ability to thrive in an otherwise bleak global environment.

The most recent economic data release showed a sharp rebound in the Chinese export sector has further enhanced the positive sentiment

In the other camp are an increasing number who believe that China’s economic
miracle is nothing but a mirage and that 2010 will be a year of painful reckoning. Some analysts are claiming that China’s growth model is fundamentally flawed and the massive stimulus measures adopted since late 2008 have only intensified the economy’s structural imbalances, which will make the inevitable downside adjustment even bigger. The usual worrying features of the economy such as asset bubbles, “mis-investment”, an inefficient banking system, growing social unrest and corrupt governance - some are predicting an imminent economic crash and even social chaos. Some prominent hedge fund managers have reportedly even begun shorting the “China story” in recent months. Well, for every buyer, there has to be a seller... so the story goes.

Is the economy headed toward a sudden collapse, as expected by the “house of cards” camp? The answers to these questions obviously weigh heavy in investors’ decision making. There has never been a lack of skepticism toward the Chinese economy. Even 5, 10, 15 years back, there were the usual China-bashers and permanent-bears who have been proven wrong over and over again by the country’s enormous economic success and social progress over the past three decades. However, the question marks about the country’s fundamental growth model deserve careful assessment. The core argument of this bearish camp is that the Chinese economy is mainly driven by capital spending and exports, both of which have exhausted their potential. The economy is bound to slow sharply due to a lack of new sources of growth. Or is that the full picture?



While there is always a chance of a major collapse in any economy, I think China is going to chug along just fine. I do not think that China’s capital spending is excessive. China’s capital spending boom has mainly been driven by profit incentives rather than government direction. Those who think that China’s capital spending is terribly inefficient and will face an imminent crash will be proven wrong. If you take the data and extrapolate on internal capital returns on the country's projects - China's figure is very much in line with other developing countries.

Second, one may argue that the U.S. consumer sector has entered into a prolonged period of deleveraging, and that its demand for Chinese products will never recover to pre-crisis levels. However, an important fact is that China’s export market has become increasingly diversified. If you refer to the chart, even though the U.S. remains the largest market for Chinese overseas sales, its market share has shrunk from a peak of 22% in the late 1990s to 17% today. In fact, Chinese sales in some of the nontraditional export markets such as Australia, Latin America, Africa and the Middle East have experienced much faster growth in recent years than sales to other developed markets.

Meanwhile, China continues to reduce trade barriers with emerging Asian countries. At the beginning of this year, China and the 10-country Association of South-East Asian Nations (ASEAN) formally established one of the largest regional free-trade zones in the world.

Over the years, the Chinese authorities have worked to boost domestic consumption in an attempt to reduce the economy’s dependence on exports and capital spending. In this sense, slowing capex and exports should be taken as a positive sign, as it means that policy makers’ consumption-boosting initiatives have finally begun to bear fruit.



The Chinese authorities still have a lot of room to boost growth. Infrastructure in the country’s rural regions is still grossly insufficient and needs tremendous government input. Massive domestic savings and the very low public sector debt burden means there is a lot of financial resources the government can utilize to buy a lot of growth, similar to what they have done over the past year. This kind of growth-boosting campaign is of course unsustainable over a prolonged period of time, but China is among the few countries in the world that are most capable of dealing with a crisis scenario with extraordinary policies – and have a significant war chest to do it with.

Hence we should not see a crash or a major crisis of any sorts in 2010. Yes, the markets will have to experience some bumps here and there, in particular when Beijing tries to tighten the screws on lending and rein in liquidity a bit every now and then - but its for the betterment of the economy, not a noose around the economy's neck.

Currently, the authorities are beginning to tighten policies again. The risk factor is the country’s bubble-prone asset markets and potential damage to its banking system. Specifically, as a result of China’s massive household sector savings and highly pro-cyclical global capital inflows, Chinese asset prices are prone to boom-bust cycles. So far the extreme volatility in asset prices, such as the 70% crash in the domestic A-share market and housing price declines in some major metropolitan areas between 2007 and 2008, has inflicted little damage on banks’ overall asset quality, as the above chart would indicate clearly. This is because policymakers have maintained a significant buffer between asset markets and the banking system - banks’ mortgage lending practices have been very conservative, with a mandatory down payment ratio of 20-40% for real estate purchases. Banks’ direct exposure to the stock market is also negligible, as leveraged investments are not allowed.

Recently, the authorities announced that index futures, margin trading and short-selling in the A-share market have been officially approved. Even though it may take months for these instruments to be developed and deployed, and they are undoubtedly positive in terms of improving the efficiency of the domestic capital market.

Structurally, China’s economic performance will most likely continue to outpace that of the rest of the world. This warrants a more positive stance on Chinese assets over global benchmarks, especially as current valuations of Chinese assets are comparable to global and emerging market averages. Have a look at the chart above on China's valuations - its very reasonable still. From a cyclical point of view, it’s important to recognize that there is a disconnect between a country’s economic performance and its stock market. One does not need to be super-bullish on an economy’s immediate growth outlook to be positive on its financial asset prices.

