Why the hard landing won’t happen

Signs of slowing growth that have emerged in China in recent months have spawned a flood of gloom-and-doom predictions of an imminent economic hard landing. The reasons range from an unsustainable boom in property, to a meltdown of the major banks due to their NPLs, to a collapse of exports due to soaring wages and social turmoil due to high inflation. In his monthly analysis of emerging markets, my colleague, Larry Brainard, showed the weaknesses in this prescription. Our analysis is that inflation will peak in the next two-three months and growth will normalize after the summer with China positioned for outperformance in H2/11.

On the socio-political front, the protests that flared up in Guangdong this month have to be taken seriously (see my note about the protest in China) but should be seen in proportion, They have not led to contagion as happened with strikes last summer. Though they make good copy, they remain isolated occurrences as do the protests in central China about the death of a popular local councillor and the dramatic cases in Fuzhou over two housing requisitions with a family setting itself alight and a man blowing up government buildings and, eventually, himself.

Larry’s report is as follows:

EM Monthly 10 June 2011

China

Unsustainable trends are an integral part of China's economic development experience over the past 20 years. But despite regular expert forecasts of coming economic collapse, the country has muddled through in rather impressive fashion. The point is not that some of these trends are unsustainable, but that the government and the Communist Party have shown the willingness and the ability to act and manage them without major upsets. It might also be added that Chinese consumers have shown a much greater ability to absorb adverse economic shocks than their Western counterparts. We are not persuaded that this time is different.

The recent slowing of growth momentum reflects two primary factors. One is the rundown in inventories and the other is a tightening of monetary policy. At the beginning of this year the major state-owned enterprises (SOEs) received their loan allocations. Rather than deposit these monies in the bank at negative real interest rates, many SOEs opted to boost their inventories of raw materials. This led to an unanticipated trade deficit in Q1/11 as such imports soared. At the same time China’s monetary authorities implemented a carefully calibrated monetary tightening via active “micro management” of banks’ lending activities. The expansion of bank lending fell from last year’s 19.9 per cent rate to 17.5 per cent to date – this was not a draconian cutback but more a measured restraint of lending.

Now SOEs are generating needed liquidity by running down inventories of both raw materials and finished products, a development that is reflected in the recent PMI data. This destocking will come to an end in several months and measured growth will pick up again; underlying final demand will not have changed much but data are lacking to show this. In other words, what appears to be a slowdown is mostly an inventory cycle imposed on a modest reduction in the economic growth trend. Underlying final demand has been relatively stable, at a more moderate and sustainable rate of expansion than last year’s double-digit growth. For 2011 as a whole we expect growth to come in at 9-9.5 per cent.

Inflation is more of a concern to policymakers due to the volatility of food prices and the uncertain effects of drought in central and south China. We expect the CPI for both May and June to rise to 5.5-6 per cent before trending down during H2/11 and finishing the year somewhere around 5 per cent. This declining trend will mostly reflect the base effect due to high inflation in H2/10, not to any real improvement in underlying inflation. As we argued earlier this year, inflation has moved up to a higher 4-6 per cent range. Policy will likely be successful in capping inflation below 6 per cent but we do not see any official willingness to push it down to the 2-3 per cent rates that were typical in the past decade.

With prospects that inflation will peak after midyear and growth will regain momentum, we expect stronger equity market performance in the coming months. We maintain our overweight recommendation on Chinese equities.

Chart 8: MSCI China Index, performance by sector, 3 May to 8 June

Last month Chinese equities performed well, led by consumer stocks. Looking ahead, we expect current worries about a hard landing for the economy to begin to lessen with the result that some of the most beaten down sectors will for a time outperform. We would include industrials and basic materials in this group.