China's Stimulus: The Big, The Bad and The Ugly?

As the world economy suffers through its worst crisis in over 70 years, the various G-20 participants have independently implemented ways to rekindle global demand, and attempt to offset what's now being termed as the "great recession" by leading economists. In the U.S., Western Europe and Japan the emphasis has been on a combination of aggressive monetary policies (taking interest rates to near-zero levels and quantitative easing) and fiscal initiatives, ranging from cleansing the international banking sector's toxic loan/investment portfolios to government-sponsored infrastructure projects and tax-related incentives - all with the ultimate goal of breathing life back into the terminally ill global consumer. China's approach to stimulating its economy up to now has been all of the above and more, but its central concern about how it contributes to correcting this global problem is summed up from a famous Chinese proverb, "ONLY when all contribute their firewood can they build up a strong fire."

When it comes to monetary policy, China's traditional method is the tried-and-true tool of cutting interest rates, but since the start of last year the People's Bank of China (PBoC) has cut rates by only half as much as the U.S. Fed. While recent consumer prices have shown a decline of 1.6 percent, giving some economists reason for deflationary concern, bank lending has grown by 24 percent over the past year. The true gauge of monetary easing is not the cut in interest rates themselves, but whether those cuts actually succeed in creating new loan demand, currently a big problem in the U.S. China is one of the few countries in the world where credit has accelerated since the global credit crunch, with the caveat that a large portion of that new lending is via state-directed banks. On the FX side of things, up until the crisis began last summer the PBoC had allowed the yuan to rise by nearly 18 percent in trade-weighted terms, but since last July the currency appreciation has stalled in a tight trading band over concern for local exporters.

In China, the correct measure of their fiscal stimulus is dramatically understated by the true economic effect in the form of public infrastructure investment via state-owned firms/local governments, and financed through state-sponsored banks. It's been estimated that new infrastructure investment, related tax cuts, various consumer subsidies and increased spending on healthcare will amount to a stimulus package by the central government of about 3 percent of GDP in 2009 (with the actual money spent, 4 trillion yuan or $586 billion). If bank-financed infrastructure spending is added into the overall number, the total is close to 4 percent of GDP. Chinese investment in railways, roads and power grids was already booming before the crisis, but in the first two months of 2009 total fixed investment was 30 percent higher in real terms than in 2008, as investment in railroads had already tripled. China's traditional method of stimulus has been on investment, rather than consumption, but in its view this is the quickest way to boost domestic demand.

As in the U.S., the Chinese government is aiming for a rebound in home sales, since property ownership is a key way to spur private consumption. Higher home sales encourage more domestic spending on furniture and consumer appliances. Construction creates jobs and, in fact, almost employs as many workers as the export sector. Since last October, the government has encouraged people to buy houses by cutting the minimum mortgage down payment on their primary residence to 20 percent and reducing stamp duty and other taxes on property transactions. Stronger sales are now feeding through into new home building as reflected in June's 12 percent rise, the first growth in 12 months.

In the year ending in June, fixed investment in China had surged by 35 percent, car sales by 48 percent and home purchases by 80 percent. After falling dramatically last year, home prices are now rising briskly again in some big cities and local share (equities) prices have soared by nearly 80 percent from last November's lows. While domestic spending has been spurred by the government's aggressive stimulus, the catalyst of this dramatic turnaround has been the scrapping of bank lending restrictions late last year. As of June, new lending was more than four times larger than in 2008. The big boost to domestic spending and the corresponding flood of liquidity has raised concerns of elevated inflation, fueling a new stock market and housing bubble and adding to a growing roster of bad loans. According to one estimate, 20 percent of new lending went into the stock market in the first five months of 2009. The current pace of bank lending is unsustainable, but as America's recent experience suggests, it's better to prevent bubbles forming in their early stages than to mop up the mess afterwards. Recently several high-level officials of the PBoC have voiced their concern that lending should be curbed. Prime Minister Wen Jiabao has recently signaled that he wants monetary policy kept fairly loose, as exports remain weak and the government fears premature tightening could derail the recovery. He is also keen to continue creating jobs and maintain social stability in the months before the 60 ^th anniversary of Communist party rule in October. In the end, the PBoC has begun to tug gently at the reins, has nudged up money market interest rates and has warned banks that it intends to increase its scrutiny of new bank loans.

Another reason for the dramatic economic rebound this year is that much of the slowdown was self-inflicted, rather than the result of America's economic collapse. In 2007, concerns about the economy overheating prompted the PBoC to curb the flow of credit for construction and home buying, causing China's economy to slow sharply even before the global financial crisis began last summer; however, after last fall's big drop, the financial credit tap was turned back on full. Despite the recent lending boom, Chinese banks' mortgage lending is still very conservative compared to lending in the U.S. as illustrated at the peak of America's housing bubble when it was relatively easy to get 100 percent financing for a home.

The underlying debate continues to be whether China's stimulus programs have been big enough or if the loose credit to finance the stimulus programs will create non-performing loan problems down the road. Exports fell by a sharper-than-expected 26 percent in Q1'09, and continues to be weak. The 12-month growth rate in industrial production has dropped to only 3.8 percent in Q1, with retail sales dropping by nearly 15 percent for the same period. On the positive side, China's year-on-year (YOY) growth rate is approaching 8.0 percent in Q2'09, but the more astonishing comparison of the headline number was the change from Q1'09 to Q2'09, which by some estimates has shown an increase of 16.5 percent on an annualized basis. China's economic stimulus has clearly been hugely effective up to this point, but many worry it may be working too well.

China's various stimulus programs have up to now dragged growth back up the 8 percent level, but they cannot keep the economy running at this pace if global demand remains depressed. The need for China to shift the mix of growth from exports to consumption has become even more urgent during this crisis. Chinese officials are probably right in saying it will take years of high levels of public spending on healthcare and a social safety net to put a dent in household savings. However, the lesson learned from America's financial crisis for China seem to be in plain sight: overly loose credit should never be ignored otherwise China's fire could burn out down the road.