The first batch of economic data in 2017 indicates that China has started the year on stable footing.

The first batch of economic data in 2017 indicates that China has started the year on stable footing.  Investment modestly improved but remains in a decade’s low range.  Factory output is stable.  Consumption numbers were weaker on lower auto sales as government-backed incentives ended.  My models hint at early 2017 growth around 6.7 - 6.8%.  The obsolete “Li Keqiang” index - often cited as proof that the government was hiding a hard-landing a year and a half ago - is running around 10.5%, enough to keep many hard-landing doomsayers at bay for the time being.  China’s current economic state appears sound by most measures released so far this year.  

Economic stability has taken hold in spite of headwinds.  Overcapacity plagues a number of large, key industries that still contribute a great deal to overall economic growth.  Analysis, including research from Capital Economics, suggests that sectors with overcapacity problems contribute roughly two-thirds of industrial output – which equates to roughly 27% of all economic output - and employs 80 million people.  Add to that a debt burden for the corporate sector that has grown massive, which has resulted in a number of zombie firms, stuck in a cycle of increasing indebtedness to support unprofitable operations.  Credit growth is still higher than nominal GDP growth, indicating that the debt burden is growing.  The corporate debt burden is roughly 150% of GDP, well above the EM country average of 80%.  Leaders in Beijing will eventually have to get serious about fixing those problems, and when they do, they risk driving up unemployment and stunting industrial output.  As mentioned in previous blog postings, China's debt troubles are not a high financial system risk.  Central government, local government, and household debt levels are low by most measures.  The country's high debt load is a serious problem for specific key industrial sectors, and that poses a risk to growth.  Here is my last blog posting on the debt burden: debt.  A weak global trade backdrop remains another headwind, and as protectionist policies rise around the globe, outlook for global trade is not bright.

To understand where the economy will go from here, we have to understand why economic prospects turned upbeat last year.  There are three primary reasons - two of which are intertwined - for China’s economic stability in the face of growing headwinds and its ability to easily beat its 6.5% growth target floor last year.  

Reflation policies
Government reflation efforts were a primary contributor to 2016’s stable growth.  Monetary policy shifted towards an easing bias in late 2015.  The PBOC cut reserve requirements five times in the year leading up to February 2016.  Central bank officials also embarked on a series of cuts to benchmark deposit and lending rates leading up to 2016, with the last cut in October 2015.  Those policy moves drove lending rates to some of the lowest in the last decade, and helped limit rate volatility.  Aside from monetary stimulus, the fiscal budget deficit was roughly 3.8% of GDP in 2016 - well above the 2.3% in 2015.  Direct monetary and fiscal boosts traditionally help heavy industries via investment in shovel-ready activity like infrastructure projects and construction.  Beyond official reflation, state-affiliated firm investment was up 18.7% in 2016, compared to 3.2% for private firms.  A question to ask is how those levels of investment can be sustained when GDP is growing at a third of that rate, and many state-affiliated firms have overcapacity and debt problems to contend with.  Looking forward, 2017 will likely bring a more hawkish PBOC given the rising inflation numbers.  The money supply target for 2017 was reduced to 12% from 13% last year.  The budget deficit target was set at 3%, after rising to 3.8% last year.  Most reflation efforts from the past few years have either started to reverse, or will likely reverse or end in 2017.

Renewed housing boom
Central government reflation had a direct impact on China’s 2016 housing market rebound.  But there are other reasons for the healthy property market, like a reduction in the required down payment for mortgages, the diversion of household savings into property and away from the turmoil-stricken stock markets, and the modest reduction in housing inventory in 2014 and 2015.  Mortgage issuance was up an eye-popping 46.5% in 2016 from the previous year. The housing boom not only improved overall growth in 2016, after a weak housing market dragged the economy down in previous years but also had an indirect impact.  Improved housing markets had the added benefit of saving officials in Beijing from making hard choices to cull the herd in the debt-burdened, overcapacity-ridden industrial sector.  Construction and real estate development are the primary sources of demand for many large overcapacity-ridden industries, like cement, steel, and copper.  Doomed firms in industries plagued with overcapacity and debt have been given a temporary reprieve by the booming real estate market.  The real estate portion of GDP in 2016 was up 8.6% after rising a paltry 3.8% in 2015.  Future weakening in housing markets would directly limit the economy’s upside, and would also compel the government to start culling the industrial herd in sectors that contribute two-thirds of China’s industrial output and employ 80 million.  So far in 2017, housing data has been mixed but mostly positive.  Monthly prices have already moderated and some tier-one cities have already seen monthly price declines.

Economic transition and innovation
The last primary reason for stable economic prospects in 2016 was unrelated to China’s traditional economic drivers.  Innovation, policy moves, and animal spirits have allowed modern industrial sectors and underdeveloped services to thrive and absorbed labor and output from decelerating traditional industries.  The underdeveloped service sector, roughly 52% of economic output, outpaced overall growth at 7.8% in 2016.  Industrial robot output, semiconductors, and electric car production in 2016 grew at 30%, 21%, and 40% respectively.  Over the last few years, Beijing tax breaks and the success of tech firms like Alibaba and Tencent have spawned a wave of new tech start-ups.  Tax cuts of $46 billion for entrepreneurs and start-ups in 2015 further boosted the start-up trend.  According to the Wall Street Journal, by the end of 2014, there were 1,600 tech incubators in China with start-up projects employing roughly 1.75 million people.  China Daily reported that 10,000 start-up firms were being set up every day in 2015.  Venture capitalists poured a record $37 billion USD into start-up firms in 2015, more than twice the tally in 2014.  For more information see my blog post here:  innovation. China’s ongoing transition toward more service-oriented growth and the solid contribution from modern industries is well known and well documented.  Continued robust growth in underdeveloped services and rapid growth in modern industrial sectors should provide a bit of a stabilizing presence should we start to see significant slowing in the more traditional industrial sectors beset by overcapacity and debt.

What to watch in 2017
There are four indicators that will hold important clues to the direction of housing and reflation policies that helped put 2016 growth on a stable footing, and whether those factors are reversing.  The first is monthly housing prices.  Development and construction eventually follow price movements.  We have already seen prices weaken and turn negative in some tier one cities.  The second is new construction starts.  New construction has done well recently, and that should keep construction activity going in the short term.  Weak construction numbers would not bode well for traditional industries like cement production and metal smelting.  Money supply and SHIBOR vs. adjusted inflation should give some insights into monetary policy.  Lastly, state-affiliated investment can help gauge whether Beijing is still applying pressure on firms to put resources to work in order to keep overall growth on track.

All in all, it is likely that we see growth moderate in 2017 given the shift in monetary and potentially fiscal policy, as well as the mixed housing data.  But, it is hard to guess just how much weaker it will be.  Robust growth in underdeveloped services and modern industries should add some stability should other sectors falter.  But, we should not forget that the most important factor of all in 2017 is the leadership turnover taking place late this year, so a deep economic slowdown is probably not in the cards this year.  See my blog posting: leadership

PMIs point to stability in early 2017, but risks still lurk beneath the surface

China's PMI declined modestly but remained in expansion territory at 51.6 for the month of February. Despite economic risks on the horizon - namely a massive corporate debt load, weakening house prices, and possible trade wars in the cards - PMI numbers indicate that the waters remain calm for now. Employment PMI remains stable. Construction seems to have improved despite the dramatic slowing of monthly housing prices.  Tier one cities saw a drop in monthly house in January. Most of the expansion remains domestically driven. But, growth still rests on the shoulders of large enterprises, most likely state-affiliated. Small and mid-sized firms continue to struggle.  Large state-affiliated firms remain the most important source of investment.

All-in-all, prospects look stable early into 2017.  But, problems going into 2017 lurk below the surface.  Decelerating housing prices, a rising corporate debt burden, slowing investment, outflow concerns, and a potential trade war on the horizon all pose serious risks to growth.  I expect any disruption to the recent stable economy will be met with a sizeable policy response this year with an important leadership reshuffle taking place in November.  2018 might be the year when the risks unfold.

