Even before the financial crisis descended on Wall Street in mid-September, the persistent slowdown of Western economies had observers in developed markets increasingly worried that the malaise would inevitably spread to the major emerging markets as well. After all, most of their stock markets slumped dramatically this year—and their economies face continuing inflationary pressures. China, in particular, is struggling with the twin challenges of declining demand from importing countries and an overheated domestic economy. Many executives are now wondering whether their hopes over the past few years for growth in China were not misplaced.
On the eve of the Beijing Olympic Games, in August, we met in Shanghai with long-time emerging-market observer Jonathan Anderson to discuss whether these concerns were justified. Anderson, the author of The Five Great Myths About China and the World and head of Asia-Pacific Economics for UBS, sees quite a different story emerging.
The Quarterly: Some commentators worry that a slowdown in Europe and the United States will have an overwhelmingly negative effect on the Chinese economy. How realistic are these concerns?
Jonathan Anderson: The bottom line is that China will slow gradually as the world around it does, by around one percentage point next year, perhaps slightly more.
Indeed, in the first half of this year, everything seemed to be going weak. Exports and trade were slowing, domestic consumption was on the decline, the property and construction sectors were under very sharp pressure, and a few bubbles burst. And while employment was strong and wages actually grew at a good clip, food became so expensive that it started to cut into other kinds of expenditures—meaning that spending in areas such as telecom and discretionary was weak.
But as we move through the second half of the year, inflation is slowing, so the People's Bank of China can start to loosen monetary policy. That means property construction will likely rebound by the fourth quarter, and price indicators should then stabilize. On the urban-consumption side, many food prices are starting to level off. With wages still growing and employment still high, that should mean better consumption numbers over the next 12 months. Overall, we're on track for real GDP growth of around 10.5 percent this year, and just under 9 next year.
The Quarterly: So China's already seen the worst of it?
Jonathan Anderson: Yes. The good news for China, and most of the emerging world, is that most of the impact of the slowdown has already been felt, and it wasn't a very big hit. Most of the fallout from the subprime banking mess hit the financial markets—particularly the equity markets, where there's been a big sell-off over the past nine months.
But if you look at the real impact on growth, on domestic money markets, on financial liquidity and so forth, the emerging markets generally have sat this one out. There's been almost no impact in China or the rest of Asia, because although Chinese, Taiwanese, and Korean banks were buying some mortgage-backed and subprime assets, they weren't leveraging. Owning these assets in itself isn't lethal, but rather the fact that many institutions levered up 10 or 20 times by borrowing short in the money market and then faced a fire sale when the mark to market went against them. The average Chinese or Asian institution bought a lot less, in a relative sense, and had no leverage on the liability side—and they're perfectly happy to hold them to maturity.
So regardless of a US slowdown and what's happening in Europe and the rest of the world, Chinese growth should be all right for the next few years. China has massive surpluses on its current account, and it has the world's largest stock of reserves. It's also just been through a big bank cleanup, which means that regardless of any near-term misbehavior, balance sheets are much better than they were five or six years ago. Also, Chinese tax revenues to GDP are rising dramatically, and there's a surplus on a cash basis. That means the country can spend money to help stabilize the economy. There's also a much broader consumption base, so for the first time in three or four years, even farmers are making money.
The Quarterly: Energy prices are at an all-time high, as are prices for raw materials. Won't that have an impact on China's economic growth?
Jonathan Anderson: Clearly, there will be an impact if these prices continue to skyrocket. It's a very different situation if coal is at $100 and oil is at $120 and food prices are at today's levels than if they all triple over the next two or three years. Eventually, high prices would start to hurt growth.
Furthermore, this is not a China-specific issue. Chinese demand may be driving energy prices up, but the Chinese aren't the only ones suffering. High global prices affect everyone, and in fact, China is not necessarily even the country with the highest exposure.
Nor is it clear that we're looking at a long-term environment of rising commodity prices. A lot depends on your supply outlook. There are good arguments that oil may actually stay around $120 and $125 a barrel. Food prices may have jumped enormously in the past 12 months, but they're starting to look "peakish." Fertilizer prices are now falling. Grain prices are falling. We could see things stabilize or even fall off. There's no guarantee that commodities will continue to go up.
The Quarterly: And after the next few years?
Jonathan Anderson: At the middle of the next decade, big demographic changes will start to kick in, bringing significant structural changes to China's industrial base. Low-end light manufacturing will likely go through wrenching structural shifts because wages are rising aggressively for unskilled labor and there are shortages of skilled workers. This is one scenario the big multinationals complain about very heavily.
China's financial system will also go through another set of wrenching changes in the next five to seven years. They're probably going to open up the capital account on the external side, and banks, as a result, will begin to see money leaving the system. They'll also start to see their margins squeezed and a lot more volatility as they get back to areas like bonds and external capital flows. These all have the potential to destabilize.
The Quarterly: Why will China eventually have to open a capital account? What pressures are compelling them to do so?
Jonathan Anderson: It's always been a stated policy goal. There's a broad view that countries are better off when they have relatively free and open capital flows, but also that they want to take it slowly and gradually. Moving too quickly to capital liberalization is something that can be damaging: one of the key causes of the Asian financial crisis at the end of the 1990s was flinging open the doors and letting money rush in at too rapid a pace.
In the meantime, allowing domestic investors to seek better returns elsewhere helps reduce the volatility of wealth in China. If you lock them up at home, then they are very exposed to big boom–bust cycles in the domestic economy.
The Quarterly: As we've just seen—China's A-share markets have come down by almost 50 percent over the past six months. In any other economy, that would be a major event. Why, in China, did it almost go unnoticed?
Jonathan Anderson: This is actually the third big collapse of the Chinese equity market in the past 15 to 18 years, so in some sense it is business as usual: this is a market that goes up and down by enormous margins. Furthermore, China can have these massive boom–bust cycles with such alarming regularity because the equity market is awfully small. If you look at the actual free float—the traded shares, with market exposure, held by corporations and households in China, excluding government holdings—it started at about 3 percent of financial wealth at the bottom of this cycle, in 2005. At its peak, in October 2007, it was up to about 15 percent of financial wealth—and now it's come back down to around 10. These are not big numbers, and as a result, there are no big wealth effects when this market goes up and down.
The Quarterly: Do you see China's approach to equity markets and capital as a long-term liability?
Jonathan Anderson: It's certainly an environment that raises risk profiles. Twenty years ago, China's socialist economy didn't have working equity or bond markets. Everything was done within the budget, through interbudgetary transfers. Since then, all of the growth, all of the liberalization, and most of the new investment has basically come from the banking system. Asset holders and borrowers had really no place else to go—and no way to get out of the economy. So these big ups and downs of overlending followed by a bust do create big risks for the banking system. This is why Chinese banks had 35 to 50 percent nonperforming loans in the late 1990s and early 2000s.
They've since cleaned that up, but as long as bank finance is the primary fuel for the economy, there will be problems. That's why China's been moving to open up its equity and bond markets. But the starting position is still pretty low, and it's going to be a long time before equities and bonds contribute a meaningful amount to finance in China.