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October 11, 2011

Xerion forecasts China Muddling through

Business week - China’s model is unbalanced and its economy has misallocated capital, but its policy makers are using the country’s plentiful reserves and policy tools to keep inflation under control and growth on a sustainable path.

China has recently been raising interest rates and restricting credit to slow things down. Credit growth has stabilized at 17 percent from a year earlier, down from 32 percent in post-crisis 2009. It’s ironic that the China bears who worried about inflation a few months ago now characterize the government’s calculated moderation as an “unwinding bubble.” Managing growth without arresting it is the very definition of a “soft landing.”

The yuan is up more than 6 percent against the U.S. dollar this year, and officials are targeting full convertibility by 2015. Nominal wages are rising 17 percent annually, and consumption has increased 12 percent.




Chinese consumers are in better shape than those in the U.S., with a household debt-to-income ratio of 18 percent, compared with 95 percent in the U.S. Bank of America points out that Chinese households have $5.1 trillion in savings, more than the GDPs of India, Brazil and Russia combined. The Chinese middle class is almost as large as the entire U.S. population and will be twice as large (as will its share of global GDP relative to the U.S.) in 10 years.

Analyst Aaron Fischer of CLSA projects that China’s share of the global luxury market will rise from 14 percent in 2010 to 44 percent by 2020. The next step is for China to broaden the base of consumption as household incomes rise across the middle class.

Xerion estimates that up to 25 percent of Chinese bank loans may be bad, implying potential losses as high as $1 trillion. That’s a huge bailout number, but not beyond China’s capacity.

Fortunately, the financial system is highly liquid thanks to the high rate of savings, which equal 80 percent of bank capital. Lacking investment alternatives, China’s depositors are victims of financial repression, receiving only 2 percent interest on bank deposits while suffering an inflation rate of more than 6 percent. China’s ratio of loans to deposits is about 68 percent, according to Paul Schulte of the China Construction Bank International, much lower than in most developed economies, which average 100 percent.

As long as bank deposits stay high and inflation stays low enough to permit the continued flow of credit, problem loans can be refinanced as they mature. In a worst case scenario, China could deploy some of its $3.2 trillion in foreign reserves to recapitalize its banks. China’s foreign credit status creates a stark contrast with the weak balance sheets of many nations in the West.

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