With America’s economy facing a subprime-induced recession, fallout from the financial crisis has spread across world markets. Will a consumer-led recession hurt China’s exports badly enough to knock the wheels off China’s growth machine? To what degree is America’s mortgage mess to blame for the turmoil on Chinese stock exchanges? And how will Chinese policy-makers balance the twin concerns of rising domestic inflation and the threat of an external slowdown? China Knowledge at Wharton asked economists and market practitioners for their views of the year ahead.


Stormy Weather


For Chinese investors, it must seem a long time since the heady days of October 2007 when the CSI (China Stock Index) 300 Index climbed to record levels. This year, the Index (which plots A shares on China’s two exchanges in Shanghai and Shenzhen) has plummeted 37%. But how much of the recent strife in China’s stock markets can be accounted for by ill economic winds blowing across the Pacific? The turmoil has been blamed on everything from bad U.S. economic news to the weather, following the worst storms in 50 years at the beginning of this year. Analysts have also cited the pressure that rising raw materials costs puts on companies’ margins.


Wang Qing, Morgan Stanley’s executive director and chief economist, concedes that the markets were “too optimistic” last year, and that only this year did Chinese fund managers and investors start to really appreciate the risks of the subprime fallout. As the rot from the subprime crisis spreads to global markets, many Chinese investors fret that a global downturn, coupled with domestic policy tightening designed to control inflation, will combine to bring about a “hard landing” for China’s economy.


However, in Wang’s view, the subprime fallout is no longer the Chinese markets’ main concern. “At this juncture, I think domestic risk is more important – that is, inflation and the related policy uncertainty,” he says, adding that investors are now worried that inflation may be out of control. The government reported last week that inflation was at 8.3% in March, close to the 11-year high of 8.7% reached in February. This announcement was immediately followed by further tightening of the money supply by means of the third reserve rate rise this year: Chinese banks must now keep 16% of deposits as reserves, the highest amount ever. (By reducing the amount of money available for lending, Beijing hopes to dampen inflation.) Following the news, the Chinese bourses recorded their biggest weekly fall on record.


Fund managers who spoke to China Knowledge at Wharton framed the markets’ tribulations differently, however. “The U.S. subprime crisis has had a big impact on China,” says senior analyst Tony Young of Hongkong-based Greenwoods Asset Management. “The money in Asia’s capital markets comes mainly from the U.S. Now the capital is going back to the U.S.” Eric Li, director of the asset management department at China Minzu Securities, explains why this should be the case. As the dollar has slid, he says, liquidity has become a problem in the U.S. American financial institutions therefore face a shortage of capital, which has led to the retreat of capital from China. This, says Li, is “one of the main reasons for the recent correction of China’s stock market.” 


Li notes that while China’s trade surplus was expanding, China’s exports brought capital inflows. However, the trade surplus has fallen 18% between March 2007 and March 2008, according to Dragonomics, a Beijing-based economics consultancy. This implies a reduced capital inflow, says Li, who nevertheless believes that yuan appreciation will continue to bring capital into China, which will eventually re-ignite the stock market. (A recent China Business News survey of 60 economists from research institutes, universities and government departments found that just over a third predicted the yuan will peak in 2009, with over half guessing that the high point will be somewhere between six and seven yuan to the dollar.)


In fact, capital has continued to arrive – by the bucket. Speaking at an industry seminar on April 13, senior state analyst Zhu Baoliang revealed that speculation on the yuan brought a massive inflow of $80 billion of “hot money” in the first quarter compared to $120 billion in the whole of last year, according to Xinhua News Agency. (Morgan Stanley’s Wang Qing notes that volatility in the global markets in the wake of the subprime crisis has meant that China attracts capital inflows, as speculators hope to earn interest and bet on yuan appreciation.) Minzu Securities’ Li sees the yuan rising for a further year or two, and is therefore “optimistic” about the market’s prospects for two or three years to come as capital returns to the markets. “My view is that, following a possible further correction, there will be a change towards stability soon, and the future trend will be upwards,” he says.


