Thursday, August 04, 2005

China: The Slowdown Has Begun

By Andy Xie, Morgan Stanley

The Chinese economy has started to slow owing to excess capacity. The rapid investment-led boom of the last five years borrowed growth from the future. I believe the economy will take at least two years to bottom.

The slowdown should be good for social stability. The recent overheating redistributed a substantial proportion of household income to businesses and governments through property, food and energy inflation. As inflation turns into deflation, the share of household income in GDP should recover.

China must be vigilant regarding financial stability during the on-going economic consolidation. The key is to prevent a sudden outflow of the hot money that has come in over the past three years to speculate on Rmb revaluation.

The First Stage of Slowdown Has Begun

Declining commodity prices and property sales have decreased corporate cash flows. In response, corporates are putting the brakes on their on-going investment projects. This typically represents the first stage of slowdown following an investment-led boom.

Decelerating energy consumption and rising inventories are the visible signs of the slowdown. The dramatic decline in China’s imports of petroleum reflects both slowing energy demand in general and the growing availability of coal. Insufficient electricity generating capacity, compounded by a coal shipping problem, exaggerated China’s demand for petroleum products between 2003-04, as export factories installed diesel generators and burnt petroleum products for electricity.

China’s installed capacity of electricity production has roughly caught up with demand this year. As the capacity under construction is very large, China may enter surplus in electricity generation capacity in 2006. 83% of China’s electricity production is coal-based, with hydro accounting for another 15%. Hence the need to use petroleum products to generate electricity is vanishing. We believe China’s overall imports of crude and petroleum products will decline in both 2005 and 2006.

The accumulation of property inventory is the most important factor in the current phase of the slowdown. Following the central government’s introduction of anti-speculation policies in the spring, speculative demand in the property market has dried up. Such demand was the main driver of the property market and developers factored it into their supply plans. Hence current supply far exceeds demand. Property developers will need to slow down their on-going projects and postpone new projects to save cash, in our view.

Other types of investment projects are also slowing down. Container port developers, for example, are requesting their contractors to slow down construction. New steel mills are being delayed as the current steel prices make steel production barely profitable.

The Next Stage of Slowdown May Begin in Six Months

We expect the second phase of the slowdown to see inventory liquidation in the property sector and further commodity price declines as a result of reduced investment demand.

Most property developers have made huge profits in the past few years. However, they also have increased their investment in new projects. Their cash positions are typically not strong. As property sales continue to lag far behind completion, cash levels among property developers are declining. We believe that the developers will soon have to cut prices to clear the market, which will set a new equilibrium price for property in China, and put a halt to new projects until the inventory is sold.

Declining commodity prices are causing less capacity addition in these industries. However, the expansion of the commodity industries was a major source of demand for commodities. Commodity prices are declining now owing to overproduction and may fall further owing to demand retrenchment on reduced capex.

The first phase of slowdown, characterized by the stretching of on-going projects, is not dramatic. This is why the market is still debating whether or not the Chinese economy is actually slowing down. When inventory liquidation and cancellation of new projects happen in the second phase, we think the slowdown will become apparent. In the last cycle, China entered the second phase in 1996 and bottomed in 1998.

Slowdown Can Strengthen Social Stability

The on-going slowdown can strengthen social stability, in our view. The proportion of household income in GDP has fallen in recent years, as the business and government sectors have captured a greater share through inflation in property and products with temporary bottlenecks. Despite the rapid economic growth, social tensions have been increasing owing to the issue of distribution.

As the economy slows, adjustments in the property market and vanishing bottlenecks should redistribute more income to the household sector through declining prices. This should benefit the low-income group especially. This dynamic suggests that the coming economic slowdown should benefit social stability, in our view.

The slowdown will likely lead to fewer employment opportunities, especially in the construction sector.

However, the benefits of the household sector’s rising income share should more than offset this negative factor in the short term.

Of course, should the economic growth rate remain low over the long term, the effect of reduced employment opportunities would accumulate – and the balance between a bigger income share for households and fewer employment opportunities would turn negative for social stability. However, as China’s slowdown is due to overinvestment, it resembles an inventory cycle. After two to three years’ digestion, China will return to a high growth rate, in our view. This is why I believe an economic slowdown to adjust for overinvestment will be positive for social stability.


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