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Monday, 23 June 2008

Is China's Economy Slowing?

by: Michael Pettis posted on: June 19, 2008

Much of the focus in China continues to be on the performance of the stock markets. Yesterday the market bounced around both above and below Friday’s close, before ending the day at 2874, up slightly less than 0.2%. That was the first positive day for the SSE Composite in nearly two weeks (after last week’s 14% decline), but a quick look at the trading patterns and trading volume didn’t seem to indicate much conviction.

Wednesday, the market dropped sharply again. It started the day with a little bit of buying – in the first half hour the market traded up nearly 0.7%, but as often happens with any strength, sellers took advantage to unload positions and prices quickly bounced their way down to 2769, down 3.7%, just 30 minutes before the close of day, before staging a late rally to close at 2794, still nearly 2.8% down for the day.

This puts us at 6.9% below the 3000 level which we broke last Wednesday and which, supposedly, was the level below which the government would intervene. As I have been pointing out during the past two months, this kind of rumored intervention means that when the market finally breaks the expected support level, it is likely to drop pretty quickly – and so far it has.

There is still a lot of discussion and rumor-mongering about whether or not the government will eventually intervene, with the introduction of index futures and the permitting of margin trading as being the most likely forms of intervention. My understanding is that Vice Premier Wang Qishan (the new economic “tsar”) and a number of other relevant policy-makers are worried, correctly I think, that China’s history of frenzied intervention has undermined the functioning of the market, and so they are reluctant to continue intervening in response to market behavior, unless of course they get any indication that the drop in the markets might causing social discontent or unrest, especially in the period before the Olympics.

So we are in a very unstable position. As of yet not a whole lot has happened to indicate that investors are furious – there have been small demonstrations and nasty comments about the failure of the government to protect investors on various investor-related websites, but not much more – so perhaps the government will hold off doing anything. I suspect that they are beginning to learn that active intervention brings with it the cost of declining credibility, and this declining credibility undermines their ability to intervene successfully in subsequent periods. Perhaps they want to keep their powder dry in case they have a bigger market problem in the near future.

But I suspect this situation is unstable because the market is still expecting some new measure to prop it up, and if the government continues to hold off intervening, I don’t see prices continuing at this level. In fact I would imagine that a lot of investors are eager to get out and just waiting to see if they can get one last chance to recoup some of their losses before doing so. My guess is that if we don’t get something positive soon, we’ll have another bad week next week, and if it is bad enough it may prompt some action by the government.

Away from the stock market, some more interesting numbers on the economy have come out recently. Fixed asset investment was up 25.6% year on year for the first five months of the year (it was 25.9% up over the same period last year). Industrial output was up 16.0% in May, compared to 18.1% last May. Both numbers may understate the decline in growth relative to earlier periods, especially the latter, because this May the “Golden Week” holiday was cut from five days to two days.

If we assume a five-day work week, presumably that means the working month was about 15% longer this year than in previous years, but I am not sure that this would be the best way to look at the amount of time worked. In fact the typical work week seems closer to six or seven days, and certainly in Chinese universities we were supposed to make up for the holiday by holding extra classes before the holiday (which, I always thought, sort of negated the point of the whole thing for my poor students). I don’t know that the real working hours are for the average Chinese worker and I don’t know if they typically faced pressure anyway to make up for the foregone work during the holidays, but I suspect cutting the holiday from five days to two days might not be as big an adjustment in output as many people think.

It is perhaps an indication of how frothy things are that, although some analysts read these numbers as indicating that Chinese growth is in good shape, many saw the numbers as indications that the Chinese economy is beginning to slow down and may run into trouble if something isn’t done. As I see it, both numbers suggest that the economy is still roaring along, and it may just be a statistical necessity that they begin to slow. After all, the larger the Chinese economy becomes, the harder it is to maintain the same levels of growth – this is partly just a question of arithmetic. This is especially true for export numbers. Still, rising inflation means that an increasing portion of the nominal growth is not real, so we probably are seeing a slowdown in domestic economic activity, driven primarily by a slowdown in global demand.

Needless to say, any perception of economic slowdown will make it all the more difficult for the authorities to achieve the consensus necessary for them to address the monetary imbalances. We may be entering into the toughest period of all – in which as the need for monetary tightening, via the currency regime, becomes all the more obvious, the opposition to monetary tightening becomes even stronger because of weakness in the economy. I guess that means more policy paralysis.

Meanwhile we are being hit with yet another natural disaster. Heavy rains in the past week are causing enormous floods across 20 provinces south of the Yangtze River. Once again we are likely to see pressure on the economy, from inflationary pressure to greater investment in reconstruction. One thing I ma not sure about is what the conditions of China’s food and energy reserves. My suspicion is that they are quite low – in part because of selling to reduce inflationary pressure.

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