Tuesday, May 6, 2014
A financial crisis in China has become inevitable. If it happens soon, its effects can be contained. But, if policy makers use further doses of stimulus to postpone the day of reckoning, a severe collapse will become unavoidable within a few years.
The country is in the middle of by far the largest monetary expansion in history. On one widely used measure, M2, its money supply has tripled in the past six years, an expansion four times as large as that of the US over the same period.
This unprecedented expansion is at least partly responsible for China’s extraordinary growth rate, which is now running up against a demographic constraint. Last year, for the first time, the working-age population declined, a trend set to continue for the next two decades. Unless the country can keep lifting the labour force participation rate (for example by getting more women into the workforce or persuading older people not to retire), China will struggle to expand its labour force by even 1 per cent per year. To sustain economic growth of more than 7 per cent, productivity would need to grow by 6-7 per cent a year across the entire economy. This would be a tall order in any country. In China, where the labour-intensive services and agriculture sectors make up half the economy, it is well-nigh impossible.
The country suffers from excess capacity in most industrial sectors. Yet investment in fixed assets continues to grow at double-digit rates. The steel sector is a case in point. China has about 1bn tonnes of annual steel-production capacity; about a third of it sits idle. Consequently, the growth statistics present a misleading figure. Output is being produced, sometimes even in the absence of any demand. A continuing burst of credit is needed to help fuel new capital spending to keep the factories busy – but that only adds to the stock of unused capital. It is a similar story with property investment. China is brimming with high-quality housing that is unaffordable. Sharp price declines are needed to clear the market. That will involve severe pain for banks that participated in the monetary expansion.
Observers often cite China’s closed capital account as a blessing that will stave off capital flight. But one consequence is a huge and persistent balance of payments surplus. Foreign money flows into the country to pay for exported goods and investment, and much less flows back out since there are few legal avenues for exit. China’s surplus over the past 10 years has been far larger than Japan’s was in the 1980s – the years when its disastrous asset price bubble was being inflated. This should have caused the currency to rise rapidly. But the renminbi has been pegged to the dollar for most of that period, accumulating a big pile of foreign reserves.
Observers often cite China’s closed capital account as a blessing that will stave off capital flight. But one consequence is a huge and persistent balance of payments surplus
Compounding it all, Chinese investors believe that none of the country’s banks or financial products will go bust because the government stands behind them all. This is partly the legacy of the banking rescue mounted a decade ago, when about 40 per cent of loans belonging to four big government-owned banks were transferred (at face value) to asset-management companies. But the broader problem is the tendency of the party leadership to provide a policy stimulus every time growth dips.
Financial controls are gradually being relaxed. But the offshore market on which the renminbi is now allowed to trade is tiny – less than 5 per cent of the value of China’s foreign reserves. Opening the capital account fully is impossible; it would result in large flows of funds and a loss of control that policy makers cannot countenance.
In a country that already accounts for half of all capital-intensive production globally, and nearly a fifth of all US imports, the growth of manufacturing will inevitably slow. A thriving service sector could pick up some of the slack. But building more houses and railways is not the way to encourage it.
China’s economy is in an unbalanced state. It can stay that way for some time – but the longer it does, the worse the eventual outcome will be. The industrial sector is already plagued by falling prices. To avert a wider deflationary spiral, the country needs to wean itself off the false cure of perpetual policy stimulus.
The US is on the brink of losing its status as the world’s largest economy, and is likely to slip behind China this year, sooner than widely anticipated, according to the world’s leading statistical agencies.
The US has been the global leader since overtaking the UK in 1872. Most economists previously thought China would pull ahead in 2019.
The figures, compiled by the International Comparison Program hosted by the World Bank, are the most authoritative estimates of what money can buy in different countries and are used by most public and private sector organisations, such as the International Monetary Fund. This is the first time they have been updated since 2005.
After extensive research on the prices of goods and services, the ICP concluded that money goes further in poorer countries than it previously thought, prompting it to increase the relative size of emerging market economies.