Here are some key numbers within the Feb 2017 PMI data:

  • Construction PMI was up 0.9 points from last month to 57.1. 
  • Non-manufacturing business expectations rose to 62.4, the highest reading over the last year.
  • Large enterprises had a PMI of 53.3.  Medium-sized firms were above the contraction level with a 50.5 PMI.  Small firms remain in contraction at 46.4
  • Manufacturing new orders remained relatively unchanged from the readings of the last five months at 53.2.  New orders point to another month of stability.
  • Service employment PMI remained modestly below contraction at 49.7, which is probably not low enough yet to cause concern among policymakers.  Service employment is the primary source of stability as China's old economy sectors falter. 

PMI Data (select category on legend to see plot)

China's December trade numbers point to relatively stable domestic activity but indicate continued weak global trade

China's December trade numbers point to relatively stable domestic activity but indicate continued weak global trade.  Exports fell 6.1% from the same month last year.  There are few events on the horizon that are likely to push exports higher.  But, against a weak global demand backdrop, downside risks to external demand are rising with the revival of protectionist trends across the globe.  Exports will likely remain weak and growth will remain driven by domestic factors for months to come.

Total imports, including those meant for global supply-chain processing, rose 3.1% from December last year.  Imports meant for domestic use are holding up relatively well, up 5.1%, pointing to stable but lackluster economic activity.  Some big ticket items saw a drop in demand, most notably a 28% decline in aircraft shipments.

Click here for updated trade data
Here are some key numbers in the data:

  • Trade for processing continued to decline, indicating either global demand is still very weak, or more manufacturing assembly is being done close to home.  Exports and imports for trade processing declined 6.5% and 2.5% from last year, respectively.
  • Capital outflows hidden in trade invoices have disappeared.  Year on year Hong Kong import numbers have come down dramatically from a peak rise of 242% early this year, falling 61% in December.  China is still experiencing capital outflows, as evidenced by declining foreign exchange reserves.  But, those flows are not being hidden in Hong Kong trade invoices anymore.  Mainland Chinese residents have found new methods to get around capital controls. 
  • Exports to the US rose 5.5%, but exports to the EU declined 4.7%.  
  • Commodity import demand was mixed in December.  By volume, iron ore and soybeans dropped 8% and 1% respectively.  Crude and copper imports were up from last year, 10% and 13%.  On a value basis, most commodities saw an increase in shipments to China on the back of rising prices over the last year.  
  • 2016 was a record year for imports of copper and iron ore driven by the resurgent housing market.
  • Trade with manufacturing-oriented economies declined overall, with exports to Singapore falling 12%, the furthest among major trading partners.  

Despite economic storm clouds on the horizon, PMI numbers indicate that the waters remain calm for now.

China's PMI declined modestly but remained in expansion territory at 51.4 for the month of December.  Despite economic storm clouds on the horizon, PMI numbers indicate that the waters remain calm for now.  Employment PMI remains stable.  Construction seems to have improved despite the dramatic slowing of monthly housing prices.  Most of the expansion remains domestically driven.  But, growth still rests on the shoulders of large enterprises, most likely state-affiliated.  Small and mid-sized firms continue to struggle.  

All-in-all, prospects look stable at the end of 2016.  But, problems going into the new year lurk below the surface.  Decelerating housing prices, a rising corporate debt burden, slowing investment, outflow concerns, and a potential trade war on the horizon all threaten to shatter the current stability in the new year.

Here are some key numbers within the PMI data:

  • Construction PMI was up 1.5 points from last month to 61.9.  Construction new orders were up 4.1 points to 59.2.
    Large enterprises had a PMI of 53.2.  But, both small and mid-sized enterprises were in a state of contraction, with 47.2 and 49.6 respectively.
    Manufacturing new orders remained unchanged at 53.2.  New orders point to another month of stability.
    Service employment PMI remained in expansion at 50.0.  Service employment is the primary source of stability as China's old economy sectors falter. 

PMI Data (select category on legend to see plot)

What impact will US trade protectionism have on China's economic prospects?

Photo by IPGGutenbergUKLtd/iStock / Getty Images

Speculation on what a Trump Presidency means for US/China trade relations is high.  Recent rhetoric from both sides suggests that at least some trade friction is on its way.  At this point, no one has solid indications of what kinds of tariffs or barriers the US might inflict on Chinese imported goods, nor do we know how Beijing might respond.  However, almost any amount of trade friction will cause pain to some unlucky firms or consumers in both countries, and risks upending an economic relationship that has been stable for nearly forty years.  This blog post will not focus on the effectiveness of imposing trade barriers and tariffs on China.  Nor will it discuss the geopolitical gains set to be made by China as the US abandons the TPP, disengages from Asian economies, alienates longstanding trade partners and allies, and opens the door for China to become the architect of an Asian economic partnership.  This analysis will focus on how US protectionist policies might affect China’s economic prospects going forward.

A quick note on the recent developments between the US and Taiwan:
In the analysis in this blog post, I am making an assumption that trade and economic disagreements between the US and China will not escalate into a wider conflict.  However, it is important to note that President-elect Trump has made it clear he intends to use US recognition of the “One China” policy as leverage in economic bargaining.  In his book, The Art of the Deal, Trump asserts that one of his key philosophies is leverage: “Leverage is having something the other guy wants. Or better yet, needs. Or best of all, simply can’t do without.”  He seems to be trying to create the maximum amount of leverage possible in order to improve the US position in trade and economic negotiations. 

There are a number of reasons why Beijing would consider the independence of Taiwan - especially if that independence is expedited by the US - as non-negotiable.  Taiwan’s official independence could embolden separatists in Tibet and Xinjiang, for example.  But, the primary reason for maintaining Taiwan’s effective, but not official, independence resides in China’s lessons from history.  After the Opium Wars in the 19th century, colonial powers carved up parts of China in a period known in China as the “Century of Humiliations.”  That period lingers in China’s collective memory, where a once proud and sophisticated civilization was broken, carved up, and humiliated by foreign powers.  The later end of that century was particularly brutal under Japanese occupation.  China took Taiwan back from the Japanese shortly after the end of World War II.  That “Century of Humiliations” has shaped social and economic policies in China for the last 70 years.  One of the mandates of the Communist Party was to make sure that China is never interfered with or humiliated ever again.  Taiwan is neither independent nor dependent.  That ambiguous state of independence limbo has allowed for Taiwan’s self-rule without violating mainland China’s historical sensitivities and provoking armed conflict.

The US “One China” policy stance on Taiwan is ambiguous on purpose.  Chinese citizens view Taiwan’s status as an official province of China as extremely important.  Ten years ago when I lived China, nearly everyone I knew viewed Taiwan’s status as important as any environmental or economic issue.  The US population, on the other hand, has never had strong feelings on Taiwan’s status either way.  And, in Taiwan, according to Forbes, over 65% of Taiwanese prefer the political status quo of effective, but not official, independence.  There has been very limited motivation on the part of the Chinese, US, and Taiwan citizens to change the status quo of independence limbo for the last forty years.  Accidentally or purposely breaking the strategic ambiguity could result in armed conflict with limited reason or gain.   If the new administration sparks a major geopolitical conflict in the South China Sea - a region where over $5 trillion in global trade cargo passes each year - by making a political miscalculation in using Taiwan’s status as leverage in trade negotiations, then the analysis below will need to be adjusted significantly.
What is in store for the Chinese economy with a Trump Presidency?
There is no way of knowing what kind of trade tariffs and barriers Trump’s administration will seek.  Trump’s recent escalation of China-bashing rhetoric, however, seems to imply that he will probably attempt to follow through on at least some of his trade protection threats from the campaign trail.  It is unclear at this point where trade measures will fall on the spectrum of seriously punitive to a flash-in-the-pan.  The range of possible effects on the Chinese economy is pretty wide.  So, to understand the many possible outcomes of a US trade barriers and tariffs on China’s economic prospects, we need to ask the following questions:  How serious could US trade protectionist policies get, how long might protectionist policies last, and what can China do to counter export losses?

