China: The Balancing Act

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With both the Olympics and Para-Olympics now over and the vestiges of Olympic advertising slowly being removed from billboards around China, it is getting back to business as usual in China, or as usual as it could be. For awhile, the feeling was that the Chinese economy would come out of the Olympics, weather the credit crunch and continue on the path of the fantastic growth that China has experienced over the past 10 years. As the situation in the United States worsens, both as a result of the credit crisis and the worsening economic situation, that feeling is changing.

Initially, as the US crisis unfolded, the primary concern in China was companies’ exposure, especially banks, to the now largely worthless mortgage securities. It gradually became clear during the Q407-Q208 earnings season that Chinese banks did have a sizable exposure to these derivatives, but the exposure wasn’t enough to drag down the growing revenues from domestic expansion, which easily eclipsed any losses from mortgage securities.

Further internal pressure came from the combination of the dollar’s depreciation against the Chinese Yuan, increasingly strict Chinese labour laws and increasing commodity and transportation costs. All of these factors started to cut into the competitiveness of China’s manufacturing industry, and consequently, profits. Many manufacturing companies either shut down completely and/or moved production out of China. Although not perfect, this was seen as an acceptable way to lower the frothy economic growth that China was going through, and the mood remained upbeat.

However, over the past few months, much like their counterparts in the US, Chinese industry followers have become far less sanguine about the situation. They are starting to see how a real risk of a global economic slowdown precipitated by the crisis in the US could effect China.

So with an economy heavy reliant on export, yet with increasing domestic demand and relatively little exposure to the credit markets, what’s coming for China’s post Olympic economy? Well, we at Kapronasia see a definite slow-down coming. However, as we move into 2009, the real issue will ultimately come from internal issues created as a result of external factors outside of China’s control.

Recent actions by the government indicate that they recognise the risk as well. Let's take a look at three of them.

Living on the Margin

Just over a week ago, the China Securities Regulatory Commission (CSRC) announced the gradual introduction of margin trading and short selling with the intent of introducing “new vitality” to the Shanghai A-share stock market. Up until this point, investors had few options with which to play both sides of stocks, i.e. to profit from both prices rises and falls; now they will. Initially the implementation will be limited to certain brokerages, and margin trading is expected to far outweigh short selling as brokerages have much more money to lend than they do shares.

Certainly margin and short selling will do wonders for brokers’ commissions and the overall volatility of the market, but will it really help? A few weeks ago, the US regulators put a freeze on short selling as many pundits saw excessive short selling by hedge funds as being one of the reasons behind the weakness in the US markets.

Still, as the practice is new for China, it likely won’t affect markets in the short-term and the global markets will have at least found equilibrium by the time that it does. Industry observers indicate that it will increase market liquidity and also weed out some of the more amateur investors. This would help as the Shanghai market has historically had a high percentage of retail investors as compared to other more established markets. Increasing institutional activity should bring a bit more stability.

Bring back the credit

In addition to the equity market, the government has also been toying with the debt market. So far this year the government has relaxed the banking reserve requirements by 5%, which has brought some liquidity to the market. In addition, In April of this year, the government opened up the 3 -5 year corporate debt market. This had some success, but was suspended in June due to regulatory issues and perceived potential conflicts with the government’s efforts to control growth.

Since June the market has changed dramatically though and now getting funding in the hands that need it has become a greater priority, so a week ago, the government reopened the market. Companies can now issue medium term debt after going through a relatively simple approval process giving better access to capital outside of equity and bank loans.

This Land is your land

Although mostly unrelated to Financial Services, this past weekend, the government passed another ground-breaking reform drastically changing the roles of land ownership. Since the state was established, most rural farming land was state owned. Previously, farming families were allocated plots of land on a 30 year lease from the government. Under the new reform, the land is still in the hands of the government, but families will have 70 year leases and may be allowed to exchange their plots of land or use the sites as assets/collateral for loans.

It may be that the average rural farmer may not understand the national implications of the rule, but they will certainly see the effect of the regulation in their wallet and that's the intention. The government wants to boost rural income and improve productivity, which will then lead to increased consumption - driving domestic demand.

Making decisions

One of the advantages of a socialist state is that tough contentious issues can be solved rapidly and quickly as the decisions are made by a few leaders who are responsible for the people of a country, yet are not responsible to the people. Hence, China’s rapidly changing economic conditions and growth since the People’s Republic of China was established in 1949, have been supported by appropriate and timely regulation and policy decisions.

Nevertheless, as much as China sometimes seems to operate as a completely isolated entity, commercially China is inextricably tied into the global economy. The US is China’s largest trading partner and if growth in the US economy slows, there will be a knock-on effect on China’s economy. How big that effect will be is not clear, but a more critical issue is if the economic slowdown will affect the social stability equilibrium that China has managed to find.

Cracks in the Wall

Beyond growth, one of the government’s key initiatives is to keep a ‘harmonious society’ or essentially maintaining social order. Growing economic wealth has to a large extent essentially ensured this by keeping the majority of the people wealthy and consequently, happy. However, current conditions are shifting rapidly and may put the government on the defensive.

Consider the labour law passed early this year. Without getting into details, it favours the worker, not the company. One aspect is letting staff go – it’s now much more difficult. When the regulations were implemented at the beginning of the year, the global economy was in much better shape, so although the new laws made life for the average Chinese company a bit more onerous and even forced some manufacturing companies to close their doors, it wasn’t disastrous; now with a potentially huge slowdown on the horizon, the situation is a bit more critical.

As the economy slows, companies that were on the edge of laying off staff to save costs, will start firing. Companies that were close to shutting down because of increased competitiveness will start shutting down. Unemployment in China will increase, but potentially, so will unrest.

As the situation progresses, the ability of the government to implement ‘crowd pleasing’ initiatives like the labour law, will be severely be limited. If GDP growth was 3% when the labour law was implemented instead of ~7%, the results would have been much worse.

Looking ahead

So as we look forward to the future, China will have to continue finding ways to drive external growth, but more importantly, will need to focus on internal stability and growth. They will need to find a delicate balance of keeping the populace happy and satisfied yet putting the measures in place to keep domestic growth on track. Expect to see many more policies like the ones we have noted above. And watch closely, whatever policies they choose will define the China of the future.

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