The estimates of the real cost of living, known as purchasing power parity or PPPs, are recognised as the best way to compare the size of economies rather than using volatile exchange rates, which rarely reflect the true cost of goods and services: on this measure the IMF put US GDP in 2012 at $16.2tn, and China’s at $8.2tn.
In 2005, the ICP thought China’s economy was less than half the size of the US, accounting for only 43 per cent of America’s total. Because of the new methodology – and the fact that China’s economy has grown much more quickly – the research placed China’s GDP at 87 per cent of the US in 2011.
For 2011, the report says: “The US remained the world’s largest economy, but it was closely followed by China when measured using PPPs.”
The figures revolutionise the picture of the world’s economic landscape, boosting the importance of large middle-income countries. India becomes the third-largest economy having previously been in tenth place. The size of its economy almost doubled from 19 per cent of the US in 2005 to 37 per cent in 2011.With the IMF expecting China’s economy to have grown 24 per cent between 2011 and 2014 while the US is expected to expand only 7.6 per cent, China is likely to overtake the US this year.
Russia, Brazil, Indonesia and Mexico make the top 12 in the global table. In contrast, high costs and lower growth push the UK and Japan further behind the US than in the 2005 tables while Germany improved its relative position a little and Italy remained the same.
The findings will intensify arguments about control over global international organisations such as the World Bank and IMF, which are increasingly out of line with the balance of global economic power.
When looking at the actual consumption per head, the report found the new methodology as well as faster growth in poor countries have “greatly reduced” the gap between rich and poor, “suggesting that the world has become more equal”.
The world’s rich countries still account for 50 per cent of global GDP while containing only 17 per cent of the world’s population.
Having compared the actual cost of living in different countries, the report also found that the four most expensive countries to live in are Switzerland, Norway, Bermuda and Australia, with the cheapest being Egypt, Pakistan, Myanmar and Ethiopia.
A rebound in German conglomerate Bayer’s plastics business has fuelled speculation that the division could be sold as part of a strategy to focus on life sciences.
The drugs and chemicals group’s first quarter core earnings rose from €2.45bn a year earlier to €2.74bn, following strong growth in its plastics division MaterialScience.
Earnings before interest, depreciation and amortisation at MaterialScience, which makes polycarbonate plastics for use in car parts and Blu-ray discs, rose by 79 per cent from €204m in the first quarter of 2013 to €366m.
Analysts have long expected Bayer to dispose of its plastics division to streamline the company. Over the weekend, the company was reported to be exploring a sale.
The German group has just completed the takeover of Algeta, the Norwegian cancer drug company, the latest indication of a shift towards life sciences.
However, in an investors’ conference call on Monday, Bayer’s chief executive Marijn Dekkers damped speculation of a sale, saying there had been no approaches over the division.
Mr Dekkers said: “Our most important goal is to drive organic growth. Take pharma we are very well on the way there, [with] 15 per cent growth. We don’t feel we have our back against the wall in terms of having to do acquisitions to drive growth.”
The 15 per cent sales growth in pharmaceuticals was led by Xarelto, an anticoagulant which is Bayer’s best-selling pharmaceutical product.
The rebound in earnings at the plastics division in the first quarter follows a difficult year. Sales of high-tech plastics were down in 2013 due to weaker global demand, while prices fell in the Asia/Pacific region due to an excess of production.
Alistair Campbell, an analyst at Berenberg bank, said that a sale of MaterialScience was “very logical”.
Mr Campbell said: “The trajectory for Bayer over the last five to seven years has definitely been towards more healthcare and less chemicals, buying Algeta, buying Schering and selling Lanxess.”
Under its current chief executive, Bayer has shifted away from its traditional three pillars of chemicals, crop science and healthcare to align itself around “understanding biology for the benefit of plants, humans and animals”, Mr Campbell said.
The analyst valued the plastics unit at approximately €9bn or seven-and-a-half times forward ebitda, based on its recovering profitability.
Bayer confirmed its 2014 outlook for currency-adjusted sales of around €41bn to €42bn, compared with €40.16bn last year. It said it continued to expect a “low-to-medium single-digit” percentage increase in adjusted ebitda for the year.