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China Continues to Tighten, But See No Risk of the Economy Contracting

China has been on a tightening cycle since the beginning of 2010. Nevertheless, economic growth has continued to be too strong, causing inflation to take hold. While still-high commodity prices are a factor, prices across the board have begun to rise because the country is firing on all cylinders, with unemployment low and wages rising.

We believe more tightening measures will be needed in China, and inflation will fluctuate over the next three to six months. There are signs that growth will slow, including a slower rate of money supply, slump in property sales, declines in commodity imports, moderation in purchasing manager indexes, and reduction of global growth estimates.

The topic of China's growth tends to evoke strong emotions by both bulls and bears and we expect a growth slowdown is likely to lead to a louder chorus from bears in coming months, with particular focus on the property market and debt.

As for the property market, while we agree that there are "bubbly" aspects, we don’t believe a decline in prices will lead to a crash in the economy. However, we believe a short-term decline in home sales and prices could occur due to the aggressive measures enacted by the government.

With nearly 50% of China’s economic growth over the past two years related to construction and China's significant contribution to global growth, a slowdown in construction could have a large impact on China's economy, as well as global growth and commodity prices. However, we believe the slowdown in construction could be short-lived due to the government’s push for affordable housing, which seeks to build 10 million new homes in 2011, and 36 million by 2015. Additionally, longer-term secular demand for housing remains strong and the nation still needs more infrastructure.

With regard to the combined $2.6 trillion in loans extended in 2009 and 2010, there will likely be write-downs due to uneconomic projects. However, in an April 2011 study by ISI Research, assuming a 51% of local government loans and 35% of developer loans go bad, China's non-performing loan ratio (NPL) will rise from 2010's very low 1.1% level to 10%, representing roughly 5 billion yuan, or $769 million.

In a worse case scenario, if banks need government assistance, the size of the problem would likely be manageable. China’s government is in a much better position to aid the largely state-owned banking sector relative to other nations. ISI Research in 2010 estimated China had a low 40% of debt-to-GDP when including local government bonds, and the government recently reported over $3 trillion in foreign exchange reserves.

Chinese stocks struggle with inflation rise

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Source: FactSet, Shanghai Stock Exchange, Nat'l Bureau of Statistics of China. As of May 10, 2011

The Shanghai Composite has moved sideways since the fall of 2010, underperforming global indexes. The reason is due to concerns that monetary tightening may need to be more aggressive to fight inflation, and that policymakers may go too far and create too much of an economic slowdown, or a "hard landing." Thus far, the government is being cautious and measured in its approach due to the fear of repeating past mistakes and the possibility of social unrest.

We believe a "hard landing" will not occur, but expect Chinese stocks to remain volatile until there is more clarity about inflation and growth.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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