No hard landing on China's horizon
Official numbers from China's National Bureau of Statistics have placed the Purchasing Managers' Index somewhere between 50.1 and 50.2 over the past three months, indicating a stable manufacturing sector. But, as sentiment about China's economy has worsened, many have dismissed the official statistics.
Rather, people have relied on the HSBC PMI, which paints a different picture. The readings show that China's manufacturing sector has been in contraction for three consecutive months, despite various policy supports.
This debate is not new. But more importantly, a PMI, as an aggregated single number, tells us little about the true state of the economy in such a vast country, or which industries and regions most need help.
Since the second quarter of 2014, the CKGSB Center on Finance and Growth has led a quarterly, large-sample survey of about 2,000 Chinese companies in the industrial sector, which accounts for about half of the nation's GDP. The initial survey sample was based on a stratified random sampling by industry, region and size -- gleaned from the NBS list of 488,000 industrial enterprises that have sales of more than 5 million yuan ($805,000). The survey design ensures that our sample fully represents industry, region (province) and company sizes.
To provide an overall picture of the Chinese industrial economy, we constructed a Business Sentiment Index. This is a simple average of three diffusion indexes, including current operating conditions, expected change in operating conditions and investment timing.
Compared with PMI readings, our BSI has at least two advantages. First, it not only contains information on current operating conditions but also includes measures that reflect the absolute level of economic activity. It should be noted that PMIs are only relative measures -- that is, based on questions relative to the previous period. As a result, even if the overall economy is very good, as long as there is a slight decrease from the last period, one can obtain a very low PMI. This can happen in reverse, too, when the economy is bad.
Second, our BSI contains forward-looking information, whereas a PMI only indicates current conditions.
Easing isn't the answer
Our most recent data shows that, after a difficult year in 2014, the industrial economy stabilized in the first quarter. Our BSI stood at 50, right at the turning point. Companies' operating conditions improved, while investment remained sluggish, with only 2% of businesses making expansionary outlays.
Most importantly, we see three reasons why China's industrial economy is unlikely to have a hard landing.
First, operating conditions have been improving over the past four quarters. The diffusion index increased from 55 in the second quarter of last year to 61 in the first quarter of this year.
Second, the largest challenge facing the economy -- overcapacity -- has stabilized since the fourth term of last year.
Finally, financing is not a bottleneck for industrial growth.
On the other hand, the Chinese economy still faces some structural and fundamental challenges, making a quick recovery unlikely.
Weak demand is a major issue. In the first quarter of 2015, 39% of companies reported that supply exceeded domestic demand for their products. Businesses are also faring worse domestically than abroad: the first-quarter diffusion index reflecting weak demand was 69 in domestic markets versus 59 for international markets. This shows there is still a long way to go to increase domestic demand.
It is clear that companies with severe excess capacity have been forced to make significant adjustments, either to reduce production or to close down. The remaining surplus, however, has been absorbed at a slower rate. In the coming years, the biggest task for the industrial economy will be absorbing this excess.
Insufficient demand has not caused inventory problems, both because companies have responded by reducing output and because of the "order-based" production model adopted by many Chinese manufacturers. As many as 43% of companies said they did not have significant levels of inventory because they produce only after taking orders, while only 3% of the whole sample said they carried inventory for more than six months.
Cost rises, especially increased labor costs, are the second-biggest challenge facing the industrial economy. After stabilizing in the fourth quarter of 2014, rising unit costs increased significantly in the first quarter of this year -- up to 27%, from 12% in the previous term. The diffusion index reflecting cost increases was 62 in the first quarter of 2015.
Price levels in the past four quarters stayed largely flat, meaning that cost increases would translate into tighter profit margins. Those cost increases are particularly prominent in companies with good investment opportunities and increased employment. Therefore, as the economy recovers, this is an area that must be closely watched.
Consistent with sluggish investment, a small and declining proportion of companies took out new loans in 2014 -- from 24% in the second quarter to 4% in the fourth quarter -- before rising slightly to 7% in the first quarter of this year. Among those without new loans, the vast majority said that they did not need capital. Those with new loans reported that the banks' lending attitude was generally accommodating, with only 8% reporting a "difficult" lending attitude.
But the fact that financing is attainable must be viewed against the backdrop of an industrial economy in slight contraction. As weak demand is the key problem, injecting liquidity through loosening monetary policy cannot spur a revival. Although financing is not a main constraining factor, financial reform is still important. If the financial system cannot allocate resources in an efficient manner, then financing would likely become a bottleneck when the economy recovers.
The government should formulate long-term policies along two dimensions. The first is to strengthen the policy of increasing domestic demand, which involves raising income and reducing household savings through public services. The other approach to dealing with weak demand and increased costs involves industry upgrades and technological innovation.
Easing monetary policy would not boost the industrial economy, but would only sustain excess capacity and thus hurt the industrial sector in the long run.
Gan Jie is professor of finance at Cheung Kong Graduate School of Business in Beijing.