And Now for a Bit on China…
The situation in Europe is of such a magnitude that it has dominated our focus in recent months. However global investors must not lose sight of China. China’s stimulus in 2009 contributed to a global rebound that was hailed as significant for the global economy. If Europe’s growth slows as we expect, will China be there to pick up the pieces? What are the prospects for China’s growth over the next three to five years? How will the Chimerica relationship buttress or hinder world growth?
China’s economy is naturally experiencing the effects of soft growth globally. The government has also been acting to cool inflation and growth in the property market which we believe is now drawing to a close. This weekend China’s vice premier Wang Qishan spoke at a meeting of local government officials and financial executives in Hubei province where he made clear that he is extremely concerned that a global economic recession could last a long time. Chinese financial news outlet Caijing quoted him as saying, “As for our country, which relies highly on external demands, we must see the situation clearly and get our own business done.”
Evaluation of the Chinese economy seems to fall into two camps, hard landing or soft landing, but what if the answer is more stimulus and growth in the near term? Of course this has implications for future landings, ones that we will address, but we do not rule out further stimulus before this happens. Our thesis that China may begin a round of stimulus in the near term is based on a mix of government confidence and government fear. The government is likely to conclude it has been successful in reigning in inflation and a booming real estate market, giving it the confidence to start stimulating again. It is also watching its exports which have been growing at a slower rate throughout the year, rising by only 16% y/y in October compared with an average increase of 21% over the last decade, including 2009 when exports fell. Our renewed stimulus thesis is also based on the increasing access the general population now has to media via cell phone text messaging and China’s version of twitter, Sina Weibo. Even Christine Lagarde, Managing Director of the IMF has joined and her initial post last Monday was reposted 1,400 times. Premier Wang’s comments suggest that the government believes it simply cannot afford the type of reaction it would get if the economy experiences a substantial slowdown in employment.
Exhibit 1: China PMI (SA, 50+ = Expansion)
Manufacturing Employment (Red),
Sources: China Federation of Logistics & Purchasing, NBS/Haver Analytics
Yet a slowdown in employment is just what the data is suggesting. The reading for the employment component for manufacturing PMI fell below 51 to 49.7 in the October reading. Meanwhile, the new business component of the non- manufacturing PMI is on the way down, with its latest reading at 52.5. Couple this with an all time low in consumer satisfaction and the government has a reason to be concerned about public discontent. However, the challenge with any plans to stimulate is that they will largely be credit and fixed asset investment driven. Unfortunately, while this will assuredly stimulate growth in the near term, it does not set China up for a soft landing in the future but rather it builds on the excessive use of these levers to create greater imbalances in the economy.
The key argument for the China can’t crash camp has been due to the lack of perceived leverage. However, we believe this myth has been debunked, most recently by the government itself. This past summer the National Audit Office did a deep dive on local government debt and the banks which are the conduits for the lending and discovered RMB 10.7tn in liabilities. This essentially means that so-called off balance sheet loans were growing at nearly the same size of official RMB lending that was being recorded on balance sheet.
Exhibit 2: China Consumer Satisfaction (NSA, 1996=100)
Sources: China National Bureau of Statistics/Haver Analytics
Rapidly growing credit and high inflation caused the central bank to put on the breaks earlier this year and M2 money supply growth has slowed to a 13% y/y rate. Yet we caution that this slowdown doesn’t reflect the rise in off balance sheet lending that is funneled through the savings system via household wealth management products. Further, given the rise in official RMB lending in October 2011 and recent comments by the government about increasing lending to smaller firms and “fine tuning” policy and we would not be surprised to see another surge in fixed asset investment. This surge would not only exacerbate the imbalances in China’s economy, it would increase the overall indebtedness of the system.
Exhibit 3: China M2 Money Supply (% Chg, YoY, Red, LHS)
China Net Increase in RMB Loans
(3m moving average, 100 mm Yuan, Black, RHS)
Sources: People’s Bank of China/Haver Analytics
It appears that financial markets are beginning to become concerned about the off balance sheet loans, and if not the loans themselves then the lack of transparency they bring to the picture. A late September Credit Sights report notes that the Bank of China’s 5 year USD CDS spread rose to nearly 250bp, reflecting a difference of nearly 130bp over sovereign spreads. While it may not seem like much after the recent increases for European banks, it represents 2 standard deviations away from the 3-year average spread differential. Add to this that Shang Fulin who recently replaced Liu Mingkang as the chairman of the China Banking Regulatory Commission, told lenders last week to step up debt restructuring and asset sales for local government financing vehicles that are struggling to repay loans and one has to consider that China’s banks may be in for a bumpy road. Adding to the concern over Chinese banks was the IMF that called for closer oversight as banks increase risks.
The question the markets need to ask themselves is how will Chinese officials handle the near term? Will they respond by allowing greater on-balance sheet lending? This could give the Chinese and world economy a boost just when it needs it most. Meanwhile, the US economy has some moderate strength in data across the board, which includes consumption of goods; this is good news for China’s exporters. The ongoing Chimerica relationship of US imports and Chinese purchase of US Treasuries looks to be on reasonably stable footing.
There are two major things that could upset the apple cart in China, a bursting of a debt bubble and a malcontent populous with the ability to organize and communicate to effect government choices. While “fine-tuned” stimulus in the form of loans and other government directed programs will ultimately not be sustainable, it is far preferable to a malcontent populous. Thus, we believe it means China will continue to be a positive contributor to growth over the next several quarters at least. However, the more that China relies on the crutch of debt fueled growth the less likely the chance that they can avoid a hard landing. We have had plenty of experience over the last two decades with financial gravity and at the end of the day China is no more immune to its force than US home owners or large European governments.
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