Guest contributor Derek Scissors has been advising corporate clients and policy makers on the Chinese economy for 15 years. He is currently a Research Fellow at the Heritage Foundation in Washington, D.C.
Everything you know about China's stimulus package is wrong.
OK, it's only most of what you know that's wrong -- but that's as far as I'm going. A few investors and writers (including some on Fool.com) assess the stimulus as likely to lead to a People's Republic of China (PRC) that is stronger than ever. Fool advisor Tim Hanson went so far as to say that it could "change the world."
Color me skeptical. I don't believe China's stimulus plan will change the world; whether it strengthens China depends on whether piling a bit more state spending -- on top of a mountain of state spending -- is a fine idea.
Never the twain shall meet
Tim states that China's stimulus will "fundamentally change the economic relationship between the United States and China" because it will enable the PRC to decouple its growth from us. But in my opinion, there's no good reason to believe this.
Beijing has created and powerfully defended, both in word and in deed, an external balance of payments system that keeps domestic and foreign currency entirely separate. At home, the Chinese government spends the old-fashioned way -- printing or borrowing through bond sales, all naturally conducted in yuan. Thus, it's not the case that any extra money China spends at home means less money invested in American bonds. (While it seems counterintuitive, one has almost nothing to do with the other.)
China simultaneously accumulates foreign currency, mostly dollars, from exporting more than it imports and receiving more capital than it ships out. That foreign currency cannot be spent within China and, due the huge amounts involved, ends up chiefly in U.S. Treasuries. In fact, Deputy Governor of the People's Bank Yi Gang was quoted in The Wall Street Journal as saying, "These reserves are unavoidably invested abroad."
This leads to the question of whether stimulus spending will fundamentally restructure the Chinese economy so that Beijing will see fit to alter its balance-of-payments regime. A floating exchange rate would cut into exports, reducing China's dependence on foreign demand. An open capital account would, among other things, make it unnecessary to store capital in foreign bonds.
The stimulus, however, will not serve to take the Chinese economy in a new direction but rather will reinforce its present structure.
Same old, same old
Two important aspects of China's new (since November), gargantuan stimulus package are:
1. It's actually old.
The 4 trillion yuan stimulus was announced over nine quarters, with well over half devoted to infrastructure of all types (including infrastructure rebuilding in earthquake-hit Sichuan).
China has been spending heavily on infrastructure for a decade, which in recent years has helped fuel the growth of U.S.-based multinationals Caterpillar (NYSE: CAT ) , Alcoa (NYSE: AA ) , and, to a lesser extent, General Electric (NYSE: GE ) . While there are different ways to look back and measure infrastructure spending, one metric shows Chinese infrastructure spending increasing more than 800% from 1998 to 2008.
Does a bit more spending on top of that constitute any meaningful change?
2. It's comparatively small.
Perhaps more telling, the 4 trillion yuan over nine quarters turns out to be an inconsiderable sum. In the fourth quarter of 2008 alone, China invested 5.6 trillion yuan. Investment has been increasing at a 24% or better annual rate for the past six years -- meaning it was set to reach 7 trillion yuan in the fourth quarter of this year in any case. The stimulus will add about 500 billion more that quarter, or another 7%.
The story of the Chinese economy will remain the same as it's been since late 2002: bank lending, investment, production, and export. The key to the stimulus plan is not the 4 trillion yuan but the bank loans behind it, and all the investment that was going to occur anyway. Lending, already quick at 15% growth in October 2008, has accelerated every month since, culminating in record loan volume and blistering 30% year-over-year loan growth by the end of March.
In the first quarter, new loans to firms were more than 10 times larger than new loans to households, financing more investment in greater production capacity. Investment is set to take a still-larger share of GDP, capping the importance of consumption.
In other words, the PRC is headed in the same direction as before, only a bit faster.
Helpful only for some
Will the stimulus strengthen Chinese competitiveness? Debating this partly depends on whether you think the PRC's model is sensible. Beijing indeed has money to spend; in particular it has yuan that can't leave the country for the same reason dollars can't be used at home.
In 2005, though, American banks were flush with liquidity. They poured it down the same housing drain they'd been pouring it down for years. Now Chinese banks are pouring it down a well-worn infrastructure drain. The starkly limited options available to depositors mean that Chinese banks aren't going to fail, but it certainly does not follow that lending will make China stronger.
Beijing is also rolling the dice on the United States. The government-directed splurge is not intended as a permanent solution but instead as a mechanism to buy time until foreign demand recovers and the good old days of 2003-2007 can return. But such a return can only occur if American consumers will again be extravagant and the U.S. Congress will remain restrained in its protectionist urges.
This is not an unreasonable gamble, but it is one with a potentially ugly downside. The safe option over the next 12 months is to stick to what are actually long-term plans to boost transport infrastructure, now highlighted by the stimulus program.
The Chinese cement and steel sectors are the logical targets, including General Steel Holdings (NYSE: GSI ) and Sutor Technology (Nasdaq: SUTR ) . Foreign companies tied to those sectors, such as Vale (NYSE: RIO ) , Lafarge, and Holcim, will also benefit.
But keep the focus narrow and the time horizon short -- the PRC is not transforming. It might not even be strengthening.