THE NEWS OUT of China in the past few weeks has not been encouraging. The economy is losing momentum, financial stresses are more evident, real estate prices are softening and there have been reports of occasional unrest. Yet, there is a fairly strong consensus view that China will somehow ride through all the difficulties because the government has the resources and the will to act decisively to keep the country on a solid track.

 

China’s long track record in managing its challenges certainly provides good reasons to support this view. But it might be a tad too complacent given recent trends: The economic deceleration that is clearly underway could crystallise structural weaknesses in the country and precipitate a sharper economic and financial shakeout than most investors anticipate.

 

Economic activity clearly decelerating, future looks uncertain 

The most striking evidence of a worse-thanexpected slowdown came in the form of the purchasing manager indices for both manufacturing and services activities: Both sets of indices point to a possible contraction in overall activity between October and November. Interestingly, the data suggests the slowdown was evident in both the export-oriented as well as domestically oriented segments of the economy, showing that the problems in the economy are not only because of global headwinds.

 

What is also telling is that forward-looking indicators are also signalling further weakening in the next six to 12 months. The Organisation for Economic Co-operation and Development indicator for China has been suggesting a moderation of activity for some months. Now, China’s own official lead indicator is also saying the same thing. Moreover, the components of purchasing manager indices that look to the future, such as new orders in both manufacturing and services, registered their first contraction in almost three years, implying that the drag on economic activity may well persist. Global problems are taking their toll: Export orders received at the 110th Canton Fair grew only 8.8%, lower than 14.3% in 2010.

 

Many observers have long warned about a number of structural weaknesses in China — speculative excesses leading to an overheated real estate sector and over-investment, excessive reliance of the private sector on unregulated lending by illegal loan syndicates and overly easy monetary conditions creating inflationary risks. There are incipient signs that some of these weaknesses are becoming a serious challenge for policymakers.

 

First, the real estate sector has clearly peaked and could decline:

This is worrying because the real estate sector has tremendous multiplier effects through the economy — more than 25% of fixed-asset investment is related to real estate. Real-estaterelated demand accounts for about 40% of steel purchases in China.

 

Second, many parts of the informal lending sector are in distress. In October, there were reports of sharply higher interest rates in that sector and expanding defaults. There have been fewer reports in recent weeks as the authorities acted quickly to ease credit in the worst-affected districts. However, as demand slows in the economy, there is increasing evidence that the cash flows of small to medium-size enterprises (SMEs) are falling. Surveys show that so far this year, the average profit margin of SMEs in the Pearl River Delta fell by up to 40% over last year. And this can only get worse.

 

 

Since SMEs are major borrowers in this informal lending market, it is only a matter of time before more problems confront this sector. Moreover, 80% of Chinese construction firms were reported to be facing delayed payments from developers: As the real estate sector weakens further, these developers or construction companies could also see more defaults.

 

There is also some evidence to suggest that speculators have borrowed money from illegal lending syndicates to stake large positions in real estate and commodities such as copper. Copper prices have fallen and will ease further as the real estate sector’s demand for copper falls. The chances are high that financial stresses will widen as the weakening economy exposes more of these imprudent speculative bets.

 

This is why the International Monetary Fund warned policymakers that “a steady build-up in vulnerabilities” in the financial sector could undermine economic prospects. The IMF highlighted the cumulative effect of speculatively driven property prices, excessive bank lending and mounting local government debt.

 

Third, local government finances are under increasing pressure. As they rely on land sales to finance their debt repayments, the weakening real estate sector hits them hard. Last month, the Guangzhou city government had to scale back its land auction four times.

 

Recent months have seen more reports of social unrest. Villagers in many parts of southern China have mounted protests against abusive local governments. Of course, a large and dynamic country such as China is bound to experience some social dislocations and it is certainly true that “incidents of mass unrest” have been reported for many years without political stability being compromised. But what is new is the larger scale and persistence of recent incidents. For example, in the Wukan area of Guangdong, protests have been going on since September. In addition, there has also been a flurry of worker strikes in some exportoriented regions. Away from the mainstream of China, a rash of self-immolations by Tibetans has rattled the authorities.

 

So, the challenges for the political leadership are certainly multiplying. The good news is that the authorities are aware of these potential threats to stability and are acting decisively:

However, policy actions are more constrained now than in 2008. Monetary policy has to be cautious — the 2008 stimulus plan unleashed such a huge wave of credit that a substantial monetary overhang remains, keeping inflation risks high: Even though inflation has eased a little, it remains too high for comfort. Moreover, while the government does not want the real estate sector to weaken drastically, political leaders still want property prices to fall to assuage demands from the urban middle class for more affordable property. So, they have signalled that they will keep their restrictive policies on real estate for now, only easing selectively and modestly.

 

Putting all this together, some things are quite clear. First, the economy will decelerate significantly early next year. Even if policy were to be eased today, the effects would take at least six months to be felt.

 

Second, some of the structural challenges could worsen before they come under control — real estate prices will almost certainly fall in 2012 and trigger other problems such as a pullback in investment in the sector and defaults by speculators.

 

So, China could see one or two quarters of the economy slowing sharply and financial stresses causing investors some shocks. As policymakers come to grips with the challenges, though, things should improve so that it avoids a full-blown crisis.