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China's Economy Cools as Lending Slows

Inflationary Pressures, Housing Prices, and Tighter Credit Affect the Red Dragon

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According to research published by the World Bank in 2011, China weathered the global economic downturn of 2008 to 2010 quite well. The country showed continued economic expansion of about 9% in 2009 and turned in higher results of more than 10% expansion in 2010. Inflation, clocked at 5.5% in October 2011, continues to push food and commodity prices higher.

Business expansion and enormous liquidity offered by the China banks (almost all of which are owned by The People's Republic) drives the China economy. Real estate prices have soared over the past decade as workers move from the interior to the cities for better paying jobs. Earlier this year, The People's Bank of China responded to what is considered the potential bursting of the Chinese real estate bubble by simultaneously raising interest rates and loan reserve requirements.

China's Five Year Plan: Reduced Manufacturing and Exports

Government leaders predicted that tightening the lending environment would slow economic growth to about 9.5% for 2011 and 2012. During the months of July to September 2011, China's GDP actually fell to less than 7% on an annualized basis. China's annualized GDP rested at about 8% for the earlier quarters this year.

Earlier this year (March 2011), the Chinese government published a five-year plan (for the years of 2011 to 2015). The report, cited as the twelfth such release by the government, proposes to stabilize the country's annual growth at about 7% over the next five years. The Chinese government says that manufacturing and exports will decrease as personal consumption and a services economy develops.

Over the past two decades, the U.S. service economy represents a higher percentage of GDP. The service economy includes such industries as financial services, education, and health care. The recent U.S. recession was called a "man-cession" by the Federal Reserve: the country lost manufacturing jobs, previously held by a higher proportion of male workers. A loss of manufacturing jobs is generally considered a negative economic factor by economists.

China's Global Trading Partners

Assuming the government's expectations come to pass, China's trading partners will of course be affected. In addition, Japan's post-earthquake economy (one of the world's largest over the past several decades) is expected to reduce that country's growth to about 1% for 2011 and 2012. Economic growth at any level is driven by the country's reconstruction efforts.

Comparatively during the global downturn that started in 2008, European nations experienced lower economic growth through 2010. According to the World Bank, the average European nation grew approximately 1.8% in 2010 versus a negative 4.1% in 2009. Patterns of economic expansion are uneven throughout the region, although the World Bank predicts an average growth of about 2% of the 27 European Union nations in 2011 and 2012.

Lower economic growth by China's trading partners, combined with tightened credit by Chinese banks and a soft real estate market, could negatively affect China's vision of a high sustainable economic growth rate. High inflation affects the increasing cost of goods to Chinese consumers.

China's Factory Activity Decreases

With the predictions of China's five-year plan in mind, the country's factory output slowed in November 2011 for the first time in the past two years. The Chinese government quickly decided to ease credit by reducing the previously increased credit reserve levels required for lenders.

Slower Western economies in the U.S. and Canada, Europe's debt crisis (and markedly slowed economic growth predictions), India's rapid economic expansion (including inflationary pressures and tighter money policies by that country's central bank), and problems with African trading partners all have an impact on China's future.

India's meteoric economic expansion brings additional economic concerns to China, according to financial advisors in our network. The attempts of India's central bank to stabilize inflationary pressures by raising interest rates more than a dozen times since 2009 provides reasonable minds with questions about China's orderly and progressive five-year plan. (Note: the Indian government reported that inflation on food products was approximately 8% for the third week of November 2011.)

China's Real Estate Bubble

According to The Wall Street Journal, Chinese lenders poured approximately 9.59 trillion yuan into China real estate in 2009 alone. (At present exchange rates 1 yuan for 0.1572 dollars according to Bloomberg, the Chinese government has attempted to soften the yuan against other currencies as its exports slow in 2011.

The three-tiered China real estate market serves an expanding Chinese middle class (seeking to own an apartment or two upgrade a modest home); low-income workers (living in dedicated low-income complexes); and wealthy Chinese real estate investors.

Real estate "flippers" in China, as elsewhere, hope to buy cheap property and resell quickly at a profit. When investors use borrowed money to buy real estate investments and the demand for real estate softens, they must pay interest on the funds for a longer time period. The projected rate of return on the real estate investment may therefore decline until the investor sells the property.

Alan Chiang, Head of the Residential Group at DTZ, a major residential real estate advisory firm in China, reported lower prices in residential real estate in the second and third quarters of 2011. He predicts continued decreasing prices over the short-term due to new construction in China's cities.

Long-term appreciation in real estate depends on the amount of supply versus demand. A slowing economy and continued tightening of credit for real estate investments from China's banks could mean a longer-term decline in residential home prices.

Conclusions About China's 2012 Economy

There's no doubt that the European debt crisis affects trading partners, investors, and sovereign nations around the world. China's decision to tighten credit earlier in 2011 met with a rapid response by China's banks to ease reserve requirements as the end of the year approaches. This decision is a way to loosen credit constraints.

Compared to the AAA sovereign credits of Austria, Canada, Australia, Denmark, Finland, France, Germany, Hong Kong (Special Administrative Region), Luxembourg, Netherlands, Norway, Singapore, Sweden, Swiss Federation, and the United Kingdom, the People's Republic of China's S&P rating of AA- (and, similarly, Taiwan's AA- credit) reflects current uncertainty about the after-effects of rapid economic expansion, easy money, inflation, exports, and manufacturing.

The People's Republic of China's debt to Gross Domestic Product ratio was approximately 33.83% in 2010, according to the International Monetary Fund (IMF).

Because of the inter-connected state of the world's economies--and our close relationship with China as a trading partner--last week's decision to join in the effort to help European nations (and, thus the world) is expected of the United States.

Concerns about a depreciating currency, rising inflation, and higher commodities prices seem to reflect China's developing economic woes. Decreasing Chinese exports and lower factory production in that nation cause cries of anguish from some financial advisors: how is the U.S. consumer economy going to fare as the steady flow of relatively inexpensive goods declines?

Africa, according to African Economic Outlook: Africa and Its Emerging Partners (2011, The African Development Bank Group), sees an opportunity to export goods and services to the developed world, including China.

According to research presented by the Carnegie Endowment for International Peace by economist Albert Keidel several years ago, China will be the world's largest economy by 2035. By 2050, Keidel predicted that China's economy will grow to twice the size of the U.S. economy.

Financial advisors in our network say that Keidel's research is sprinkled with excessive optimism about China's growth potential. Serious concerns about overly rapid growth, China's real estate market, and reduced manufacturing and exports could delay the super-sized economy imagined a few years ago.

There's no present doubt, however, that when China sneezes, the world catches a chill.

Foreign investment capital, calculated as Foreign Direct Investment (FDI), to China was approximately USD 190 billion in 2010. Some financial advisors believe that the global financial crisis remains in process. During the throes of the last global downturn cycle, FDI to China decreased by 33%.

An analysis by S&P of capital markets in Greater China sheds some light about what financial advisors call the deepening of debt concerns there. Though the sovereign entities continue to hold AA- ratings, lower credits for China's industrial corporates are expected in 2012.

Keep reading to learn about the credit risks of borrowers in Hong Kong, Taiwan, and mainland China. An article planned for publication this week explores rapidly growing offshore renminbi debt market.

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