Stock markets are highly sensitive to policy shifts, which is a lagging response to economic performance. Weak growth leads to policy easing, which is stimulative for the stock market. Similarly, strong growth normally leads to tightening policy, which bodes ill for equity prices. In some cases, good economic news turns out to be a headwind for stocks. Currently, China’s strong growth recovery is pushing policymakers to tighten, a critical juncture that is typically associated with heightened volatility in equity prices. While the Chinese A-share market will continue to struggle in the coming months, investors should not take this as a sign of pending economic troubles. These tightening measures are good problems to have.


p/s photos: Gu Chen

How The West Was Won & Lost - Why Has This Not Been The Headline For The Past Week???

Almost every major international papers have made this their headline news for the past few days - well, not in Malaysia apparently. With two gigantic Free Trade Agreements (FTAs) entering into effect on New Year’s Day—China- Asean and India-Asean—Asia’s economic interlinking has taken off. Asia has for long been divided into self-contained sub-regions like South Asia, West Asia, Central Asia, Southeast Asia and East Asia. Now, Asean’s two path-breaking FTAs with Asia’s second (soon to be first) largest economy, China, and third largest economy, India, enmesh the fortunes of South Asia, Southeast Asia and East Asia into a mosaic. Together with the currency swap agreements among South Korea, Japan and China, these FTAs signal a definite turn towards Asian countries viewing each other as valuable partners, markets and investors.

For decades, the target of reference for Asia’s leading economies was the West. The FTAs couldn't have come at a more ironic time. Now China is about the major engine of growth to lift the global trade. It is also timely as the US and EU are at a weakened position economically. Talk about salting the wounds. The financial meltdown since 2008 has reconfigured these horizons and brought home the imperative for Asian producers to diversify their export markets away from just the West.

A similar pattern of China's successful engagement with neighbors can be seen in the Shanghai Cooperation Organization with Russia and Central Asia and, less successfully, in the six-party talks in northeast Asia over North Korea's nuclear program. With the exception of China's trans-Himalayan border, promotion of regional multilateral institutions has progressed hand-in-hand with strengthening bilateral relationships.

Every country in Southeast Asia has benefited from broader and deeper relations with China, and ASEAN as a regional organization has been strengthened by China's involvement.China's single most successful gesture in its regional relations. In 1997, China held the value of the yuan steady against the dollar while the Southeast Asian currencies were falling. Its neighbors were impressed that China could succeed where they failed, and they were grateful that China prevented a race to the bottom in currency devaluations.

Since August 2008, China has pursued exactly the same policy, but its effects on Southeast Asia are the opposite of a decade earlier. Now the yuan's peg to a declining US dollar is forcing neighbors to compress their currency values in order to maintain market share. China's neighbors wonder how long currency compression will last and what will happen when the yuan finally does revalue. There is little reassurance from China, and no claim that it is helping the neighborhood.

World's Third Largest Free-Trade Zone Takes Full Effect Between ASEAN and China / 31 Dec 09

