Morgan Stanley’s chief economist Stephen Roach lays out quite well what is wrong with the Chinese economy and, moreover, why it is difficult to judge when a downturn will take place. To simplify, the state may seek to use market-boosting measures to prevent a significant slump. As Roach notes, this will not just forestall the downturn, it will create a more precarious situation for China and the world when an inevitable downturn happens.:

The die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle.

About six weeks ago, I threw in the towel on the ever-elusive China slowdown call (see my 21 October dispatch, “Wrong on the China Slowdown”). In doing so, however, I cautioned that we simply may have been too early in looking for a downshift in Chinese economic activity. Based on intelligence gathered during a recent visit to Beijing, I am increasingly convinced that is, indeed, the case. In my view, the die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle, driven by an important and surprising contraction in bank lending.

China’s booming investment cycle is on an unsustainable path. For 2005, we estimate that fixed asset investment is likely to exceed 46% of Chinese GDP — astonishing by historical standards for China or any other economy. Given China’s special investment needs as a large developing country — namely, urbanization, industrialization, and infrastructure — there is every reason to look for an investment-led growth dynamic. But the Chinese investment cycle has gone well beyond what those fundamentals might suggest. Even in the heydays of their own development booms, the investment shares of the Japanese and Korean economies never got much above the low-40% range. I very much agree with Andy Xie who recently argued that China is now at a point where its ever-rising investment share is a recipe for excess capacity and deflation (see Andy’s 22 November dispatch, “China: Toward a Deflationary Landing”).

The consensus view in the markets is that China will sustain its investment boom through the 2008 Beijing Olympics — that it will simply not accept the potential embarrassment of a growth slowdown until after that momentous event is over. Old China hands also note that the Chinese economy never slows immediately after the unveiling of a new development plan. With the 11th five-year plan covering the 2006-10 interval, this historical tendency also suggests any slowdown could be deferred until after 2007. Consider the implications of that possibility: If China stays the course of its investment-led boom, then the fixed asset investment share of its GDP could well be in the 55-60% range by 2008 — a recipe for a monstrous overhang of excess capacity. With Chinese inflation already quite low — the CPI increased at only a 1.2% y-o-y rate in October 2005 — China is not that far away from outright deflation. Should its capacity overhang continue to build through 2008, a deflationary endgame in China would be more likely than not, in my view.

If you read the whole thing, you will note that Roach is optimistic that financial sector reforms will mitigate the Chinese tendency or ability to continue to use its state-owned banks (SOBs) for pump-priming. He also notes that cynics doubt that governments will permit the SOBs to act according to shareholder interests when loan and investment growth stalls. AsiaPundit is generally among the cynics, and his cynicism is amplified as ‘the state’ is a far more complex beast than Roach mentions in his note.

The PBoC would no doubt be keen to see the end of policy loans, but NDRC economists have already been hinting that pump-priming may be needed. Further down the chain, it must also be considered how much control the central state has over regional banks, and how much control the big state lenders have over their branches (for that matter, AP is also concerned about the head offices).

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