On Monday, the People’s Bank of China issued a secret memo to tighten the way mandatory reserve-requirement ratios are calculated. The move is one part of an attempt to curb runaway lending by the tens of thousands of state-owned bank branches. Since these unprecedented levels of cheap money circulating throughout the Chinese economy have been a boon for commodity prices, any slowdown in Chinese credit and therefore fixed-investment is bad news for Australian resources companies and our terms of trade. But Australia can sleep easy, for the next year or two at least.
There are powerful short-term factors preventing any significant slowdown in Chinese fixed-investment and therefore demand for resources, despite the PBC warning that the rebalancing of the Chinese economy is urgently needed.
The common wisdom that China saved Australia from the worse of the Global Financial Crisis is correct. From 2008-2010, the world witnessed an unprecedented surge in Chinese bank lending and fixed investment. Total bank loans issued jumped from around $740 billion in 2008 to $1.4 trillion in 2009, before falling to $1.1 trillion last year. This means the total outstanding loans in the economy have jumped by nearly 50 per cent over the past two years.
Before 2008, around three quarters of these loans went to the fixed-investment obsessed state-owned-enterprises. The proportion of loans received by SOEs jumped to around 90 per cent from 2008-2010. In 2010, China allocated over $US2.6 trillion to fixed-investment in what was then a $US4.5 trillion economy—the highest proportion allocated to fixed-investment of any major economy in world history. Unsurprisingly, fixed-investment (ie. building things) was responsible for about 80-85 per cent of Chinese GDP growth from 2009-2010.
With inflation running at about 6.5 per cent officially (and perhaps double that unofficially), it is no wonder the PBC wants to slow down lending. Persistently warning that there are serious and potentially fatal imbalances in the Chinese economic growth model, the PBC has consistently been the prudent and sensible voice emanating out of Beijing’s labyrinthine policy and decision-making set-up. But economics almost always comes second to politics in China’s political-economy. Ironically, this is why Australia can breathe easy for the moment, but should brace for a hard Chinese landing somewhere down the line.
Observers of the Chinese system will realise that tightening the definition of the mandatory reserve-requirement ratio—the minimum reserves that banks must hold—and even raising the ratio has little effect on lending levels. For example, the RRR has been raised no less than nine times since July 2010, and interest rates have been raised five times during the same period. The fact that the RRR for the six largest banks is now at a record 21.5 per cent has hardly slowed the runaway lending, averaging well over $US100 billion per month so far in 2011.
There are a number of domestic and external reasons why Chinese central bankers are largely powerless when it comes to significantly slowing lending.
First, the provincial and local government officials who significantly influence a large number of lending and investment decisions in local branches of state-owned banks are hooked on these loans. In many provinces, up to half of all local government revenues are based on SOEs—commonly known as Local Financing Vehicles—making money from the property market. From 2009 onwards, it is estimated that 20-40 per cent of all loans have been used to finance the building of residential property even if few ordinary Chinese citizens can afford to buy them. Even if Beijing could enforce its will on the 45 million local officials—and it cannot—local fiscal reliance on an ever more precarious property bubble means that local officials will not easily accept slower loan growth and a construction slowdown.
Second, stagnating consumption in the United States and the European Union means that Beijing needs to find other ways to maintain and create jobs for its 750 million workers—particularly its 200 million itinerant workers throughout the country. The number of workers employed in the export manufacturing and related sectors has not increased (and possibly has decreased) since 2007.
Because of the unfair bias towards SOEs in the system, the domestic private sector in China has actually shrunk in relative and absolute terms since the onset of the GFC. This means that there is more reliance than ever before on SOEs to create jobs throughout the country. And building things through fixed-investment finance is all many of China’s 150 central and 120,000 local SOEs (and their countless subsidiaries) know to do.
There is also another potential short-term boon for Australian resource companies. America remains the only place big and safe enough to park most of Beijing’s huge foreign currency reserves. Hence, Beijing has been buying even more US Treasury bonds and other dollar assets despite America’s woes. One minor asset diversification option is to stockpile commodities, as Beijing did from 2009-2010.
China’s perpetual fixed-investment stimulus means that it will eventually have a hard landing. We are deluding ourselves if we think we can avoid the ‘Dutch disease’ by relying on the construction of more and more empty residential blocks, shopping malls, ghost cities and unused infrastructure. The danger is that the Chinese Communist Party, rather than the central bank, is calling the economic shots throughout the country.