(10/26/11) Is China Headed for a Hard Landing?

Nothing makes for better TV or copy than controversy, and one of the biggest debates now is whether China’s economy lands hard or soft or somewhere in between, say John Bishop of InvestingDaily.

China’s third-quarter economic growth slowed to its weakest pace in two years, suggesting that the government’s policy measures to cool growth have taken effect.

The Chinese economy grew by 9.1% year over year in the third quarter, compared to 9.5% in the second quarter and 9.7% in the first quarter, the National Bureau of Statistics said on October 18. The slower-than-expected economic growth rattled markets; the Shanghai Composite Index lost 2.3% for its biggest loss in almost a month.

Investors this year have contended with a host of concerns over China’s economic health—runaway lending in the banking sector for dubious local government infrastructure projects, government policies aimed at slowing economic growth, rising inflation and a brewing sovereign debt crisis in Europe that could strike China’s mighty export sector. Investors fear that this confluence of risks could add up to a precipitous slowdown, or “hard landing” for China’s economy.

Some believe that China’s hard landing has already begun. Hedge-fund manager, short seller, and famous China bear James Chanos told MarketWatch last week that real estate sales in China declined by 40% to 60% year-over-year in September and October—despite the fact that these are usually peak months for sales. Chanos has long claimed that China’s bust will be 1,000 times worse than Dubai’s financial meltdown.

Soft Landing for China is More Likely
Yiannis Mostrous, editor of the Global Investment Strategist, believes that fears of a hard landing for China are vastly overdone. He continues to forecast 8.5% to 9% growth for China’s gross domestic product (GDP) in 2011.

A number of analysts, commenting on the recent economic data to The Wall Street Journal’s China Real Time blog, broadly agreed that China will achieve an engineered soft landing for its economy.

Chinese Inflation Remains a Problem
It remains unclear, however, whether the government will loosen its monetary policy in response to the latest numbers.

Although inflation moderated to 6.1% in September, Chinese policymakers continue to grapple with rising prices for food, which increased 13.4% year over year in the same month. Notably, the price of pork—a staple meat in China—rose 43.5% year over year.

Citizens in emerging markets devote a high proportion of their salaries to food, which makes food price inflation a potent threat to social stability—a fact never far from the minds of China’s leadership. For example, the 1989 pro-democracy protests in Tiananmen Square occurred at a time of heightened inflation.

It’s likely a safe bet that Chinese officials will keep the reins on monetary policy until they see a more meaningful decrease in inflation.

NEXT: Watch Chinese Consumer Spending

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Watch Chinese Consumer Spending
Zhiwei Zhang, an analyst with Nomura, noted that the latest economic data indicate that China’s economic “growth is increasingly driven by domestic demand.”

Boosting domestic consumption in China has long been a goal of China’s policymakers, a need made all the more pressing by economic hardship in the EU and US. China’s exports in September rose by 17.1% year over year, compared to 24.5% growth the previous month.

An official with China’s customs administration recently said that trade conditions were deteriorating, and that an appreciating currency was hurting export growth.

The good news: China’s retail sales grew by 17.7% in September. These figures don’t account for strong retail sales growth during October’s “Golden Week” holiday, when retail sales surged by 17.5% to RMB696.2 billion ($109 billion).

The bad news: China isn’t moving to a domestic-demand driven economy any time soon. As Chanos told MarketWatch, “Chinese consumers are not the next big hope.”

Since the dismantling of the “iron rice bowl”—the social safety net provided by the Communist government that is one of the purported benefits of China’s command economy—Chinese citizens have become famously frugal.

They save for a number of reasons: expected medical treatments, old age, a child’s education. It’s also become expected that parents will purchase an apartment for their sons at the time of marriage. Not only is there an ingrained culture of saving in China, the country’s economic model transfers wealth from households to state-run banks and state-owned enterprises.

Michael Pettis on China
It’s a point that’s long been made by Michael Pettis, a professor at Peking University, a senior associate at the Carnegie in Asia program, and a patron of Beijing’s indie rock scene.

In a recent op-ed in The Wall Street Journal, Pettis notes that a “small but rising number of Chinese economists” predict that China’s economy will grow by only 6% to 7% in the next years. However, he believes the figure could turn out to be only half that number.

China’s households only consume about 35% of GDP, and the government wants to boost that figure to 50% of GDP over the next ten years. However, Pettis says it would take a sea change in China’s economic growth model to achieve this goal:

Achieving this goal is problematic, since it requires that household consumption grow four percentage points faster than GDP. In the past decade, Chinese household consumption has grown by 7% to 8% annually, while GDP has grown at 10% to 11%. If one expects Chinese GDP to grow by 6% to 7 percent, Chinese household consumption would have to surge by 10% to 11%.

It’s an unlikely scenario because of a growth model that transfers income from households to the corporate sector via artificially low interest rates. The lower rates reduce borrowing costs for China’s state-owned enterprises, which are then funneled into mega-investments:

The easy financing also gooses banks’ profit margins and allows them to resolve bad loans with ease. This cheap borrowing comes at the expense of depositors. Low yields on deposits force them to sacrifice consumption, to save more. This results in a sharp decline in consumption’s share of GDP.

If China is to replace investment with consumption as the engine of growth, this process of financial repression has to be reversed. Households must get a rising share of overall growth.

Pettis’ conclusion is that any rebalancing of China’s economic growth model will “require that the economy stop growing as fast as it used to.”

Investment Bottom Line: Be Selective
Where does this leave investors? On the one hand, businesses have been waiting in vain for decades for every Chinese consumer to buy that apocryphal “one pair of shoes.”

But fortunes have been lost betting against China. An across-the-board bet on Chinese domestic growth or rising incomes in emerging markets won’t fly in today’s uncertain economy.

The key to successful investing, as always, will depend on selecting the securities that are in the strongest position to benefit from pockets of very strong growth in these markets.