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Wednesday, March 11, 2009

Prices Drop As Exports Fall

Perhaps one of the most heated debates which is taking place among investors and economists at the present time relates to China. Economic growth plunged in the fourth quarter of last year, and the economy may even have contracted. Yet the government has lashed out "loads of money" on a huge stimulus programme. Will this work? The Jury is still out.

Certainly some sectors of the economy are suffering badly and China’s trade surplus plunged in February on the back of a record drop in exports. The trade gap narrowed to $4.8 billion - roughly one eighth of the amount registered in January, according to data from the customs bureau. China's trade surplus hit a record $40 billion in November. Exports dropped sharply in February - down 25.7 percent from a year earlier (following a 17.5% fall in January), while the collapse in imports slowed, falling by "only" 24.1 percent following January's record 43.1 percent decline.

Meanwhile China announced earlier this week that its consumer inflation fell for the first time in more than six years in February, suggesting we might now be entering a period of price deflation - the consumer price index fell 1.6 per cent from a year earlier in February. This followed a 1.0 per cent rise in January .

China's CPI last fell in December 2002, when it dropped 0.4 per cent, capping a year in which CPI fell every month save one. The latest data show the risks of prolonged general price declines - deflation - are rising. Beijing has targeted headline inflation of 4 per cent this year but it certainly now looks like the government will struggle to get prices back into positive territory and may have to confront a prolonged period of deflation. Food prices, a key component of in the Chinese CPI, fell 1.9 per cent in February from a year earlier; non-food prices fell 1.2 per cent.

And more evidence of possible deflation in the works comes from wholesale prices, since the producer price index fell 4.5 per cent in February from a year earlier, a steeper drop than January's 3.3 per cent decline.

Industrial Output Falls Back

China’s industrial-production growth slowed at the start of the year on the back of the export decline, with output rising only 3.8 percent in January and February from a year earlier, slowing from a 5.7 percent increase in December.

However China’s investment spending has maintained its momentum (and even increased), as the government pours money into roads, railways and power grids. Urban fixed-asset investment climbed by 26.5 percent in January and February from a year earlier.

Retail sales, on the other hand, have been slowing, and rose by 15.2 percent in February from a year earlier in current price terms (after a 19 percent rise in December) or by 16.8% in real (price adjusted) terms (given that prices fell year on year). The downward momentum in retail sales growth since the summer is evident on both measures.

Huge Loan Expansion

So the big question is to just what extent will the government investment programme help restructure the economy? Certainly it won't kickstart it, since the export sector is dependent on demand elsewhere, and that is unlikely to move in the near tyerm. However the emphasis in Chinese economic activity might be able to switch towards domestic consumption, and that is the big question we now face. Certainly bank lending has increased, with China’s new loans more than quadrupling in February (from a year earlier) as the government pressed banks to support a 4 trillion yuan $585 billion). The problem is, just how much of this lending can turn bad?

Banks extended 1.07 trillion yuan of local-currency loans in February and M2 climbed 20.5 percent from a year earlier, the fastest pace in more than five years, after growing 18.8 percent in January. The lending, which is in addition to a record 1.62 trillion yuan in new loans in January has given rise to concerns that the pace of new lending may be unsustainable and endanger the overall health of the financial system. Lax credit assessment now may lead to an upward surge in delinquencies in the months and years to come.”

Central bank Governor Zhou Xiaochuan said earlier this month that loans and money supply may have grown too quickly, since Premier Wen Jiabao announced a whole year target for lending of 5 trillion yuan, so that the banks are already halfway through their target with 10 months still to go. The surge in credit has also triggered concern that some of the money is being pumped into the stock market. The Shanghai Composite Index which tracks China’s largest stock exchanges is now up by 17 percent since the start of the year.

The worries about bad debts are being taken seriously, and China’s banking regulator have told banks to boost provisions to 150 percent of their outstanding non-performing loans, according to an article in the 21st Century Business Herald. The bad loan ratios of the country's five biggest banks -- Industrial & Commercial Bank of China Ltd., Agricultural Bank of China, China Construction Bank Corp., Bank of China Ltd., and Bank of Communications Ltd., is to be raised to 150 percent from 130 percent at the end of 2008, while the requirement for smaller national banks remains unchanged at 150 percent.

Liu Mingkang, chairman of the China Banking Regulatory Commission, has described such moves as "prudent", and in line with the regulatory decision to carry out spot checks on bank loan books to “ensure quality of growth”.

Rural Squeeze

But while the banks dole out the money, and stocks surge, China’s rural population are feeling the pinch as farm incomes drop this year on the back of falling agricultural prices.

“The pressure from declining agricultural prices is high,” Yin Chengjie, vice chairman of agricultural and rural affairs of the National People’s Congress, said in an interview in Beijing. “We cannot be optimistic about growth” in farm incomes this year, he said.

Prices of agricultural products - including cotton, soybeans and corn have fallen over the past year as bumper harvests swelled stocks and restaurant sales and food processing output declined. The net consequence is that the disparity between the urban and rural population is widening, and the situation is further aggravated by the large number of migrant workers who now find themselves unemployed and have returned to their villages.

And just to show that the export data isn't simply a one off problem, it is worth noting that the OECD leading indicators reading has been sliding steadily for months now, and continue on its way down in January regardless (see chart below). Also foreign direct investment in China fell for a fifth consecutive month in February.
Investment dropped 15.8 percent to $5.83 billion from a year earlier - according to the commerce ministry - compared with a 32.6 percent decline in January. So the stimulus programme is acting as a brake on the rate of decline, but we still have a decline. That, I think, is the best we can hop for at this point.