Before we answer those questions, let’s take a look at the state of US/China trade.  Here are some important number to note:

The US trade deficit with China dwarfs all other countries.  In 2015, the US trade deficit with China totaled $366 billion.  The next closest deficit country was Germany, with a relatively tame $74 billion.  $366 billion amounts to roughly 2% of US GDP, and has been stable around that percent for the last five to six years.  The US/China trade deficit was 0.5% of GDP in 1996, and accelerated dramatically over the early-to-mid 2000s.  The state of US/China trade today is as much a result of US policies in the 2000s, which stoked high rates of consumption funded by unsustainably low savings rates, as it is a result of China’s own trade policies.

US trade is becoming less important to China’s economy.  According to data from the US Census Bureau and World Bank, exports to the US have gone from as high as 10.7% of GDP a decade ago to 4.4% by the end of 2015.  That has largely been driven by China’s transition to domestic consumption as the major driver of economic growth in the economy.  China is less reliant on trade in general than in the past.

Exports to China are growing more important at the margin to the US economy.  Exports to China as a percent of US GDP are roughly 0.65%.  But, that comes from a base 20 years ago of 0.10%.  US exports to China are 9.7 times higher than they were in 1996.  As a comparison, China’s exports to the US are 9.4 times higher.

China’s main product categories in the US/China trade deficit have grown more complex and advanced over time. 

China sends more advanced products to the US than the US send to China.  According to the US Dept. of Commerce, the US shipped $34 billion worth of what is described as “Advanced Technology Products” (ATPs) to China.  China shipped $155 billion of ATPs to the US.  But, nearly all of the difference comes from a single category, information and communications.  Of that category, most of the difference comes from mobile devices and cell phones. 

A large portion of the US trade deficit with China comes from other economies.  High-tech imports, defined by China’s Customs Administration, amount to 85% of China’s high-tech exports.  Much of what is considered advanced product shipments coming out of China are advanced components manufactured in places like Japan, South Korea, and Germany that have been assembled in China.  Just over 50% of China’s trade is categorized by the China Customs Administration as “General Trade” meant for or produced in the domestic market.  The rest is processing, assembly for export, and other. 

Mobile devices and phones make up China’s largest US destined export category.  According to the US Census Bureau, mobile devices constitute 13.4% of all of China’s shipments to the US, and 17% of the trade deficit.  77% of all US cell phones come from China.  The next largest supplier of mobile phones is South Korea, with 12% of the total. 

The largest US export to China continues to be aircraft.  Shipments in 2015 amounted to over $15 billion.  China sales are roughly 13% of Boeing’s total revenues. 

A favorite talking point during the election, steel imports from China, could likely become a prime target for trade barriers or tariffs.  But, for all of the headline grabbing concerns over China steel shipments, iron and steel imports from China are only about 0.60% of US total imports from China.  Steel exports to the US account for 0.02% of China’s economic output.  The largest supplies of foreign steel are Canada, Brazil, and South Korea.
How serious could trade barriers and tariffs get?

  • What can the US president actually do?   

The Constitution gives Congress the sole authority to impose tariffs on foreign goods, with a few limited exceptions.  There are options for the President to act unilaterally.  Based on the US Trade Act of 1974, the President has the ability to impose blanket tariffs of up to 15% for no longer than 150 days.  If a foreign country is found to have unjustifiable and damaging trade policies targeted at the US, targeted quotas and tariffs may be applied.  The Trump administration would likely find targeted trade restrictions on Chinese products easier to implement.  A large blanket tariff on all Chinese goods would require congress, and would be politically challenging.

The WTO would present an obstacle to US protectionist plans.  Under WTO rules, any member must treat all imports from member countries equally.  Additionally, a WTO member can’t impose tariffs beyond the bound rate in its tariff schedule.  Hefty tariffs on Chinese goods would likely violate WTO rules.  Unless the new administration decides to withdraw from the WTO, trade protection overreach could be limited.

Labeling China a currency manipulator as proof of unjustifiable and damaging trade policies in order to clear the way for targeted quotas and tariffs seems likely given the rhetoric on the campaign trail.  But, that would require evidence that Chinese authorities are intervening to devalue the currency, when in fact China has spent $700 billion in foreign reserves in order to keep the yuan from a freefall in the face of capital outflows.  Most market indicators, including long-term real effective exchange rates, reveal the Chinese yuan as one of the world’s most overvalued major currencies.  But, proving the value of a currency is a murky exercise, and there is plenty of room for imaginative interpretation. 

  • How far is the US willing to take things?

This is probably the most important consideration in the calculus of trade import restrictions.  Trade restrictions or taxes on Chinese imports, with or without Chinese retaliation, will cause at least some short-term pain in the US. 

Pain felt by Trump’s core supporters could limit the willingness to take punitive trade measures too far.  A blanket tariff on all China shipments will certainly be felt in the form of price increases for everyday products.  According to the Economic Policy Institute, a liberal think-tank, 11% of Chinese imports are sold through Walmart. That would constitute nearly 40% of non-grocery US domestic sales at the retailer.  Blanket tariffs and the inevitable decline in the Chinese yuan in the face of reduced China economic sentiment would be punitive for the Trump administration’s core supporters.  Sizeable imported inflation numbers would also likely expedite Fed rate hikes, cooling the recent employment growth.  The administration may not be willing to take things too far if his core supporters feel too much pain at the checkout line.

Without Chinese trade retaliation, tariffs and trade barriers on specific Chinese imports would concentrate the pain on specific sectors and firms.  It would be difficult to make a sizeable dent in the China trade deficit without putting up barriers to tech products.  The US trade deficit with China is dominated by tech.  44% of the trade deficit falls in the category of tech, telecom, tech components, or electrical machinery.  Anyone looking to purchase a mobile device, computer, or nearly any product that has incorporated some tech components would see prices rise. Window dressing by raising tariffs and barriers on products that grab headlines but have limited effect on trade numbers, like Chinese steel, would be an option for an administration less willing to inflict economic pain on voters.

Chinese retaliation would increase the pain of a protectionist trade policy.  China’s trade retaliation is expected to be levied against the major US export products, like soybeans and aircraft.  According to the USDA, over two-thirds of US soybean exports go to China.  But, soybeans are a globally traded commodity.  China would need to get soybeans from other producers, like Brazil.  US farmers would need to supply markets that once bought soybeans from Brazil.  Agricultural product retaliation probably won’t be too painful.  However, China accounts for 13% of Boeing’s sales, so the aircraft manufacturer has the most to lose from trade policy retaliation.  Additionally, Beijing officials have a great deal of control over domestic markets, and can apply punitive policies to US firms operating in China.  US carmakers are highly vulnerable to Chinese retaliation.  GM revenues from China this year are higher than those generated in the US and represent 38% of the firm’s total sales.  Tech firms have a particularly high level of interest in China.  According to Bloomberg, 43% of Micron Tech sales, 23% of Apple sales, and 57% of Qualcomm sales come from China.  Over 30% of Texas Instruments sales come from China.   China can make things very difficult for firms operating on the mainland, and many of those firms have deep pockets for lobbying the US congress to stop the pain.

Pain felt by US allies could limit the willingness to take punitive trade measures too far.  China is not only a manufacturer of export products, but the world’s largest assembler of component parts manufactured elsewhere.  Just over 50% of China trade is categorized by the China Customs Administration as “General Trade” meant for or produced in the domestic market.  The rest is processing, assembly, and the like.  Nowhere is that fact more evident than in China’s $65 billion mobile phone and device shipments sent to the US market in 2015.  The iPhone is a good example of the extent to which China is simply the last stop for many goods on an extensive global supply chain.  Apple has component suppliers in 31 countries.  Big-ticket components, like displays and processors are made in Japan, South Korea, and Taiwan.  The cameras are made in Japan and the US.  The gyroscopes are made in Europe.  According to Credit Suisse, Taiwan suppliers are projected to earn up to $26.9 billion from the iPhone 6 alone.  A trade war with China would effectively be a trade war with staunch US allies, namely Japan, Germany, South Korea, and Taiwan.  An escalating trade war would also be felt globally by friend and foe alike.  In October, the IMF warned that a rise in global protectionism could shave 1.5% off of global growth for the next several years.


