Hard Landing vs Soft Landing
By Ayesha K.

It is called the boom-and-bust investment cycle and east Asian countries, such as South Korea, Thailand and Singapore, experienced the brunt of it in the late 1990s. Now economists are saying that China is likely to join the club of over-achievers who eventually burn out. Over the past two decades, China has been one of the fastest growing economies in the world, with real GDP growth peaking at 9.5% in 2004, the highest rate since 1996.

Several factors appear to be driving investment growth in China: a high savings rate, which has resulted in high liquidity to the banking sector; a surge in bank lending, which has reduced the cost of capital for businesses; and the artificially low peg of the yuan to the dollar, which has caused massive capital inflows and therefore, further liquidity in financial markets. If China’s investment in industry is unchecked, this could lead to overheating and the economy could face deflationary pressures — some industrial sectors, such as such as consumer durables, steel and property, are already exhibiting signs of this — which would bring China’s economy crashing to a halt.

Chinese officials believe this “hard-landing” scenario can be precluded by effective management of the investment process, and they have also hinted that they are considering an “unexpected” revaluation of the yuan. Meanwhile, predatory speculators are continually nudging the peg on which the yuan rests. Most recently, when the government announced in February that the yuan could be revalued, speculators flooded the market with forwards that bet that the yuan would rise considerably versus the dollar. In the face of what academics call inevitable and Chinese officials fear, China is working on a “soft landing”, which will gently constrain and cool the economy.

Unbridled investment

While it is common for countries to invest heavily during periods of rapid economic growth, China has far exceeded the investment rates of any other country. The US invests about 15% of its GDP (gross domestic product) in fixed assets, while Japan invests less than 30%. China, however, in recent years has invested a whopping 40% of its GDP per year in fixed assets and banks have been lending to companies without undertaking the risk analysis common in developed economies.

The Chinese government has been attempting to slow the pace of credit and investment, in order to combat over-heating in sectors like property and the consumer durables. These measures have been mainly administrative, and included an increase in bank reserve requirements, short-term loan freezes and putting pressure on regional administrations to stop lending to sectors which are displaying signs of country-wide over-capacity. Interest rates were also raised in October 2004 — the first rise in about 9 years. However, the impact of the interest rate rise is uncertain, since most credit is allocated by the state-banks (which ultimately amounts to the state directing the use and destination of credit), and not through market mechanisms, while the rise of 27 basis points itself, is insufficient to restrain the economy.

However, the state’s administrative measures appear to have had an effect, since investment growth began to slow towards the end of 2004. Nevertheless, at over 25% year on year in December 2004, it remained high. If the supply of goods and services exceeds demand, factories would lie idle and returns on investment would fall further, the economy itself would begin to slow to a grinding halt, prices would fall and a recession would set in. China’s central bank announced in March that it “will continue to carry out a stable monetary policy, closely monitor the economy, financial operations and rationally control new loans” in order to control over-heating.

An unrealistic yuan valuation

When China pegged its currency, the yuan, to the dollar in 1994, it joined the other Asian countries that have long managed their exchange rates to limit the appreciation of their currencies, thereby maintaining artificial trade advantages. The Chinese yuan has been fixed in a narrow trading band of around Yuan8.28:US$1 for about a decade. This has forced China to hold down interest rates, which has spurred inefficient investment and lending. Experts argue that China’s dependence on exports makes it vulnerable to external shocks and one way to curb this dependency is to let the yuan float freely. The US is the largest importer of Chinese exports (it consumes about 20% of China’s exports), and their Siamese twin relationship can become unhealthy if US consumer appetite for Chinese goods declines. While China’s export-led growth has undoubtedly served as a major spur to economic growth, creating jobs, raising foreign reserves and fueling industrial growth, its dependence rate, of over 50% on foreign trade, does leave it exposed to external shocks. By contrast, the US and Japan have dependence rates of 10% and 20% respectively.