Decoupling By Any Other Name?


Some economists are not so optimistic. To simplify somewhat, the debate over the degree to which the subprime crisis will knock China’s economy off kilter has pitted those who believe that emerging economies can “decouple” from problems in advanced economies, and those who do not. The decouplers commonly argue that developing countries can ride the recession, thanks to burgeoning trade links between emerging markets, and stronger domestic consumption.


The decoupling theory has proved controversial, however. “We do not buy the view of a de-linked world economy,” says Stephen Green, head of research for Standard Chartered in China. Green argues that, as spending by U.S. and UK consumers falls and corporations adjust to the new reality, China’s exports will feel the effects. “A U.S. slowdown will hit China’s other export markets, too,” he adds. Exports to the U.S. rose only 5.4%, according to official figures, and the growth of overall exports has shown a gradual slowdown since the second half of last year.


According to Wang Qing, however, so far the subprime crisis has had little direct impact on China. “If the U.S. economy slows, China will export less and it will have an impact on China’s growth,” Wang says. “But so far we haven’t seen a very significant impact from this channel.” The latest trade figures show that total exports grew at 21.4% in the first quarter, although down 6.4% from last year’s rate. Exports have been affected by a mixture of factors, according to economists. Shen Minggao, an economist at Citigroup in Beijing, cites slowing demand from Europe and the U.S. (China’s biggest export markets), the quickened yuan appreciation and the rising cost of labor, among other reasons.


Furthermore, although Bank of China suffered the largest subprime losses of any Asian bank ($9.7 billion), and other leading banks have admitted lesser amounts of exposure, Wang says that Chinese banks’ exposure to the U.S. mortgage market turmoil was small. “Overall, Chinese banks are financially strong,” he notes, adding that their subprime losses are “manageable”. Besides currency speculation, Wang says the other way in which subprime fallout indirectly impacts on China is via the weak dollar’s tendency to drive up commodity prices: The upshot of this is that China imports inflation.


Meanwhile, the better-than-expected growth of 10.6% in the first quarter — China’s economy grew 11.9% last year, according to revised figures — appears to give ammunition to those who believe that China can “decouple”. Wang puts it this way: “If China delivers 10% growth, you can call it decoupling [or] you can call it recoupling. Whatever you call it, China can grow 10%.” Wang predicts that China will continue to motor along at 10% for the year. Green predicts an only slightly less supersonic 9.5% growth.


Beijing’s Inflation Complication


On one thing, at least, economists agree: This is a confusing time for policy makers in Beijing. “Policy uncertainties in China at the current juncture could not have been higher,” notes Wang. Just as China’s leaders might consider loosening monetary controls to stimulate demand and provide exporters with more credit, galloping inflation is tying their hands. A similar dilemma surrounds the value of the yuan: “Should one accelerate Chinese yuan appreciation to cope with inflation, or slow it down to support exporters?” asks Green.


So far this year, in managing these trade-offs, Beijing has confined itself to tinkering with the reserve ratio. With the U.S. Federal Reserve holding interest rates low in the U.S., it has been argued that higher rates in China would only encourage the flow of “hot money” seeking greater returns. And as state economic analyst Zhu Baoliang noted recently, the new wave of speculative inflows puts pressure on the central bank to raise money supply, threatening to thwart the government’s fight against inflation.


However, many economists argue that Beijing will be obliged to use stronger measures. Indeed, Zhou Xiaochuan, governor of China’s central bank, recently stated – to the alarm of the markets – that there is room to raise interest rates. An April 18 survey by Bloomberg News found that 11 out of 15 economists expect interest rates to rise this year to contain inflation. “The risk of inflation will outweigh concern that speculative inflows will fuel price gains, prompting the central bank to resume lifting rates,” the survey stated. Green falls in this camp, predicting four rate rises in 2008. Nevertheless, he expects food prices — a major component of the Consumer Price Index (CPI), which rose by one fifth in the first quarter — to keep climbing. “Higher food price inflation will have to be coped with for a while – and will continue to support overall CPI,” he states.