How long could trade tariffs and barriers last?

How new tariffs and import barriers impact China’s economy not only depends on the severity of those measures, but the length of time they are in place.  Chinese leaders can patch the hole from short-lived tariffs by extending cheap financing to exporters in order to help bridge the production gap, and running some short-term stimulus.  A one-time devaluation of the yuan would help, as well.  However, a long, protracted trade war would require more intensive actions to fill the hole in China’s economy, and result in stoking inflation, delaying economic rebalancing, and increasing China’s large debt burden.

Unfortunately, examples of historic trade measures have varied significantly.  In 2009, the Obama administration set punitive import taxes of 25 – 35% on Chinese tires for three years.  In 1964, President Johnson put a 25% import tax on potato starch, dextrin, brandy, and light trucks entering the US.  That import tax still exists today, 53 years later.  So, based on historical presidential action, punitive tariffs might last three years, or they might linger for over 50 years.

Two factors probably point to import penalties landing on the short end of the time spectrum.  First, Chinese retaliation against deep-pocketed US firms like GM, Apple, and Boeing will probably result in increased lobbying efforts for a speedy end.  Congress is ultimately responsible for imposing tariffs, and Congress is also susceptible to lobbying.  The second factor comes from Trump himself.  What we know about the President-elect more than anything else is that he considers himself a master dealmaker and negotiator.  It stands to reason that the administration will be looking to use trade protection measures to produce a deal that, at least in appearance, can be held up as an example of stellar negotiating and successful policymaking.  While the timing of US trade protectionist measures against China is an unknown, it is likely that such measures will be short-term.

What does it all mean?
So, what does all of this mean for China’s economic prospects?  The outcome for China lies somewhere between the unlikely worst case and the best case scenario. 

The worst case scenario for China economic prospects – assuming no major geopolitical escalations beyond trade policies – would be a blanket tariff on all Chinese goods of 45%, a number Trump frequently cited in campaign speeches.  If we make a very simple assumption that a 45% tax on all China imports results in a 45% drop in US imported goods from China, and China’s domestic production falls by the same amount, then the economic output shortfall will amount to roughly $216 billion.  But, since half of China's trade is assembly and processing of components manufactured elsewhere, not all of China’s export revenues are captured by domestic producers.  So, if we conservatively assume that domestic producers only feel 60% of the production drop, the production shortfall would be $130 billion, or 1.20% of GDP.  Using simple math and not accounting for multiplier effects or tariff evasion and other secondary effects, GDP growth could drop from 6.7% to around 5.5%.  Production declines would primarily be focused on light manufacturing and tech assembly, industries concentrated in the wealthy southern coastal provinces.  It will be difficult for the government to use fiscal stimulus to help those industries without buying excess products and dumping them on another country.  Unless Beijing can somehow extend support to export firms directly affected by the tariffs, the result could be tens of millions of job losses, and that would be a serious problem for China’s leaders.
The best case scenario would be "window dressing" policies that both Presidents can point to in order to prove their nationalist bonafides.  The Trump administration could apply more trade barriers to Chinese steel imports with close to zero economic implications for China.  China could respond in kind with some headline grabbing, but fairly benign trade restrictions of its own.  That would limit the economic impact on China to virtually zero.
But, the likely scenario will be somewhere in the middle.  Specific Chinese products will probably be targeted by US tariffs rather than a blanket tariff on all goods.  A realistic assumption is that some of the largest product categories face 25% to 35% import tariffs for a limited number of years.  In that scenario, China could see 0.30% to 0.50% shaved off of annual growth, and 3 to 4 million jobs at risk, concentrated in the wealthy coastal regions.  That outcome would be painful, but manageable.

What can China do to limit the impacts of trade friction?
China has tools to dampen the impact of increased US trade protectionism.  But, plugging holes in economic output and escalating retaliation to force an end to trade barriers would risk stoking inflation, damaging China’s restructuring efforts, and boosting the debt burden.  Here are some measures China can take in the face of increased US trade protectionism.

  • Evading trade tariffs and barriers.

Chinese firms will likely try to evade trade restrictions.  Tariff evasion has been used for years by clever importers.  Ford Motor came up with a clever method to skirt the steep 25% tax on its foreign-manufactured imported light trucks.  The firm simply adds windows and seats, imports the light trucks in disguise for the much lower 2.5% passenger car import tax, and then removes the windows and seats back in the US.  In the 1980s, in order to give extend a lifeline to Harley-Davidson Motorcycles, the US put in place 45% import taxes on 700 cc Japanese motorcycles.  Yamaha and Suzuki evaded the tax by producing a 699 cc engine for export to the US.  Evasion can relieve some of the pain of protectionism, but will not work on all tariffs and barriers.

  • Retaliation or threaten to retaliate.

It would be hard to imagine that Beijing would not respond to import taxes or quotas with retaliatory trade protectionist measures of its own.  If we use the same worst-case scenario from a previous example and assume China responds by stopping 45% of all imports from the US, US GDP growth could potentially be impacted to the tune of 0.30%.  But, almost a third of all US shipments to China are commodities and agricultural products traded in global markets.  So, the full impact of a 45% drop in US exports to China would be less than 0.20%, without adjusting for secondary effects. 
If China wants to expedite the end of US protectionist policies, the most likely retaliation target will be US firms with deep enough pockets to hire armies of lobbyists.  Large US firms with a significant presence in China, like GM and Ford, could start to be subject to sizeable punitive retaliation.  Apple and other tech firms might also be subject to Beijing interference in their Chinese operations.  Pain from China’s trade retaliation will be concentrated more in specific firms than in overall US economic growth prospects.  US firms facing potential losses in the tens of billions have great motivation to step up lobbying efforts.
China’s retaliation would not come without costs to its own economic health.  Restricting agricultural imports or US aircraft purchases, for example, would drive up both food inflation and service sector inflation.  Chinese citizens are particularly sensitive to food inflation.  Food constitutes over a quarter of household expenses for the average Chinese family.  Retaliation by China may also run afoul of WTO rules.

  • Domestic stimulus to counter the impact of export losses.

The most likely measure to counter an export driven slowdown will be fiscal and monetary stimulus.  Traditionally, officials have countered unexpectedly slow growth and economic shocks with infrastructure spending and rapid credit expansion.  Beijing deployed $157 billion of infrastructure spending in 2012 to counter a couple of years of pretty steep economic deceleration.  That stimulus stabilized growth for some time.  To counter the global financial crisis in 2008, the central government massively boosted credit expansion to reflate growth.  Outstanding annual credit growth peaked in November 2009 at 40%.  In absolute terms, outstanding debt increased by an eye-popping $2 trillion in 2009.  Countering the worst-case scenario $130 billion drop in exports and production discussed earlier with massive stimulus measures is well within the realm of extraordinary actions taken in the past to stabilize growth.  But, domestic stimulus has its own downsides. Monetary easing to boost credit growth and fiscal stimulus are both inflationary.  More credit will exacerbate China’s already risky debt burden.  Stoking inflation at the expense of consumers and spending massively on infrastructure would go against China’s urgent efforts to rebalance the economy.

  • Devalue the currency.

Once the US labels China a currency manipulator, the threat of using that label as a negotiating tool will disappear.  China could let the yuan go into a freefall without worrying about a US retaliatory policy response because that policy response will have already been used.  Given the long-term valuations of the yuan and the capital outflow pressures faced by the central bank, it would not be outside the realm of possibility for the yuan to drop over 20% in response to harsh US blanket tariffs.  The cheaper yuan would provide a sizeable lifeline to exporters in the face of rising US tariffs.  But, a yuan devaluation would not be without costs.  Inflation, already accelerating, would certainly rise, and complicate the job of the central bank.  A falling yuan would effectively be a tax on consumers in order to support exporters.  Such a tax would be in direct conflict with economic restructuring towards a consumer and service based economy, a transition seen pivotal to China’s long-term economic sustainability.

