Not liking those odds of a China hard landing

FT Alphaville

A new Nomura report puts the odds at one-in-three of a hard landing in China in the next three years, which they define as four consecutive quarters of sequential GDP growth at 5 per cent or less. It’s a pretty epic paper, with numerous authors, charts, and historical references, so we’ll focus here on their key six reasons why they’re becoming more wary of a hard landing. Before we get into that, though — one interesting point made early in the report is why economists are more optimistic than investors on China; despite a sell-off in Chinese equities and bonds, they point out, the IMF is forecasting 9 per cent growth in 2012 while Consensus Economics’ latest survey came up with 8.5 per cent next year and 8.4 per cent in 2013.

Nomura’s strategists see it like this:

The way we would reconcile this gap is that economists forecast the modal, or most likely, outcome, whereas the financial markets tend to take a weighted-average probability of different possible outcomes. If we apply our baseline and hard-landing probabilities to the market method {(8.5*0.66)+(5.0*0.33)}, it gives a weighted-average GDP growth forecast of at most 7.3% in 2012-14. In other words, like-for-like, our forecasts are probably not that dissimilar to what the market is pricing in – the key will be whether the risk of a hard landing rises or falls going forward (…)

… Which is where they start talking about their new “China Stress Index”. Which we won’t go into here, but suffice to say that the stress index is moving has been staggering upwards in the 10 year period covered, with the past two years showing a sharper rise, although the last couple of months have eased somewhat.

On to Nomura’s six reasons for thinking the situation in China is looking increasingly uncool:

1. Overinvestment and excessive credit

The big question is not if, but when, China’s investment and consumption ratios re-balance – and will it happen in a gradual, policy-controlled way, or will the process involve one or more episodes that are abrupt and beyond the control of policymakers, causing major disruptions to the economy and markets? International experience shows that rebalancing is never easy, as it usually means redistributing income and power from vested interests that have benefited from the old model – in China, notably large SOEs and local governments(…)

This will come as no surprise to readers of Michael Pettis; but even then, there are some rather impressive charts. For example:

Nomura - China GDP/investment ratio compared to other Asian economies

So, how different will China turn out to be?

On to the other reasons:

2. Rudimentary money architecture

China’s monetary policy is not keeping up with the times and becoming less effective. At the root of the problem is the inflexible exchange rate, which significantly hinders the PBoC in pursuing its domestic goals. The increasing free-flow of capital means the fixed exchange rate is becoming more of a hindrance, Nomura says. It requires massive market operations to mop up excess liquidity and keep the renminbi.

3. The privileged state-owned enterprises

Particularly their oligopolistic power and capital intensity, their generous subsidies and other market distortions such as the segmentation of the credit markets favouring SOEs over private SMEs, despite the latter being far more important in terms of employment, tax receipts and output.

4. Unintended consequences of financial liberalisation

Rapid internationalisation of the renminbi is adding pressure for China to accelerate capital account liberalisation — but if that happens too fast, it could cause… crises! Faster capital account liberalisation can also speed up domestic financial deregulation, such as loosening controls on deposit and lending rates.. but this in turn could lead to pressures on the banks to become more competitive and drop their credit standards if, say, companies are able to tap local debt markets more easily.

5. The Lewis turning point

This refers to Nobel winning economist Arthur Lewis. The “LTP” is the point at which the surplus of cheap rural labour migrating to cities begins to diminish, creating a “kink” in the labour supply curve, from which point wages can quickly accelerate.

6. The setting in of growing pains

This is demographics and social order — the main culprits being a shrinking workforce, due to an ageing and increasingly male population (an astounding 120 boys are born for every 100 girls in China today); plus increasing social inequality between urban and rural citizens.  This could be eased, they suggest, by relaxing the discrimination against migrant workers, or the one child policy, or improving redistribution of wealth. But, a little like the financial liberalisation in Point 4, these risk creating other problems or even further exacerbating the demographic problems by through urban over-crowding, worsning social tensions and accelerated environmental degradation.

Still. It’s better than two-in-three, right?


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