The US is also the greatest critic of the yuan policy, with some US analysts claiming that the yuan is undervalued by as much as 40%. China, however, is reluctant to let the yuan float freely, mainly because of the need to reform its banking sector. Officials are concerned that a freely floating yuan has the potential to destabilize the economy. But China could be in for additional trouble. Speculators are buying up yuan in anticipation that the currency will have to be revalued. This has resulted in a massive inflow of capital — tens of billions of dollars — into the economy, adding fuel to fire. Whenever there is an excess supply of foreign currency, the central bank must increase the money supply to keep the exchange rate stable. This releases more liquidity into the banking system and further boosts the credit boom. Even though the government has undertaken sterilization measures, such as issuing bonds, the money supply has continued to swell. In an effort to defuse speculation, the Chinese government announced in March that it was considering widening the band within which the yuan trades, and that this measure would occur “unexpectedly”. However, this move only resulted in further speculation in the forwards market.

Learning from one’s neighbors

The conditions that preceded the 1997-98 East Asian crisis will seem familiar to those who compare it to present day China. They all share in common excessive investment in fixed-income assets, intervention in foreign exchange markets, corrupt banking systems and an overbearing government presence in economic affairs. Indonesia, Malaysia, South Korea, the Philippines, and Thailand — the Asian tigers — all experienced currency and banking crises in the late 1990s. This included speculative attacks on their currencies, which led to a further downward spiraling of their economies — although speculators bet on a depreciation of the currencies of these economies, whereas in China they are betting on a re-valuation. China also differs in another key respect: the fact that it has massive foreign-exchange reserves, which stood at US$615bn in December 2004, and ran a current-account surplus of 2% of GDP in 2004. By comparison, Thailand had a current-account deficit of 8% of GDP in 1996.

Regardless of this, China should note the similarities rather than the differences if it is to learn from its neighbors' economic history. All the East Asian crisis economies registered investment booms in their housing and industrial sectors, suffered from poor corporate governance, and had currency pegs. These structural weaknesses left them extremely vulnerable to the 1998 crisis, which crippled economic performance in these countries. By practicing prudent corporate governance and cleaning up the banking system, economies such as South Korea have re-emerged from the crisis, wiser and more stable. Key to this recovery was a strengthening of consumer demand.

Given the low wages and little social welfare offered by the state, Chinese consumers tend to have high savings and low consumption rates. If the government could simulate private spending, it would be effectively able to generate economic growth based on consumption as well, instead of near-total reliance on export-led growth. Although there has been some evidence of a rise in private consumption in recent months, particularly in rural China, owing to a rise in food prices, wages in rural areas remain a fraction of those in urban centers. This implies that it will take time before domestic consumer spending can become a key driver of economic growth, alongside exports of goods and services.

Rethinking the economic model

In the short term, the over-heating in some sectors of the economy will have to be allayed by raising interest rates, taking further measures to curb investment growth and cautiously re-valuing the yuan. This should cool the economy and allow for a gentle readjustment, avoiding a crisis in market — the coveted “soft landing” scenario. Success at engineering such an outcome would mean that the Chinese government would succeed in their aim of slowing growth from its current rate of nearly 10% year on year, to about 7%. However, if the plan backfires, and policy is excessively restrictive, economic growth would fall significantly below 7% year on year.

In the medium term, reform of the banking sector is crucial in sustaining effective credit management. China’s banking sector is almost wholly state-owned and some estimate that bad loans constitute 40-50% of all loans. But perhaps China’s whole approach to long-term economic growth is flawed.

An economic model that depends on high investments, external demand and weak domestic consumption may have generated explosive growth in China, but is unsustainable and unreliable in the long run. In fact, even Chinese officials are internally grumbling that it may be better to rethink the whole model of growth that has held them in such good stead in the last two decades. It would not be the first time the Chinese have shown wisdom in the face of experience. They’ve successfully moved from a communist economy to a more capitalist structure, which remains communist only in name. As Chinese political leader Deng Xiaoping once famously said, “It doesn't matter whether the cat is black or white, as long as it catches the mouse.” If history is anything to go by, China will rebound softly yet surely from this impending crisis.