All in all, there is a great deal of uncertainty about China’s growth prospects as the Trump administration prepares to take the reins of government.  At this point, there are some likely events and outcomes.  US import taxes and barriers on Chinese goods will probably be targeted and short-term.  China’s retaliation will probably hurt influential US corporations with large stakes in China’s markets.  Beijing’s measures to counterbalance export declines will exacerbate inflation and the country's debt burden. And, the risk of political miscalculation rapidly escalating into major conflict is rising.  Listening to the rhetoric in the lead up to January 20th, I can’t help but imagine that China’s leadership is in for a bumpy ride for the next four years as it copes with an administration unlike any it has contended with in the last forty years.

China's policymakers will strive for stability in the lead up to 2017's leadership shuffle.

China's Politburo Standing Committee, the country's nexus of power, with Xi Jinping at its center.

China's Politburo Standing Committee, the country's nexus of power, with Xi Jinping at its center.

China faces a long list of challenges over the coming year.  Private investment has slowed significantly.  Overcapacity plagues old economy sectors and threatens to swell the ranks of the unemployed by millions.  Weak global growth has sapped export demand.  And now you can add a US pivot to protectionism and nativism to China's list of challenges.  But one factor looms over all others in 2017:  The Communist Party leadership shuffle.

In the fall of 2017, China's Communist Party (CCP) will meet for its National Party Congress, as it does every five years, to select the Party leadership.  Due to retirement age limitations, five of the seven members of the Politburo Standing Committee - the nexus of all power in China - will be replaced.  Only President Xi and Premier Li will likely remain on the Committee.  Eleven of the twenty-five members of the Party's Politburo are slated to be replaced as well.  To put it simply, 2017 is a huge year for Chinese politics.  Powerful officials and political factions looking to consolidate control will have a much lower tolerance for turmoil, economic or other, than any time in the past decade.  Historically, the CCP strives for economic and social stability during leadership shuffle years.

The Party and the Politburo Standing Committee

For those who are unfamiliar with China's political system, here is a very quick primer.  China's paramount leadership body is the CCP.  The CCP runs China by sitting atop the military and the government.  Within the CCP, authority over the government and military lies in the Politburo, a twenty-five member decision-making body.

The primary power within the Politburo resides in its seven member Politburo Standing Committee.  The Standing Committee is the principal core power within Chinese politics, exercising control over the Politburo.  Its members include the President and Premier, and like the Politburo, its membership is selected every five years.  Membership in the Standing Committee is conferred through a system of patronage.  Powerful men, like former president Jiang Zemin, attempt to put proteges and allies into key spots on the committee in order to extend their own power and influence.  Ascendancy to the pinnacle of China's political power, the Standing Committee, remains an opaque process, prone to factionalism and surprises.

The Party's Politburo exercises its control over the military and government through appointments to key positions.  Xi Jinping, for example, oversees the CCP as General Secretary and lead member of the Politburo Standing Committee.  He directs the government as President, a role handed to him by the CCP.  He also oversees the military as chairman of the Central Military Commission, an appointment given to him by the CCP.  

So, in a year where nearly all Standing Committee members will be replaced, and nearly half of all politburo members will be reshuffled, there is much at stake for those looking improve their standing in the political hierarchy.

Xi will look to consolidate power

Since his ascendancy to Party leader in 2012, President Xi Jinping has maneuvered to consolidate his control and influence over China's political system.  He has used anti-corruption fighting to purge political opponents.  Last year, he took the unprecedented step of jailing a very powerful former Standing Committee member, Zhou Yongkang.  He has squashed civil rights, jailed lawyers, clamped down on internet freedoms, and recently appointed himself effectively commander-in-chief of the armed forces for a more direct role in military leadership.  It is highly likely that he is looking to 2017's leadership shuffle in order to amass greater control and extend his leadership mandate.

A widely spreading theory among China watchers highlights the extent of Xi's potential power consolidation.  The next Standing Committee will include Xi's successor, who would possibly take control of the CCP chairmanship, the government, and the military in 2022.  But, because no clear successor has been signaled, many analysts are reading this as a sign that Xi is not planning on relinquishing control when his term is up in just over five years.  The role of president carries a constitutional ten year term limit.  Xi's leadership of the CCP via his role of General Secretary of the Communist Party has no term limits.  Maintaining control over China's political system beyond his ten year term would require stacking the ranks of the Party leadership with his own people.  Xi may be looking to become the new Deng Xiaoping, the paramount leader for life, but so far the likelihood of that is not certain.

Xi's ambitions for consolidating power will require him to place as many allies and proteges in positions of power as possible, a feat made extremely difficult without insuring the CPP's mandate of maintaining stability.

What does this all mean for the economy?

There are two main forces at play in 2017.  First, economic momentum is on a downward trend.  Overcapacity in heavy industries will continue to drag down growth.  Global growth is weak, and China's export manufacturers will continue to suffer.  Private investment has slowed, and private firms have been the biggest driver of China's productivity over the last few decades.  The massive corporate debt overhang limits monetary easing policies, and has created zombie firms that drain valuable economic resources just to stay open.  Stimulus reflation has become less effective over the last few years.  Spending and easing have been slow to spread to growth.  

Xi and his allies will do everything possible to postpone any signs of economic disruption until 2018, after they have locked in power consolidation for the next five years.

But, efforts to maintain economic stability during the leadership reshuffle will trump all other economic factors.  Recently in the developed West, accumulating political power can be achieved by exacerbating fear and highlighting turmoil.  In China, the Party's leadership mandate comes with the expectation that stability - economic and social - will be provided.  Government's key role is to deliver at least the appearance of harmony.  Nothing threatens the Party's leadership mandate more than turmoil.  A meaningful breakdown in economic or social stability over the next year would compel rival factions and party elders to disrupt carefully laid leadership transition plans already in the works.  To that end, Xi and his allies will do everything possible to postpone any signs of economic disruption until 2018, after they have locked in power consolidation for the next five years, or longer.  Worries of creating long-term structural problems at the risk of short-term economic gain will be shelved for most of 2017.  

The use of all of Beijing’s reflation tools are a potential detriment to long-term economic health, but can certainly be applied to keep the wheels on the rail in 2017.

So, what should we expect?  Due to the diminished effectiveness of broad fiscal and monetary policy, and because of the importance of patronage, we may see attempts to boost growth directed towards specific industries and provinces.  Given the recent difficulty in pushing growth forward with fiscal spending, we may see more supply-side policies, like targeted tax cuts.  But, if worse comes to worst, every possible reflation measure will probably be on the table.

One of China's largest economic stimulus packages came during the last political reshuffle.  During the last leadership changeover in 2012, $157 billion was allocated to 60 specific infrastructure projects.  Many of those projects were slated to take place in 2013, but presumably moved up to counter the economic slowdown in a Party Congress leadership reshuffle year.  Large sums of capital was borrowed and spent by local leaders at the time as well.  

While government intervention efforts have dinimished in effectiveness in recent years, those efforts are not ineffective.  In 2016, stable growth was a result of state-firm investment and a government supported property market boom.  Beijing has useful tools to stabilize growth, including a low sovereign debt load, the potential to easily drive down the currency, and complete control of the PBOC with its new monetary policy toolkit.  The use of all of Beijing's reflation tools pose a potential detriment to long-term economic health, but can certainly be put to use to keep the wheels on the rails for 2017's power reshuffle.

So, while most economic factors seem to be applying downward pressure on growth prospects, the leadership reshuffle means that tolerance for economic turmoil and disruption is extremely low.  The potential for reflation interventions is high.  Expect all possible efforts to maintain economic stability in 2017.  Those forecasting turmoil, a hard-landing, or financial sector problems next year will need to postpone dire predictions until at least 2018.






Weak imports point to more evidence of weak growth to come.

Exports and imports declined in September from the same time last year.  As mentioned in earlier blog postings, weak investment data points to a potential half percent shaved off of real GDP growth by the end of the year, or potentially in early 2017.  Weak import demand is likely additional evidence that another round of slowing is on its way.

