China's fiscal stimulus package has boosted growth, but excessive liquidity risks major side-effects, including asset price bubbles and a spike in non-performing loans, according to Brian Jackson, senior emerging markets strategist at investment bank RBC Capital Markets, which is part of the Royal Bank of Canada.
"Strong stimulus has supported growth and eased concerns about a protracted economic slowdown, but now other concerns are building," says Jackson. "The surge in bank lending has several potential side-effects that threaten the sustainability of China's recovery and that could force a sharp reversal in the policy stance. The accelerator is working well, but at some stage Beijing will need to apply the brake."
The risk, Jackson says, is that excessive liquidity in the economy may require the brake to be used sooner and more forcefully than policymakers and investors would prefer.
The potential side-effects of China's policy stimulus reflect the size and speed of the lending surge, Jackson notes. With so much financing made available so quickly, it is almost inevitable that there will not be enough shovel-ready investment opportunities available to absorb these funds. This implies that much of the new lending will be used for other purposes. And even among those investment projects that can be started quickly, it is very likely that many of them will prove to be ill-advised, eventually putting the borrower under severe stress.
Rising asset prices provide strong circumstantial evidence that a significant proportion of new bank lending is being used for speculative purposes, Jackson adds. Chinese equity markets, in particular, have recorded massive gains, with the main Shanghai index up almost 90% year-to-date. These gains have prompted renewed retail interest. Property markets in major cities have also rebounded in recent months. With growth still below trend and the outlook for corporate earnings still weak, these sharp moves in asset prices clearly raise concerns that a new bubble is forming.
China is among the most favoured markets of fund managers investing in Asia, largely because of the Rmb4 trillion ($586 billion) stimulus package announced in November, which is aimed at combating the most serious economic threat to the mainland since the Asian financial crisis in 1997. Before the stimulus package was announced, China was riddled with worries over the impact of the global financial crisis on both domestic consumption and exports.
The stimulus package, with a life span that extends until 2010, covers key areas including affordable housing, rural infrastructure, railways, power grids, post-earthquake rebuilding in Sichuan, and social welfare to raise incomes. It also includes reforming the value-added-tax system to encourage investment in new technologies.
With foreign reserves and a budget surplus amounting to around $2 trillion, investors are generally confident that China has the capacity to further stimulate the economy if needed. There are those, however, who believe that too much faith has been placed on China's growth prospects and, as it stands, the market could be over-crowded and valuations stretched.