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By: Costas Bocelli — January 19, 2012

Will China Drag Us All Down?

For China, 2012 will be the Year of the Dragon...

But for the rest of us that have plenty of skin in the game, it will undoubtedly be the Year of the Landing:

Will China be able to engineer a soft economic landing, or is it headed for a hard fall that will send shock waves reverberating around the world?

It’s a question that continues to be highly debated, with very stark differences of opinion as to China’s future path when it comes to its financial health.  It’s also a very important question, as China is now the second largest economy and, in this symbiotic world of global finance, they’re a vital piece to worldwide growth and boom or recession and doom.

China recently released its fourth quarter GDP data, which showed that the economy grew at an annualized rate of 8.9% from the previous year’s quarter.  That was the lowest rate of growth since the second quarter of 2009 (2-1/2 years ago).  For the entire of year of 2011, China’s economy grew at 9.2%, which was also the lowest rate of growth since 2009 -- the year that global equities bottomed.

So, basically, China’s economy continues to show signs of slowing down.  But once the markets opened on Tuesday, the mainland Shanghai index jumped 4.2% -- the biggest one day gain in over two years.  Aside from the GDP data, industrial production showed signs of expansion, and retail sales grew at an annualized rate of 18.1% for the month of December (11.7% for the full year).

All the data came in better than expected, and let’s not forget that the Shanghai index was a bit oversold -- down 21% from last year. 

Was this simply one big short covering rally, and is the index soon headed for a plunge as the economy heads for a hard landing?  Or, is China closer to a bottom, with this slow but painful grind lower merely the symptom of their successful engineering of a soft landing to cool the economy at a controlled pace?

Shanghai Composite Index (1 year- daily)
(click to enlarge the image.)

 

Hard or Soft Landing?

To truly debate the issue, one must go beyond government-manipulated data... especially when we’re talking about the economic data coming out of the Chinese government.

The reality is that, while China is the largest economy behind the US, they are extremely reliant on exports to grow their economy.  Their two biggest customers for their goods are the Eurozone countries and the US.  Much of the weakness in the GDP data comes from lower demand for exports out of Europe, which is teetering on a recession. 

The hard landing argument suggests it’s only going to get worse, as Europe is forced into more deleveraging and austerity takes a further toll and crimps spending.

The soft landing argument suggests that Europe’s painful slog is nearing a pinnacle, and the Central Banksters will continue to prime the pump and flood the markets with plenty of liquidity, preventing serious demand and deflation destruction.

Also contributing to China's weakening growth has been their weakening residential real estate market.  After the previous few years of torrential growth and double-digit price appreciation in property, prices have been coming down -- and in some places fairly significantly.

The Bank of China had been tightening monetary policy by raising interest rates and bank ratio reserves on capital to stem the sharp rising inflation in the housing market.

The effect has taken its toll, and briskly cooled the residential housing market, new construction, and home prices.

The hard landing argument suggests that a full blown banking crisis is looming, akin to the bursting of the US housing bubble market.  They continue to argue that there is too much capacity and that the banks, local governments and the “shadow” (underground) banking sector is far too leveraged and exposed to systemic risk.

The soft landing argument suggests that the Bank of China was correct in strict monetary tightening, and has successfully reined in out of control prices and brought them down to sustainable and stable levels.  Inflation has indeed receded from nearly 7% to 4.1%, which is very close to policy target.  Also, the mortgage criteria and rules on home and investment properties are much stricter and require greater capital outlays for purchases, which is a stark contrast to the once highly leveraged and exposed US housing market.

The next few quarters of growth data will be extremely important.  While practically every economy in the world would be ecstatic to have annualized economic growth in the +8% area, China really can’t afford to slip much further.

The communist country is ruled by a one-party system that has complete control over the entire country, including its people.  Without above average growth, China could be vulnerable to what we’ve seen with the Arab Spring and revolution from dictatorship.  The economy must grow to continue to fund and subsidize their people to preserve the peace and avoid social instability that could spiral out of control.

China has plenty of tools and resources at its disposal to avert or attempt to prevent a hard landing.

The biggest thing is that they have plenty of room on the monetary policy front.  After years of tightening, they actually reversed their stance and loosened the reins on the banks and housing market by reducing bank ratio reserves by 50 basis points in late November 2011.  This action increases the money supply and promotes more lending.  There is a rumor that they will cut the ratio reserves again at the end of the month.

They also can lower interest rates.  While the US has been at Zero interest rate policy for years and has to revert to unconventional means to stimulate (QE), the Bank of China actually has an interest rate they pay depositors and has plenty of room to cut -- and China’s interest rates are now currently above the rate of inflation... quite rare these days.

And, lastly, the Chinese sovereign wealth fund (SAFE) has built a foreign currency reserve war chest of $3.2 trillion -- mainly in US denominated assets.  This is an enormous resource, and could be easily leveraged many times over in an emergency or worst case scenario.

By the end of this year, we should most likely get the answer on the hard or soft landing debate.

For now, in the very short term and especially with Europe still trying to sort out its mess, it’s more like over easy to me.

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