5 things to note about China’s trade data:

  • The September declining trade numbers were a result of both domestic and external  trade weakness.  Imports for domestic use declined 0.30%, and imports meant for processing and assembly dropped 8% from the same month last year.  As has been noted in this blog recently, weak industrial investment numbers and fading construction numbers will eventually hit demand for industrial-related inputs.  These trade numbers might be a sign of weak production numbers to come.  Exports and imports remain sluggish, as global trade continues to slow.  Two weeks ago, the WTO changed its forecast for 2016 trade growth from 2.8% to 1.7%, slower than global economic growth.
  • Commodity import volumes were mixed.  Iron ore and crude oil demand remain strong, but copper imports dropped significantly.  Energy imports remain strong, possibly a result of slowing investment in oil and nat gas sectors over the last few years.  Manufacturing imports also remain mixed. 
  • Trade numbers with Hong Kong seem to be in a reasonable range.  That would indicate hidden capital outflows have stopped for now.
  • The numbers go against the weaker yuan.  Currency depreciation has not added much to trade competitiveness, in particular vs. Japan.  The CNY has dropped 5% vs. the USD, 4% vs. the EUR, and 18% against the JPY.  China’s massive trade surplus has declined 30% from the same months last year.  The problem with the latest trade numbers is weak global demand and slowing domestic demand.  A massive policy depreciation would not change either of those factors but would cause a headache for the PBOC as well as hurt consumption.
  • China’s exports to Europe, its second-largest trade destination, and the UK have been a trend for some time.  Sluggish demand from Europe may continue as a result of the Brexit vote turmoil, which will likely keep exports subdued. 

China PMI Data: Stability Now, Slowdown Later.

China's official PMI numbers point to short-term stability.  The Official manufacturing PMI number of 50.4 was the highest in two years and unchanged from August.  The number points to more stability in the short-term, and perhaps relatively strong production numbers to be released in a few weeks.  The service PMI number has been stable all year, coming in at 53.7 in September.

The stable PMI numbers have been driven by mid-year new construction starts, property price increases, and the massive surge of project investment in the pipeline early this year.  Those factors have given a temporary reprieve to old economy industries on a downward trajectory over the last few years.  We can see that reprieve in the rising electricity output (heavy industries use almost two-thirds of China's electricity), improved steel output, higher cement production, growing rail freight volumes, and improved industrial profits.  But, with the large drop in investment recently, driven by a decline in private investment, economic activity will most likely take another leg down in the near-term.  

It is hard to fix a timetable to when we might see China's economic stability shaken a bit, whereby downside economic surprises are meaningful.  In the past, I have used the rule-of-thumb that it takes about 5-6 months for investment to spread through the economy.  Fixed investment fell from 10% YoY to around mid-7% in May.  Then, July saw a drop to 3.9%, one of the slowest investment numbers in decades.  It is likely we see weaker numbers in the last few months of 2016, and meaningfully slower numbers in early 2017.  My models point to a potential half point shaved off of real GDP growth as a result of weakening investment.  Slowing indicators could renew hard landing worries in the markets.  For now, there is still enough fuel in the pipeline for a few more months of expansion.  

Important numbers to note:

The positive PMI numbers are still being driven by large enterprises.  Large firms had a PMI of 52.6, up from 51.8 last month.  Mid-sized and small firms had PMIs of 48.2 and 46.1 respectively.
The steel PMI fell just under 50, coming in at 49.5, after pointing to expansion for previous two months.
Both service and manufacturing expectations are still high, coming in at 61.1 and 58.4.
Employment PMI has been rising (see chart on the top right).  That should be a good sign for policymakers.
Nothing in the PMI numbers this month gives a good indication of Beijing's stimulus policy trajectory.
All-in-all, PMI data points to stability in September.  But, worries in the investment data puts the future of those stable numbers at risk.

Three Important Things to Note About China's August Economic Data

Most of China’s data surprised on the upside in August and points to stable growth for now.  But, there are some details in the data that point to prospects going forward

Here are three important things to note about China’s August data:

Investment data highlights the biggest risk to growth over the next six months.
Investment data is worrying for a number of reasons.  First, as has been reported for some months now, private investment has stalled.  That trend has pushed overall investment lower.  August private investment was flat at roughly 0% growth after declining modestly in July.  Overall investment over the last three months has averaged around 6.5%, some of the weakest growth in years. Most private investment declines have taken place in the hinterlands and rust belt provinces of the northeast.  The wealthy eastern provinces grew at 7%, in contrast to the massive 30% drop in private investment in the northeast.  And, within overall investment numbers, service sector investment is growing, while industrial investment is not (see chart).  The recent rebound in investment, from 3.9% in July to 8.9% in August, was concentrated in services.  That will result in much weaker industrial output months from now.  The last major concern with investment in China is the difference that has grown between credit growth and investment growth.  Over the last three months, investment has grown and an average of around 6.5%, while overall official debt accumulation has grown around 11% from last year.  That could mean either debt is being used to keep zombie firms alive or used to fund consumption.  Those are both problematic given China's sizeable growing debt burden.

So what does that all mean?  My models indicate that the recent weak investment will likely amount to roughly a half a percent shaved off of real GDP growth.  Investment historically leads output by 5-6 months.  So, we could see weaker economic activity in a few months, but certainly by early 2017.  The lower growth would come from the industrial sector, currently starved of investment.  And regional disparities would indicate old economy rust-belt industries would take the brunt of the slowdown.  So, the temporary reprieve for the old economy sectors we have witnessed this year is due to expire by the end of the year.

Construction is fading, housing prices are still rising.
Housing sales and prices continue to boom.  Mortgages are up 52% this year as households begin to embrace debt.  But, construction and developer activity has already started to fade.  Housing starts have moderated, slowing to 3.4% from last year after rising in the double-digits earlier this year.  Land acquisition by developers fell 12% in August.  

The eventual fading of construction was bound to happen given the existing inventories.  The loss of construction momentum will result in a renewed slowing of construction related industries, like steelmaking, cement, heavy machinery manufacturing.  As with the recent investment slowdown, fading construction activity will eventually reverse the recent rebound in old economy heavy industries.

Property price growth has been positive for consumption.  According to a 2015 NIH paper, housing assets account for over 70% of household wealth in China.  The wealth effect from rising process has been good for consumption.  Retail sales in August grew 10.6%, outpacing nearly all other months this year.  Auto sales grew at 13% from last year.

Stimulus policies are more limited than in the past.
If the current weak investment results add more downward pressure on the economy, we will probably see Beijing act to boost growth.  But, fiscal difficulties and corporate debt burden risks will limit the use of traditional stimulus measures, like easing and infrastructure spending.  Beijing will probably need to rely on more supply-side policies, like targeted tax incentives or regulatory reforms to reflate private investment and stimulate growth.

Due to significant debt burden risks, the potential for more dovish monetary policies is much more limited than in the past.  Much of China's upside credit growth surprise in August was caused by seasonal distortions. Total outstanding credit growth, in fact, remains subdued in comparison to historic rates, growing around 11% in August.  But, that number is still higher than nominal GDP growth.  China's debt burden as a percent of GDP is still growing.  Corporate debt is around 140% of GDP, and much of that debt has been issued to inefficient unprofitable firms.  Trust lending has bounced back and become a concern once again.  And, debt creation is not translating into investment, implying that debt is being used for either consumption or used to keep zombie firms afloat.  Those factors will limit the PBOC's willingness to ease monetary policy.  Inflation running at 1.3% - below the 3% target – implies that there is room to ease.  But, the real limitation to more rate cuts and reserve requirement reductions is the risk associated with the growing debt burden.  August numbers show that the debt burden is still rising.

China's traditional infrastructure building engines, spendthrift local governments, are seeing revenue sources under pressure this year.  That will restrict fiscal stimulus.  Local government revenue pressures are coming from three main sources.  First, tax reforms this year moved the remainder of sectors from the Business Tax (BT) system to a VAT tax system.  Previously, BT taxes were collected by local governments.  VAT tax revenues are split 50/50 with the central government, reducing tax revenue locally.  Add to that the sizeable drops in revenue in the rust-belt regions as mining and smelting come under pressure.  The resource-rich Liaoning province in the northeast suffered a 33% decline in government revenues in 2015. 
Local governments get roughly a third of their revenue from land sales, and developers have already reduced land purchases.  