Morgan Stanley’s Wang is not in favor of rate hikes, and does not foresee any this year. During the 1987/88 bout of inflation, for instance, he notes that Beijing used a mix of domestic tightening via implements, such as interest rate hikes combined with external easing through currency devaluation, and that this resulted in a hard landing for the economy. Besides the disruptions to stock and property markets, rate hikes could exacerbate China’s existing “external imbalances,” he argues. And it is these external imbalances (that is, China’s trade surpluses and burgeoning foreign exchange reserves) that economists point to as a significant source of the liquidity and money supply growth that are to blame for high inflation. Raising interest rates weakens domestic demand for imports, for instance, thus widening the trade surplus. Wang does not think Beijing will dust off the interest rate tool this time round.


In fact, he does not believe that inflation is out of control: The unusually severe winter storms, for instance, played a part in February’s 11-year high CPI figure, he argues. But if it should prove necessary to take further measures to combat inflation, Wang believes that gradual currency appreciation is a better option than aggressive interest rate hikes to rein in inflation.


How does this work? Besides domestic savings and speculative inflows, the excess liquidity in the Chinese economy also derives from foreign currency accumulated selling exports to other countries. Among other benefits, yuan appreciation makes Chinese exports more expensive for foreign consumers, theoretically reducing China’s trade deficits and discouraging capital inflows through this channel, Wang says. He also points to a silver lining to slower growth in China’s export sector, as this could help cool the Chinese economy and counter inflation.


The yuan’s gains in value have also been held responsible for encouraging the inflow of “hot money” into China. Nevertheless, at the National People’s Congress Assembly in March, Zhou Xiaochuan, governor of China’s central bank, recognized that “an appropriate appreciation of the yuan does help contain inflation in China, but fighting inflation will not be a main reason for the exchange rate reforms or market fluctuations.” And Tan Yalong, a senior analyst at Bank of China, has also said that the government is considering making use of the exchange rate as opposed to interest rates to control inflation – although Tan herself sees no evidence that the yuan’s appreciation has helped narrow the trade gap or put the breaks on foreign reserve accumulation, according to Xinhua.


A Year of Two Halves?


In fact, many analysts have attributed the yuan’s already speedier appreciation in the past six months to the government’s anti-inflation drive. For instance, Mirza Baig at the world’s largest currency trader, Deutshche Bank, was quoted by Bloomberg as saying that, “The immediate focus on controlling inflation will keep the yuan on its current trajectory through the second quarter.’ In the second half of the year, she said, there may be “a more balanced approach towards growth and inflation, and thus a slowdown of currency gains is likely.’


With foreign and domestic conditions tugging in opposite directions, Green agrees that this will be a year of two halves for Chinese economic policy. Domestic concerns will dominate the agenda for the first part of this year, when tightening will be the name of the game. “The second half of 2008 and 2009 presents a different challenge,” says Green. “Slower U.S. and global growth, alongside Chinese yuan appreciation, will take some of the steam out of China’s export demand.” As exports slow, officials will face a choice: “Do they allow banks to lend freely again, which might trigger a new wave of loans to projects which would ultimately become redundant? Or do they continue to control lending with a revised objective — to ensure that banks do not make themselves even more vulnerable to a downturn?” Green reckons the former, predicting that when inflation starts to drop, the balance of policy debates in Beijing will shift towards lobbies — such as the provinces and industry — which depend on easy credit and therefore favor loosening.

Similarly, Morgan Stanley’s Wang dismisses fears that Chinese officials will get stuck in a tightening mode. He notes that the current tightening policy was announced in a mostly benign external environment. “Developments in the global economy and market have since made Chinese authorities recognize the potentially large downside risks and stand ready to adjust their policy stance as external demand weakens,” he observes. “We believe the risk of policy overtightening – where an aggressive tightening policy is pursued even when external demand weakens substantially – is quite low.” Based on this and his expectation of externally led cooling via slowing exports, Wang thinks that the most likely scenario for this year is an “imported soft landing.”

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