Think again (China no longer just assembles imported components)

• Chinese banks are filled with NPLs.  
• China runs a surplus with the US but a deficit with the rest of the world, so its trade is in rough balance.
• China just assembles imported components with little value-added.

New realities:

Chinese banks are stuffed with sterilization bills.   The asset management companies are now stuffed with the bad loans formerly held by 3 of the 4 big state banks (ABC is still a mess).   Most of the loans extended in the recent boom are performing – with nominal GDP growing so much faster than bank’s lending rate, it is hard not to come up with the funds to pay the banks interest.   That – plus a juicy lending to deposit spread -- is the underlying reason why the former state commercial banks are now worth quite a lot, even if they may not be worth quite as much as the markets now think they are worth. The risk facing the banks is that a large share of the current crop of loans will go bad … 

China runs a big surplus with the world, not just the US.  The World Bank estimates that China’s 2006 current account surplus will reach $230b, or 8.7% of China’s GDP.   Net exports – incidentally – contributed an estimated 3.3% to China’s GDP growth in the second half of 2006, up from 2% in the first half of 06.   So much for rebalancing.  Export growth accelerated even more in the first couple of months of 2007.  Citi now expects China to run a $30b monthly trade surplus in the second half of the year.

And China is rapidly developing the capacity to manufacture high-value added components, not just to do the final assembly.  You don’t need to trust me on this.    JP Morgan and the World Bank have reached a similar conclusion.

Grace Ng and Qian Wang of JP Morgan note: 

Following its 2001 WTO accession, China has steadily evolved from a simple assembly and finishing hub.  In the past, China used to import a high portion of the capital equipment and intermediate goods needed by its manufacturing sector.   But the surge in FDI into China early this decade – with WTO entry as an important catalyst – from tech-heavy North Asian economies, including Japan, Korea and Taiwan, has been important in lifting China up the valued-added chain.   Domestic manufacturers are now able to produce machinery, equipment and intermediate goods onshore.   At the same time, as foreign manufacturers have become more entrenched in China, they have begun to source equipment (as well as funding) domestically. 

Ng and Wang provide details from the auto sector and the capital goods sector.   But the basic trend is also apparent in the broad data. 

Despite the rise in commodity prices and despite the perception that China’s exports have a rather high import content, import growth has lagged export growth by a significant margin … while merchandise exports as a share of GDP have been rising steadily, imports as a share of GDP have been rather stable since late 2004.   In part, slower import growth reflects Chinese manufacturers rising ability to produce onshore higher value-added capital goods and intermediate products, categories for which they have relied heavily on imports in the past. 

(Source: JP Morgan, Global Data Watch, February 2, 2007)

The same story emerges from the World  Bank’s most recent report on East Asia.    The graphics are well-done, and tell the story well.   Look, for example, at Exhibit 2 (p. 9).  It highlights the strong recent acceleration in Chinese export growth.  

The World Bank also highlights that some of the synergies between China's growth and the rest of the region seem to be breaking down – likely because a Chinese supply chain (think of Intel’s planned investment) is replacing the regional supply chain.   The pick-up in China’s export growth hasn’t been matched by a pick-up in export growth in other Asian economies.    

The contrast between accelerating export growth in china and decelerating export growth in the rest of the region suggests that competition for international market share among Asian economies may also be intensifying.   For example China’s exports to the sluggish US market were still growing at 25-30% in year over year dollar terms in the later part of 2006 and in early 2007, a time when Korea, Taiwan (China) and Malaysia’s exports to this market slowed to around 5%.  …

China’s own import growth has been slowing over the course of 2006, which partly reflects some slowing in the face of investment spending, but also as China deepens its domestic supply chain for domestic goods.”

The World Bank report is full of other useful information – and, remarkably for a publication from the IFIs, actually reflects the most recent data.   The coverage of China, for example, includes the January and February trade data.    I am impressed.

The World Bank also hints – I suspect correctly – that the ongoing slump in investment in some Asian countries is probably linked to the surge in investment in China and China’s progression up the value-added chain, which has created uncertainty about the competitive advantage of other Asian economies.   The argument that low levels of investment reflect a hangover from the 97-98 crisis no longer works as well, as the balance sheets of non-Chinese banks have been cleaned.   The ADB told a somewhat different story, but I think that they looked only at FDI  (rising direct investment in China doesn’t seem to have reduced investment elsewhere) not overall levels of investment.   Exhibits 35 and 36 (p. 37) show the contrast between the surge in investment in China, and the prolonged slump in investment in six other regional economies. 

Exhibit 6 – which shows the surge in China’s trade surplus (I don’t see any sign of a slowdown yet); Exhibit 12 – which shows East Asian reserve growth and Exhibit 22, which shows the contrast between the 10% real depreciation in China since 2002; the 10% plus real appreciation in Thailand and the 30% real appreciation in Korea are all worth looking at as well.

On one question, everyone (China, the US Treasury, the ADB, the World Bank, the IMF) now seems to agree.   The World Bank – citing work by Jeanne and Rancierre of the IMF (talk about coordination) – estimates that “deepened financial integration” pushed optimal reserve levels up to around 25% of GDP.  But with reserves equal to 45% of GDP, East Asia is clearly over-reserved.    Alas there is no agreement on how to keep Asian reserves from continuing to soar, let alone on how to bring Asian reserve levels down …