Lastly, the crackdown on local government borrowing over the years has limited infrastructure spending potential.

Those limitations on easing and fiscal infrastructure spending will probably move Beijing to use less-traditional measures to stimulate growth, like reducing regulatory hurdles in order to get private firms to invest again, targeted tax incentives, or more migrant worker reforms to boost consumption.  Going forward, economic support out of Beijing may not look like it has in the past, and therefore it is hard to know what sectors will benefit.

China Trade Data: Positive Signs for Short-term Domestic Demand. No Signs of Improving Global Trade.

China's exports fell 2.8% from last year, with annual imports rising for the first time since October 2014, up 1.5%.  Changes in commodity prices over the last year will keep import numbers positive for some time.  Weak global trade has kept export numbers weak, and there is no sign of that trend reversing.

I estimate that imports adjusted for commodity price declines rose 4.5%.  And imports for domestic use - excluding imports for trade processing - rose 6%.  That indicates some of the strongest import demand in months.  Import demand for manufactured goods was flat to mixed, but mostly positive.  

Here are some key points in the data:

  • China's imports of key hard commodities - by volume - are still very robust.  Crude oil imports in August rose 24% from last year, with iron ore import volumes up over 18%.  Ag imports - by value rose - a modest 4%, with soybeans imports down 1% over the last year.  Hard commodity imports are still rising as heavy industries see demand from rising construction and new projects.  With the recent drop in investments, that trend will reverse over the next 6 months, or so.
  • Hong Kong imports rose only 14%, after 122% last month and as high as 243% in May.  That indicates capital outflows hidden in trade invoices dropped considerably in August.  If illicit capital outflows are still taking place, they are not happening through Hong Kong trade channels.
  • Trade meant for processing is still weaker than trade for domestic purposes.  Imports for processing fell 4.5%, with general trade for domestic purposes rose 6.3% from last year.  Exports for processing fell 7.8% from last year, much weaker than overall exports.
  • Exports to countries on the global trade supply chain dropped in August.  Exports to Malaysia, Singapore, and Taiwan fell 8%, 7%, and 16% respectively.  That would indicate that there are no signs of improving global trade in these August numbers.
  • All-in-all, trade numbers continue to show domestic stability on the back of a temporary improvement in old economy sectors. The numbers are in line with recent PMI data.  But, the recent drop in investment growth will most likely lead to weaker import demand for commodities and heavy machinery by the end of the year.

China PMI Numbers: Stable Now, Slow Later.

China's official PMI numbers point to short-term stability.  The Official manufacturing PMI number of 50.4 was the highest in two years, although modestly above 50.  The number points to more stability in the short-term, and perhaps a slight bump up in production numbers to be released in a few weeks.  The service PMI number has been stable all year, coming in at 53.5 in August.

The better than expected PMI numbers have been driven by construction, property price increases, and the massive surge of project investment in the pipeline early this year.  Those factors have given a temporary reprieve to old economy industries on a downward trajectory over the last few years.  We can see that reprieve in the rising electricity output (heavy industries use almost two-thirds of China's electricity), improved steel output, higher cement production, and improved industrial profits.  But, with the large drop in investment recently, driven by a decline in private investment, economic activity will most likely take another leg down in the near-term.  

It is hard to fix a timetable to when we might see China's economic stability shaken a bit, whereby downside economic surprises are meaningful.  In the past, I have used the rule-of-thumb that it takes about 5-6 months for investment to spread through the economy.  Fixed investment fell from 10% YoY to around mid-7% in May.  Then, July saw a drop to 3.9%, one of the slowest investment numbers in decades.  It is likely we see weaker numbers in the last few months of 2016, and meaningfully slower numbers in the beginning of 2017.  Those weaker numbers could renew hard landing worries in the markets.  For now, there is still enough fuel in the pipeline for a few more months of expansion.  

Important numbers to note:

  • The positive PMI numbers are still being driven by large enterprises.  Large firms had a PMI of 51.8, up from 51.2 last month.  Mid-sized and small firms had PMIs of 48.9 and 47.4 respectively.
  • The steel PMI is still showing expansion, at 50.1 in August.
  • The expansion remains domestically-driven.  New order PMI was 51.3.  New export orders came in at 49.7.
  • Both service and manufacturing expectations are still high, coming in at 59.4 and 58.2.
  • Employment PMI has been rising (see chart on the top right).  That should be a good sign for policymakers.
  • Nothing in the PMI numbers this month gives a good indication of Beijing's stimulus policy trajectory.

Data Update: June Trade Data

Exports are still weak, primarily due to sluggish global trade and low demand for manufactured goods.  Evidence of weaker global demand can also be seen in the recent PMI numbers.  Domestic sectors like construction and services are relatively strong, but overall manufacturing remains flat, with new export orders falling below 50 to 49.6.  Most of the declining year-on-year changes in China’s trade numbers are a result of weak external demand and commodity prices. 

Here are some key things to note in the June trade data:

  • Commodity import volumes are still rising.  Copper shipments to China rose more than 20% from June last year.  Iron ore and oil volumes are rising faster than overall economic growth.  Industrial metal demand will continue for the rest of the year as construction heats up from the recent housing rebound.
  • If we adjust for commodity prices, imports were up roughly 3% from last year, with the bulk of the weakness from manufacturing imports for processing.  The negative commodity price effect on imports will diminish after the end of next month, if commodity prices in general remain stable.
  • Imports and exports for trade processing declined more than general trade for domestic purposes.  Imports for processing fell 15%, and exports for processing dropped 9.6% from last year.  Exports and imports from key manufacturing economies on the global trade supply chain also fell.
  • Capital outflows disguised as trade flows moderated.  Imports from Hong Kong, up over 240% last month, rose only 70% in June.  Capital outflows are still taking place, but the pace has dropped.
  • Going forward, expect weak export numbers until global trade accelerates again, even with a weaker yuan.  Import numbers will move into the positive after next month, as the negative numbers due to price drops over the last year will fade.  Overall, the numbers confirm what we have seen in the PMI numbers already: Weak economic activity due to sluggish external demand, but stable to positive domestic demand, for construction related commodities in particular.

Five important things to note about China’s debt burden


China’s total outstanding credit growth has stabilized around 11-12% over the last half-year or so.  That has stabilized investment and broad growth for the time being.  But, that pace of credit growth is higher than nominal GDP growth, pushing the country’s debt burden higher.

My estimate for China's total debt to GDP is around 240%*.  That compares to the IMF’s 225%, McKinsey & Company’s 217%, and Goldman Sachs' 270%.  Estimates vary, but China’s debt burden is large for an EM country.  More importantly, that debt burden is still growing, and the possibility for deleveraging is a long way away due to some core structural reasons.  Debt has been a drag on growth and will certainly result in an unfavorable outcome for some individual commercial banks.  But, risk of a systemic collapse is lower than many headlines have implied over the years. 

Here are five important things to note about China’s debt burden:

There are three primary reasons at the core of China’s rising debt burden: 
First, the country’s savings rate is very high.  According to the IMF, China’s savings rate is 46%, one of the highest in the world.  Only Qatar has a higher savings rate.  And it is growing nearly as fast as overall debt.  Yuan-denominated bank deposits in May rose 11.5% from last year.  China is awash in liquidity, which is also the main reason why it is so prone to inflating asset bubbles like housing, stocks, or commodities. China’s loan to deposit ratio is roughly 71%.  Asia in general runs with a lower loan to deposit rate than much of the world as a result of high savings rates.  Western Europe averages about 111%, and Latam has the highest average regional rate at over 114%.

Second, China’s massive savings is trapped in the country.  The capital account is closed and managed closely by the PBOC.  So, there are few options for diligent savers other than bank deposits, property, financially engineered products, or stocks.  Most of the population opts for bank deposits, with property as the main non-bank investment destination.  