A free-trade agreement between China and 10 member states of the Association of Southeast Asian Nations (ASEAN) will come into force on 1 January 2010, liberalising trade and investment in an economic zone covering 1.9 billion people. IHS Global Insight Perspective Significance China and South-East Asian countries will tomorrow establish the world's third largest free-trade area, after the European Union (EU) and the North American Free Trade Area (NAFTA). Coming into effect, the ASEAN-China Free Trade Agreement (ACFTA) is set to cover 1.9 billion consumers and an estimated trade volume of US$1.2 trillion, with a combined GDP of US$6 trillion. Implications The FTA is a key milestone for Asian regional integration, heralding a more open market for goods and services in the region. While zero tariffs for 90% of the agreed products, and the removal of 6,682 import duties on Chinese goods, offer great business opportunities for some, not all are enthusiastic. The ACFTA raises economic and political concerns in South-East Asia over China's increasing dominance. Outlook The ACFTA is likely to provide a major boost to regional trade and investment following a year of sharp economic slowdown. Given the similarity of ASEAN and China's industrial structures, competition in domestic markets will increase, however, provoking fears particularly in those less economically developed ASEAN countries. For China, the ACFTA offers great prospects of being able to sate its enormous hunger for natural resources. New Year's Day 2010 marks the establishment of the world's third largest free-trade area between China and the ten member states of the Association of Southeast Asian Nations (ASEAN). Under the ASEAN-China Free Trade Agreement (ACFTA)—signed in 2002—China, Brunei, Indonesia, Malaysia, the Philippines, Singapore, and Thailand will eliminate barriers to investment and enforce zero tariffs for 90% of the agreed products, ranging from textiles to steel and vegetable oils. This will require the average tariff rates charged by ASEAN countries on Chinese products—currently at 12.8%—to be cut to 0.6%, while average tariffs imposed by China on ASEAN goods are set to fall from 9.8% to 0.1%. The late participants to ASEAN—namely, Cambodia, Laos, Myanmar, and Vietnam—will follow behind gradually reducing tariffs and totally eliminating them by 2015. The new free-trade zone will have an estimated trade volume of US$1.2 trillion and a combined GDP of US$6 trillion. It will cover 1.9 billion consumers—more than any other regional economic block. Clearly, this marks a huge milestone for Asian regional integration, traditionally less advanced in comparison with Europe and the Americas, as the region has played "catch up" in recent years. Although the realisation of ACFTA brings huge opportunities for both China and ASEAN, it also raises concerns over China's increasing economic and political domination in South-East Asia. China's Expanding Economy—Driving Force Behind Integration The rise of China in economic and political terms has been the most important development in pushing Asian integration further. The ACFTA framework agreement was signed in 2002 and was the first stand-alone free-trade agreement signed by China. The agreement followed China's joining of the WTO and its decision to start pursuing a regional trade policy that led to the initiation of negotiations on free trade with the ASEAN bloc. Evidently, from China's point of view, the ACFTA will help in securing access to South-East Asia's abundant natural resources. Despite the economic downturn, China's economy is expanding and it needs resources to satisfy its hunger for energy. Closer trade relations with South-East Asian countries also provide China greater control over the crucial nexus between the Indian and Pacific Oceans. There is also the opportunity to strengthen political ties within a region that has traditionally been under strong Japanese influence. ASEAN Opportunities and Fears The ACFTA is set to determine regional co-operation and trade relations in 2010. What ASEAN seeks through the ACFTA is to gain greater market access for exports and the ability to attract more foreign direct investment (FDI). "In 2010 we are sending as a strong signal that ASEAN is open", Sundram Pushpanathan, of ASEAN, told Agence France-Presse yesterday, indicating that the pact is set to offer huge benefits for ASEAN economic growth, too. In particular, as U.S. and European demand for ASEAN exports plummets following the global economic crisis, China's growing economic interaction will generally be very welcome. Given the huge economic and development disparities within ASEAN, the impact of the free-trade regime will, however, be felt differently across the region. Under the ACFTA Early Harvest programme, China granted ASEAN economies very beneficial terms to export more competitive agricultural products to China, bringing benefits to grassroots-level farmers in South-East Asia. However, as soon as the clock strikes midnight tonight, small- and medium-sized farmers and enterprises throughout ASEAN will face a harsh reality—they will need to compete with more price-competitive imports from China. Rising fears and subsequent social tensions have already been evident in some countries. Earlier this month, the Indonesian government came under mounting pressure from the country's domestic industries to delay full implementation of the ACFTA. A number of business associations proposed a temporary exemption of 11 additional industries from the FTA. The proposed exemption list included textiles, footwear, steel and iron, food and beverages, plastic, transportation, tools, electronics, forestry and plantations, the downstream chemical industry, the creative industries, and machinery. While the government opted not to take an eleventh hour appeal further, it has agreed to seek a delay in eliminating import tariffs on over 300 goods that are deemed too "fragile" to compete with cheaper Chinese imports. Indonesia is still "committed to the [agreement]… but we will ask for a tariff modification on 303 products whose competitiveness we consider has declined because of the global economic crisis", said Edy Putra Irawadi, Deputy Minister for Industry and Trade at the Co-ordinating Ministry for the Economy. Outlook and Implications Even though ACFTA's final realisation comes after years of gradual implementation, it is still a landmark event, promising great opportunities for traders and investors and raising the region's status in the international trade arena. No doubt there will be challenges too. What the ACFTA does not mean, however, is that China-ASEAN integration is complete. Instead, it will provide further impetus for deeper economic co-operation between the two entities. Further progress is expected to be made across the board, including laws and regulations on the free-trade area; construction of infrastructure facilities; agriculture and rural co-operation; sustainable development; and cultural and social exchanges. Although bilateral trade between China and ASEAN has already exploded over the past decade, the most eagerly awaited advancements that the ACFTA is expected to bring are in the fields of greater trade and investment volumes. China and the ASEAN bloc are already each other's fourth largest trading partners, and trade volumes have been growing from US$105.88 billion in 2004, to US$202.5 billion in 2007. This is nevertheless likely to increase significantly now, with ASEAN's secretary expecting exports to China to grow by 48%, while China's exports to ASEAN will increase by 55.1%. Integrated markets and lower market risk and uncertainty are also expected to generate more foreign investment into ASEAN countries, not just from China, but also from U.S., European, and Japanese companies. In addition to this positive impetus, there will be increasing competition which will likely decrease the enthusiasm for integration among the general public in those involve countries, for example particularly in Indonesia. All in all, the realisation of ACFTA represents a turning point in the Asian economic and political sphere, and is another indication of China assuming a leading role in the South-East Asian region, where it looks set to stay.

p/s photos: Reon Kadena