[OPE-L] China's dilemma

From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Thu May 10 2007 - 01:30:43 EDT


China's dilemma
China's export success has not only financed real 
sector growth but spawned asset bubbles that 
could trigger a financial crash.


There has been a huge increase in investment in 
real estate on account of excess liquidity caused 
by the burgeoning foreign exchange reserve.

CHINA'S economic predicament today is unenviable. 
Its problem is not that it is experiencing slow 
growth or is faced with recession, but that it 
has grown too fast for too long. Its difficulty 
is not that it is strapped for foreign exchange, 
but that it has an embarrassing surplus of 
foreign exchange reserves exceeding a trillion 
dollars in value. Its concern is that the export 
success that had won China the world's admiration 
is widening its trade surplus far too much for 
The paradoxical problem of excessively high, 
externally driven growth was flagged mid-April 
when China's National Bureau of Statistics 
announced that growth during the first quarter of 
2007 had touched 11.1 per cent relative to the 
corresponding period of the previous year, up by 
0.7 percentage points, when compared with the 
last quarter of 2006. The announcement triggered 
panic selling in the Shanghai stock market, 
resulting in a 4.5 per cent drop in the Shanghai 
Composite Index. Coming in the wake of a 9 per 
cent decline on February 27, 2007, this 
"correction" of an index widely held to be 
overvalued indicates that the perception is that 
Chinese growth must slow.
The reason for that perception is only partly 
inflation. It is indeed true that an inflation 
rate (as measured by the Consumer Price Index) of 
3.3 per cent in March, driven by a 6.2 per cent 
increase in food prices, is seen by the Chinese 
central bank and the Chinese government as a bit 
too high for comfort. But inflation rates of this 
magnitude are low by global standards, especially 
when placed in the context of China's 
consistently high growth.
The explanation for expectation of a slowdown in 
growth must therefore lie elsewhere. One source 
from which such expectations derive is the fact 
that China's exchange rate is under pressure to 
appreciate. Large foreign exchange reserves and a 
rising trade surplus, combined with large inflows 
of foreign capital, are a sure-fire recipe for 
exchange rate appreciation. China had for long 
been managing its exchange rate, keeping it 
pegged to the dollar. But after pressure to undo 
the peg forced the Chinese government to loosen 
the fixed link between the renminbi yuan and the 
dollar, the yuan has appreciated by as much as 
6.7 per cent (from 8.2765 yuan to the dollar to 
7.7211) between late-June 2005 and April 27, 2007.
Though this is a minor appreciation given the 
depreciation of the dollar vis--vis most world 
currencies, it has implications for two reasons. 
First, once the process of appreciation has 
begun, preventing further appreciation of the 
yuan becomes difficult given the fact that 
China's rising trade surplus is the focus of the 
world's attention. China's trade surplus for the 
first two months of this year was about $40 
billion, which would have taken it to $240-250 
billion for the whole year. However, there are 
signs that the appreciation of the yuan is having 
some effect. We must recall that China's trade 
surplus tripled in 2005 to $102 billion, but rose 
by only 74 per cent in 2006. Moreover, on April 
12, the People's Daily reported that China's 
trade surplus was merely $6.9 billion in March 
2007, reflecting a 38 per cent fall on a 
year-on-year basis and a 70 per cent decline from 
a surplus of $2.4 billion in February. The March 
figure represented a 13-month low. What is 
noteworthy is that the decline in the trade 
surplus was not the result of a rise in imports, 
which stood at $83.43 billion in March, a rise of 
only 6.9 per cent year-on-year.
Dependence on u.s. market

These signs of a shrinking trade surplus bring us 
to the second reason why the effects of the 
appreciation of the Chinese currency trigger 
expectations of a slowdown. This is because of 
China's heavy dependence on the U.S. market. 
According to the International Monetary Fund's 
Direction of Trade Statistics, China's exports to 
the U.S. accounted for more than a fifth of its 
exports to the world as a whole and two-fifths of 
its exports to industrial countries. If 
appreciation of the yuan vis--vis the dollar 
continues, adversely affecting the country's 
competitiveness in U.S. markets, export growth 
can decelerate further, slowing China's growth.
But, besides the effects of an appreciating 
exchange rate, the threat to real sector growth 
in China is financial. China's economic success 
generates and feeds on a huge expansion in money 
supply and credit that results from its rapidly 
increasing reserves of foreign exchange. Those 
reserves are the inevitable corollary of the 
Chinese government's efforts to moderate 
appreciation of the yuan by buying out a large 
part of the foreign funds flowing into the 
As a leader in the Financial Times (January 12, 
2007) put it: "The market intervention needed to 
hold the renminbi down boosts domestic liquidity, 
fuelling asset price bubbles and greatly 
complicating the task of economic management." 
The danger is that the expansion in credit that 
fuels real growth is fuelling speculative real 
estate and stock market investments that could 
unwind and generate a crash.
credit-led investment

