Popping the China question

by Andy Xie

Financial markets are worried about a hard landing in China. Should they be?

China's government has tightened credit policy and restricted land supply to cool investment--this is the right policy. Speculative capital poured into China for two years as the Fed cut interest rates to 1%. Ample liquidity triggered an investment boom that exacerbated inflation. The resulting negative real interest rate amplified investment demand and caused a speculative bubble. China may have invested US$200 billion more than it should; fixed investment may be 20% above trend. This must be brought below trend for a period to absorb the excess.

It is still too early to say whether China will have a soft or hard landing. The measured pace at which the Fed is raising interest rates increases the chances of a soft landing, while the uncontrollable nature of unwinding a speculative property bubble makes a hard landing more likely. In either scenario, the global impact on commodity prices and equipment demand is roughly similar.

Longer term, whether the landing is hard or soft does not make a significant difference. In a soft landing, the economy decelerates to trend after a period of above-trend growth. In a hard landing, the economy decelerates below trend for a period. A hard landing can actually be a good thing, as excess capacity is flushed out quickly, leading to faster recovery in demand and profit. A soft landing brings less pain short term but may retain excess capacity, causing demand to recover slowly and profit margins to stay low for longer.

A slowdown in China affects commodity and equipment industries most. Commodity prices have risen sharply in the past two years on surging domestic demand, and the global equipment sector is booming. Imports to China have doubled since 2001, mainly on demand for commodities and equipment, so economies specializing in these would be most affected as Chinese demand cools.

Global consumers would benefit from a China slowdown. Negative real interest rates helped Chinese businesses pay for commodities, causing prices to rise. Higher prices trimmed consumer purchasing power around the world. As China's economy softens and commodity prices revert to trend, consumer purchasing power everywhere should improve.

A government-controlled financial system amplifies Chinas business cycle. The financial sector does not price risk properly, causing the economy to overshoot in both directions. As the financial system is reformed and becomes more market-based, China's economy will become less volatile.

Cycles matter. From a low base, the industrialization of China has had a long history of rapid growth. However, economic cycles will always come and go, and businesses must plan accordingly. The right strategy is to accumulate cash at cycle peaks and invest at cycle bottoms. China will become a rich country. You can enjoy its wealth, too, if you are still in business.

This is an edited summary from recent reports by Andy Xie, including "Hard or Soft Landing?" dated August 10, 2004, "Global Landing Scenarios" dated June 10, 2004, and "Interest Rate Must Go Up" dated June 28, 2004. For copies of the full articles, including important information and disclosures regarding Morgan Stanley, please see www.morganstanley.com/ourviews or contact 800-962-1343. This article does not provide individually tailored investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. It was based on public information, and Morgan Stanley makes no representation that it is accurate or complete. Estimates of future performance are based on assumptions that may not be realized. Investments and services offered through Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., members SIPC. Morgan Stanley and One Client At A Time are service marks of Morgan Stanley. [c] 2004 Morgan Stanley.