SARS and China

Sars is primarily a human and a health problem, That notwithstanding natural born economists cannot help reaching out for the used envelopes in the bottom drawer, and trying to make out some rough numbers. Andy Xie reckons that the consequences in China could be mild but significant - 0.2% to 0.4% - but that the knock-on balance sheet impact could be more important. I'm not willing to risk my shirt on this, but my feeling is that unless things go down the worst case road (which isn't of course excluded - once the thing became endemic it would be all hell to erradicate) the impact could be less than even Andy is imagining. Firstly all that money that isn't spent on tourism will most probably simply be redirected into other sectors (the situation in Asia ex-China is another matter, as all the periphery countries lose their newly rich Chinese visitors: remember even if only 5% of the population are doing relatively well out of the growth spurt, that's still a hell of a lot of people). But secondly in terms of global business structure SARS is just one more reason to move away from face-to-face: bad news for the airlines, but good news for communication technology. As they say: some die, others are born. And if Roach and others (hmm, hmm) are right, and the negative feedback impact of slow growth in the US is accelerated growth in China, then this should give plenty of investment and extrenal demand stimulus. Plus, if Andy is right on the balance sheet front (but not too right) the main impact will be yet more internal deflation in China, more investment and more exports. So come on, I'm sticking my neck out, ex-worst-case-scenario-impact economic growth in China should maintain its momentum this year. Incidentally, one of the factors which is making SARS a health nightmare over there are the 150 million plus migrant workers occupied in the new economic zones, a terrible demographic for controlling epidemics, but a fantastic one for economic growth. Finally, not the final paragraph about crony-capitalism, and remember Japan.

In my view, the short-term economic pain will be acute. Cancellation of the weeklong May Day break could decrease this year’s GDP growth rate by 0.2-0.4%. The disruption to normal economic life could incur even more economic costs. On April 2, we reduced our forecast for China’s 2003 GDP growth rate to 6.5%. This is sufficient to cover the economic losses associated with SARS for one quarter of the year. There are three scenarios for how this crisis could unfold in the coming months. First, the virus loses its virulence going into the summer months, as do many other contagious respiratory diseases. Second, the virus remains as it is but the public campaign reduces the infection rate and brings the epidemic under control within two months. Third, the virus mutates and hits in several waves as did Spanish flu and Hong Kong flu. The first two scenarios are consistent with our current GDP growth forecast. Most of the economic impact would be concentrated in the second quarter and probably be equivalent to giving up one quarter of growth. Normalization should take place in July.The third scenario would imply a significantly lower growth rate than we are currently forecasting. It is virtually impossible to make such a forecast. The only relevant message is that it would imply much more downside than is currently in the market.


As China’s economy enters a period of rapid slowdown, it is impossible to predict the downside associated with its balance sheet risk. Large amounts of non-performing loans in state banks and the low profitability of state-owned enterprises are widely known risks embedded in China’s balance sheet. However, they may not represent the most important risk in this cycle.

An opaque private sector represents the gravest risk to China’s economy in the short term, in my view. A large number of private companies have flourished in the past few years by manipulating financial accounts to obtain bank loans. Some have even controlled local banks and used them as their own piggybanks. A large number of private companies have negative cash flow but present positive profits through accounting tricks. If the cycle turns down hard, they may face bankruptcies, which would magnify the economic cycle.This risk is especially pronounced in the property sector. Commercial building space under construction rose to 928 million square meters last year from 772 million sq. m. the year before. The industry didn’t have much equity to begin with and used mostly bank loans to fund its growth. Poor capitalization has been partly hidden by creative accounting. Further, purchases by Taiwan and Hong Kong residents are quite important to this sector’s health. The SARS crisis would reduce such demand. The balance sheet problem within this sector could be exposed in a downcycle. The sector contributed 23% of overall economic growth last year. If it experiences a hard landing, the impact on the economy would be large.

Further, the rise of China’s private sector, especially in the non-export sector, is modeled after Southeast Asian crony capitalism. Many, if not most, private companies that sell into domestic demand do not make returns above their cost of capital. They plug their cash flow problems with more loans. This has given them incentive to control local banks to ensure their cash source doesn’t dry up. This new risk represents an immediate challenge to China’s economic stability.
Source: Morgan Stanley Global Economic Forum
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