There is reason to believe that credit-financed 
investment spurs real growth in China. The 
investment rate in China (investment as a share 
of gross domestic product) has fluctuated between 
35 and 44 per cent over the past 25 years, and 
has ruled well over 40 per cent in most recent 
years. However, what is interesting is the high 
share of real estate development in the total, 
amounting to 17-19 per cent in the first five 
years of this decade. This category includes real 
estate development by central and local 
government bodies as well as investment in 
residential construction. The former includes 
investment in economic development zones and what 
have come to be referred to as "image projects" 
launched by local leaders to beef up their public 
stature. The latter includes a substantial amount 
of private residential construction that is under 
way, especially in urban China, in the wake of 
relaxation of laws governing residential property 
It should be expected that the relaxation of 
residential property ownership rules must have 
resulted in the conversion of savings accumulated 
in the past into investment in residential 
property. This spurt, together with the high 
degree of volatility of local government 
development expenditures, has made real estate 
development the most volatile part of fixed 
assets formation. According to economist Yongding 
Yu of the Chinese Academy of Social Sciences, 
during the early 1990s, the growth rate of 
investment in real estate "varied between 11.7 
and -1.2 per cent".
This kind of volatility is partly facilitated by 
the manner in which capital formation is financed 
in China. Budgetary appropriations and foreign 
investment account for small shares of between 
8.6 and 11.7 per cent of total fixed assets 
formation during 2001-2005.
The major finance comes from three sources, all 
of which involve a substantial degree of 
borrowing: domestic loans (17.3 to 20.6 per cent) 
and raised funds and others (70-74 per cent). 
Domestic loans refer to loans of various forms 
borrowed by investing units from banks and 
non-bank financial institutions. "Raised" funds 
refer to extra-budgetary funds received by 
investing units from Central government 
Ministries, local governments, enterprises and 
institutions for investment in fixed assets.
And "other funds" refers to funds for investment 
in fixed assets received from sources other than 
those listed above, including capital raised 
through issuing bonds by enterprises or financial 
institutions, funds raised from individuals, and 
funds transferred from other units. All of these 
involve some degree of direct or off-budget 
It is not surprising therefore that excess 
liquidity created by China's burgeoning foreign 
exchange reserves is resulting in a 
credit-financed investment and real estate boom. 
For instance, the annual rates of growth of 
property prices stood at 15.1 per cent and 19.5 
per cent in 2004 and 2005. The evidence suggests 
that bank lending played an important role in 
this increase in property prices. The credit 
exposure of commercial banks to the property and 
property-related sectors increased from just 3.6 
per cent in 1998 to 14.8 per cent in 2004 and the 
mortgage loan to total loan ratio increased from 
only 0.59 per cent in 1998 to 8.88 per cent in 
2005 (Qi Liang and Hua Cao, Journal of Asian 
Economics, 2007).
Faced with this credit-financed speculative boom 
in the property market, last August China's 
Banking Regulatory Commission (CBRC) announced 
policies aimed at tightening bank credit to the 
real estate sector. Principally, financial 
institutions were barred from granting loans to 
property development projects whose developers 
fail to raise 35 per cent of the investment from 
their own resources. The policy also tightened 
lending to developers suspected of hoarding land 
and property.
With respect to personal housing mortgage loans, 
the new policy required banks to decide on down 
payments by borrowers on the basis of their 
credit worthiness rather than some unified 
standard. The move was a clear indication that 
the government was concerned about commercial 
banks falling victim to a real estate bubble gone 
bust. If that were to occur, a liquidity crunch 
could ensue, slowing growth sharply.
Overall, efforts are on to slow down credit 
growth by raising reserve requirements and hiking 
interest rates. Most recently, on April 29, 2007, 
the People's Bank of China hiked the reserve 
requirement of commercial banks by 50 basis 
points, to 11 per cent. This increase in the 
stipulated reserve ratio is the fourth announced 
by the central bank this year and the seventh 
since last June. The central bank has also 
increased interest rates three times in the past 
To the chagrin of the central bank, this has not 
put the brakes on credit growth. Chinese banks 
are reported to have extended new loans to the 
tune of 1.5 trillion yuan ($186.6 billion) in the 
first quarter of this year, which was more or 
less equal to the loans advanced over seven 
months from June through December last year.
Stock market volatility

Credit growth of this kind also seems to underlie 
stock market volatility. During one week in 
April, Chinese retail investors opened more than 
1 million new accounts, taking the total for the 
previous four months to more than 10 million, or 
more than that seen during the previous four 
years combined. Not surprisingly, the Financial 
Times reports that the Shanghai stock index has 
been ruling nearly 40 per cent higher so far this 
year, on top of a 130 per cent increase last year.
Retail investors began swarming into the stock 
market in May last year, after an almost 
five-year bear run. Part of the reason was a boom 
in the market that attracted Chinese households 
and corporations holding $4.5 trillion in bank 
deposits earning less than 3 per cent per annum. 
At the current rate of inflation these depositors 
were earning negative real returns, which 
attracted them to the stock market.
This, of course, implies that if the stock bubble 
unwinds, many innocents would burn their fingers. 
Not surprisingly, China's policy-makers are 
concerned that cheap and easy liquidity is 
fuelling the boom in the domestic stock market. 
But the fear remains that any drastic correction 
could unwind investments too fast, leading to a 
crash. The two sharp downturns in the market have 
only enhanced those fears.
In sum, the danger today is that the liquidity 
built up by China's external success has not only 
financed real sector growth but spawned asset 
bubbles that could trigger a financial crash. 
Together with the effects of the inevitable yuan 
appreciation, this could set off China's next 
growth slowdown.

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