China’s Growing Pains

For most of the past two years, investors have been pre-occupied with the fiscal catastrophe in Europe – and with good reason. However, the relative health of the world’s second largest economy arguably deserves more consideration.

A year ago, China’s stock market led the broader emerging markets down due to pervasive inflation concerns. Official figures reached as high as 6.5%, and some reports of pork and other food price inflation reached double-digit levels. Chinese authorities were forced to slow down the pace of their economy by raising bank reserve ratios and key lending rates.

Coinciding with these efforts to “cool” overheating growth, they have embarked on a more far-reaching goal of transitioning China from a manufacturing-led, export economy to a more consumer-oriented, self-sufficient one.

Indeed, more than half of GDP in 2011 was driven by public and private consumption – the first time this had occurred since 2001. Unfortunately, some question the methods through which China has pursued this objective including the Organization for Economic Co-operation and Development (OECD), which believes that public infrastructure investment financed off-budget has made up most of the domestic demand.

Still, there are other signs that China is seeking greater economic liberalization. None may be more important than a fix of its troubled financial sector, which is saddled with bad debt and failing to meet private sector demand. The failure of the Chinese banking system to service the private sector has created a “shadow” lending system, in which some lending rates reach 100% annualized.

While fears of a “hard landing” in China helped drive prices of H-shares (stocks available to foreign investors) to an 18% loss in 2011, Chinese stocks rebounded in late 2011 and early 2012 as inflation cooled and growth began to stabilize. The MSCI China index rose 18% in January and February of this year, among the top performing global markets during that period.

However, China looks to be re-entering a soft patch. Industrial production advanced 11.4% in the first two months of the year, well below China’s 15% average. In early March, China officials lowered their target growth rate for the first time in eight years.

Investors have taken notice. A 7% loss in March by the MSCI China index was the worst return in the global index, resulting in a first quarter return to investors of 9.9%, trailing even Europe, which is mired in a technical recession.

Most believe that Chinese officials have the resources and control to manipulate its economy effectively. However, one cannot help but question the relative firepower available to the government. Following a massive $586 billion stimulus program launched in late 2008, on top of the virtual peg of the renminbi, the amount of Chinese currency pumped into the economy over the past few years is staggering.

Inflation remains the key to what flexibility China has. Officials had successfully pushed down inflation to a 21-month low of 3.2% in February, but new data revealed prices spiked back to 3.6% in March – well above estimates of a 3.4% rise. The data underscores just how delicate China’s situation remains.