China should win 2009 'Crisis Policy of the Year' Commentary: But 2010 will pose tough challenges

China should win 2009 'Crisis Policy of the Year'
Commentary: But 2010 will pose tough challenges

By Craig Stephen

HONG KONG (MarketWatch) -- As we start a new decade there appears to be increasingly polarized forecasts for China's economy, ranging from it leading the world out of recession to teetering on the precipice of collapse.

Reviewing the past 12 months, the lesson was surely not to underestimate the impact of Beijing's resolute policy response. Rewind and China was facing an export collapse, a moribund housing market that threatened to bankrupt its developers and an economy hemorrhaging jobs.

A massive lending program and infrastructure stimulus quickly got the economy back on track. Equity, property and commodity markets rebounded, and gross domestic product growth is expected to back near 9%, while Chinese initial public offerings led the world with a record-busting year.

For this crisis management, you might think that China's leaders should get a little more recognition. But somehow, the Time Magazine "Person of the Year" award for an economic crisis response went to Fed Chairman Ben Bernanke. Last time I looked, U.S. unemployment was at 10% and the greenback appeared in a terminal tailspin.

But despite the recovery, China's growth story still has a sense of unease. Where does China's economy go next? The bears warn China is poised to follow the U.S. and Japan with its own housing bubble bursting.

They are dismissive of indicators showing strength in China's economy (the purchasing managers index hit a 20-month high in December), saying that deep-rooted structural imbalances are growing. These include economy-wide overinvestment and capital misallocation, growing excess property supply and sky-high housing prices. Added to that are still-anemic domestic consumption and a serious over-dependence on exports.

What this will add up to is a bubble mixed in with large pockets of excess capacity -- not an economic miracle.

We have heard many times this was to be China's century, but it could be foolhardy to overlook this list of economic ills. Even if this somewhat exaggerates the situation, it will take some skilled policy making to finesse a broadening economic recovery.

Still, others are decidedly more upbeat on China's outlook. The economists at UBS in a new report offer reassurance that the "sky is not falling." They do not see evidence of structural problems in China's economy, although they concede there are cyclical risks after last year's lending spree. One figure that jumped from the page was that, last year, bank lending accounted for over 50% of GDP, they estimated.

UBS also reeled out a number of arguments that property-bubble fears are overblown. For affordability, it's the not the average urban resident that matters but the rising middle class. And to date, mortgage lending as a proportion of GDP has not increased, which is common when a bubble is reached.

China also has a manageable loan-to-deposit ratio of 70%, which makes it one of the most stable emerging-market financial systems, says UBS.

Still, it appears mainland Chinese leaders appear less sanguine about the property outlook. Last week, Premier Wei Jiabao warned that property prices have risen too fast and hinted taxes and loan interest rates may used to stabilize the market. See full story on Chinese premier's remarks.

Once again, much will depend on the policy response. A new memo to banks released over the holiday period gives a few clues of what to expect.

The expectation is for no change to interest rates for the first half of the year, but rather new administrative controls on lending. Consumer prices on the mainland climbed 0.6% last month from a year earlier, ending a nine-month run of deflation, so policy makers may have to move on interest rates sooner than they think.

What's certain is lending will be cut back from the 9.5 trillion yuan ($1.39 trillion) in 2009 to 7.5 trillion yuan this year, Merrill Lynch reports.

The memo refers to "smooth" lending, so the massive front-loaded lending of last year is likely to be avoided. It also encourages banks to make loans available for mergers and acquisitions. This should be good news for those able to consolidate markets and is a good theme to support equity-market valuations.

Much of course still depends on the external environment. China will be hoping there is more of a recovery in the major economies to give some momentum to its exports. Last year, China and its exporters benefited from being pegged to the weakening dollar, and if that trend is reversing, it will be another factor to consider.

China, like many emerging markets, also benefited from carry-trade investment, as investors borrowed Ben Bernanke's depreciating greenbacks at basement rates. Hot-money flows accelerated into China. If the assumption of a weak dollar has to be rethought (in December, the dollar had its first monthly gain in a year), so too will the risk of investing in China and other emerging markets.

This all means investors, as well as China's leaders, will have to keep a close eye on what the Man of the Year is doing in 2010.