China must get rid of investment addiction

China must get rid of investment addiction

Good morning and welcome to today’s foreign exchange market commentary on Tuesday, the 26th of February.

A World Bank report shows investment contributes 6-8 percentage points of the average 9.8 percent annual economic growth that China achieved in the 30 years since Deng Xiaoping initiated economic reforms. Improved productivity, on the other hand, only contributed 2-4 percent, making the growth model unsustainable. Faced with slowing external demand, rising labour cost, weak domestic consumption and falling productivity, China’s reliance on investment is on the rise.

Between 1995 and 2010, when the communist state achieved an average GDP growth rate of 9.9 percent, investment in fixed-assets grew by a factor of 11.2. On an average, the ratio of fixed-asset investment amounted to 41.6 percent of GDP, hitting a high of 67 percent in 2009, unthinkable in some developed countries.

Also a declining efficiency of investment capital, as reflected in China’s high incremental capital-output ratio, has boosted demand for capital. Since early 1990, China’s ICOR has more than doubled, demonstrating the substantial more investment required to generate an additional unit of output.

But deepening of capital also stimulates overproduction. When domestic demand is lower than production, dependence on external trade increases. But if external demand falls, inventories pile up, prices decline and profits are squeezed. While credit expansion can compensate some of the problems, productivity leveraged by credit surely leads to huge financial risks.

Thus a vicious cycle of high investment, credit and debt perpetuates an ever increasing cycle of overproduction. Chinese banks were advised to expand credit in the wake of the global financial crisis and large-scale infrastructure projects were encouraged to stave off the slowdown. Subsequently China’s credit/GDP ratio rose by 40 percent between 2008 and 2011. Bank lending has become the main source of capital in China, a risky proposition given the inadequacy and low quality of bank capital.

Consequently, China’s banking system is becoming increasingly fragile due to high level of leverage. Massive debts in local financing platforms, combined with off-record shadow banking system, may soon cause a banking meltdown. Hence, China needs a new growth model to propel into the next level of economic development. Over-reliance on investments will not allow the country to achieve sustainable growth. It may rather cause serious harm to long-term prospects.

CURRENCY RATES OVERVIEW

GBP/EURO – 1.1628
GBP/US$ – 1.5168
GBP/CHF – 1.4140
GBP/CAN$ – 1.5562
GBP/AUS$ – 1.4796
GBP/ZAR – 13.4216
GBP/JPY – 139.32
GBP/HKD – 11.7645
GBP/NZD – 1.8268
GBP/SEK – 9.8420

EUR: The euro had a mixed day yesterday rallying against the US dollar and hitting a 16-month high against the pound in early trade before witnessing a sharp sell-off in the afternoon. There was confidence early on that centre-left leader Pier Bersani will win an majority, but confidence waned after figures showed Berlusconi may have won enough seats to win Bersani an outright majority, triggering an euro selloff across the board on speculations of another round of elections. The EUR/USD pair slumped to a six-week low of 1.3047 as investors turned to safer assets while the shared-currency fell to a low of 118.77 against the Japanese yen before recovering at 120.03. European policymakers tried to boost confidence later with the European Union Economic and Monetary Affairs Commissioner saying the reforms are starting to show results as deficits have declined and Europe will gradually return to growth. However, CESifo, an economic research group in Europe warned further austerity may dampen economic activity in most member states as domestic demand looks set to shrink further in 2013 due to high unemployment. The EUR/USD opens at 1.3085 this morning in London while the GBP/USD pair is trading around 1.1581.

USD: The US dollar fared well against most of its trading partners yesterday as risk sentiments diminished following developments in Europe. Sterling dropped below 1.5100 following Moody’s downgrade on Friday, but has recovered this morning to trade at 1.5217 as investors take a closer look at what the UK downgrade means for the UK economy. The ICE dollar index, which measures the US currency against a basket of six currencies, climbed to 81.766 from 81.454 on Friday. The Japanese yen made a surprise rally against the US dollar, trading at 91.84 compared to 93.43 on Friday as demand for US dollar by Japanese firms soared. We have the US consumer confidence and new home sales data due today while Federal Reserve chairman Ben Bernanke testifies before the Senate in the afternoon.

Have a great day!

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