China’s financial intermediation system is still bank loan-centric.  Bank loans comprise 65% of total credit outstanding, and many other forms of credit, like wealth management products, originate with banks.  Other forms of intermediation are growing rapidly.  The corporate bond market, for example, is only 10% of outstanding credit, but growing at 28% a year.  Banks are still at the center of China’s financial intermediation, and so is the massive debt that banks have extended, both wisely and unwisely.

Those core reasons will not change soon.  So, the debt burden will continue to rise until Chinese consumers become more spend-thrift, the capital account is opened, and financial intermediation develops much further beyond bank originated debt.  Until things change, those massive, trapped savings will be turned into massive credit flows via the bank-centric system.

China’s debt problem lies in the massive buildup of corporate debt.  The government is relatively frugal by global standards.  

Households hold debt equivalent to 39% of GDP.  That compares to 79% in the US, 88% in Korea, and 89% for Malaysia, according to Trade Economics.  

Debt as a % of GDP by Sector

Source: McKinsey & Company, Laohu Economics Estimates

But, non-financial corporate debt is roughly 140% of GDP.  That is nearly twice as high as the 80% average among EM economies according to the Institute of International Finance.  Much of that corporate debt was directed to state-owned and state-affiliated firms which have return on assets two to three times lower than private firms, according to the Peterson Institute.  China has always had a problem with lending to inefficient state firms in order to stabilize employment.  Add to that the massive Beijing mandated lending spree for the years following the financial crisis, and the country has been left with many unprofitable, inefficient firms adding to overcapacity, kept alive solely on borrowing from banks.  Those zombie firms consume capital that would be better invested by competitive new economy firms. 

NPLs continue to rise, and the actual NPL number is hard to determine. The official number for NPLs is 1.75% of total loans, up from 1.67% at the end of 2015, and well below the global average of 4%.  NPLs rose this year to an 11 year high of 1.4 trillion yuan.  But, China’s NPL calculations are different than Western bank “norms”.  Chinese banks only need to recognize an NPL if they expect a loss, giving them greater leeway in categorizing delinquent loans.  A better comparison would be to use the banks’ “special mention” loan category for delinquent loans that are not yet NPLs and combine them with the official NPL numbers.  That calculation provides a better comparison to global peers.  NPLs and “special mention” loans combined are roughly 4% of total loans, on par with global averages, but growing for 18 consecutive quarters.  Pimco estimates that NPLs will top out around 6% of all bank loans.

The IMF estimates that Chinese banks have $1.3 trillion in “risky loans” - risky, but not NPLs - on the books.  If all of those risky loans were to become NPLs, they would total 15% of all lending.  At a 60% loss ratio, that means $760 billion of potential bank losses; large but manageable.  That is equivalent to 1.9 years of the banking system’s pre-tax 2015 profits.  

The debt problem does not pose a risk of systemic financial collapse, but will present problems for specific individual banks and financial institutions that have stretched risks and regulations quite far.  Banking crises usually begin with liability problems.  China’s bank liabilities are overwhelmingly dominated by sticky deposits, which are now part of Beijing’s recently created depositor's insurance program.  The required reserve imposed on banks is 17%.  And, roughly 95% of China’s debt is domestic, with minimal foreign currency debt.  On top of that, debt has gone to fund assets and not consumption.  

If the IMF loss estimates outlined above were realized in full, some individual banks would be vulnerable.  Those losses would not be evenly spread across the sector, but instead disproportionately hurt banks that have stretched regulations and risks as far as legally possible.  The large state-owned banks that face greater regulatory scrutiny, like ICBC and Bank of China, will fare much better with losses than smaller, free-wheeling private banks like Industrial Bank.

Steps are being taken to fix the debt problem, but not all of the right ones yet.  Policymakers need to do two things to mitigate the country’s debt problems.  First, they need to stop the flow of debt to inefficient, debt reliant, unprofitable zombie firms.  Then, they need to facilitate the removal of bad debt from the books.  In doing so, eventually an appropriate amount of credit will flow to competitive firms.  

Beijing has launched a test program this year whereby the six largest banks can sell up to a total quota of 50 billion yuan of securitized NPLs to clean up balance sheets.  The program has had questionable success so far.  Plans are also in the works to convert loans to troubled state-owned firms into shareholdings through debt-to-equity swaps.  

It is widely agreed by both bulls and bears that Beijing will only fix the massive corporate debt problem by cutting credit flow to debt-addicted, inefficient, unprofitable zombie firms.  That has met with political resistance over the years. Cleaning up NPLs will not work if banks are creating more at a rapid pace.  Beijing still has much work ahead.



*If you include financial firm debt, that number approaches 300% of GDP.  But, that method double-counts debt.  If a policy bank extends a loan to a commercial bank, and that commercial bank lends the money to a factory owner, that is effectively one loan, not two.

4 important things to note in China's May trade data

4 things to note in China's May trade data:

  • Commodity demand remains strong.  Import volumes of metals and crude oil surged from last year.  Iron ore imports rose over 20% as rebar inventories - nearly half of the world's steel production - declined over the month.  Copper import volumes rose 18% from last year.  Crude oil shipments to China in May were 39% higher than last year.  The data underscores the improved demand in commodities as investment and construction rise on the back of a renewed housing boom.  Adjusting for the double-digit declines in broad commodity prices over the last year, I estimate that imports were up roughly 9.8%.  After August, we should see import numbers rise from the commodity price base effect.
  • Most signals point to worsening global trade.  Manufacturing imports and exports declined meaningfully from last year.  Exports and imports to many key economies on the global supply chain fell.  Exports and imports for processing declined much more than overall trade, -13% and -14% respectively.
  • Hong Kong imports rose 244%, pointing to more hidden capital flight in the form of trade invoices.  China is still in a state of outflows, but the outflows have moderated considerably.  China's forex reserves stabilized over the last few months, down in May primarily as a result of market moves.  Capital Economics estimates that capital outflows in May were $32 billion, much lower than the $100-plus billion seen in previous months.
  • Currency impacts were minimal.  A weaker yuan vs. major trading partners failed to lift exports higher.  The yuan lost ground against the yen, dollar, and Euro over the last year.  But, all three regions saw a drop in shipments from China.  

China's Renewed Housing Boom to Support Short-term Growth.

  1 YEAR PRICE CHANGE FOR 70 CITIES APRIL 2016                  

China's Renewed Real Estate Boom
Over the next 6 to 12 months it will be costly to be a China bear.  The reason: Real estate.  China’s renewed real estate boom is being underestimated by many analysts and pundits.  After China's disappointing economic data in April, the latest narrative has centered around a loss of economic momentum as Beijing reflation efforts wane.  But, dig deeper into the details, and there are some eye-popping numbers in China’s real estate market.  April numbers included:

  • A 25% annual jump in new housing starts.  
  • A 64% increase in the value of home sales.
  • An near 80% increase in mortgage issuance.
  • The construction PMI was 59.
  • Residential investment rose 11%.
  • Land sold to developers grew at 8%.
  • Commodity imports have been fairly robust so far this year (see my trade data for more details).

Real estate is a big deal in China
Property is the largest source of household wealth and home prices have a sizeable wealth effect.  Land sales pay a lot of local government bills, and sales are up.  Construction is a massive industry and employs millions.  Real estate overall, potentially 25% of China's economic output directly and indirectly, dragged growth lower in 2014 and 2015.  But, 2016 will see a reversal. 

The boost will come from a temporary reprieve for doomed old economy industries, like WW2’s battle of the bulge for large industries like materials, steelmaking, and construction.  As growth slows and restructuring unfolds, China’s economy has become highly uneven.  In fact, China’s economy is like four different economies in one: The tech and innovation sector riding high, the underdeveloped service sector proving resilient, light industry slowing in the face of weak global demand, and heavy industries sinking fast under the weight of debt and overcapacity.  The renewed housing boom will prove to be a temporary boost to the last sector on that list, and provide a window of stable and possibly improving economic prospects in the short-term.  In that scenario, it will be costly to be a China bear for some months to come.

How long can this new real estate boom continue?
The recent boom has been primarily driven by a few key factors:  

  • Supportive housing policies out of Beijing (including easier mortgage financing and lower interest rates).
  • Investment money diverted from the hot stock market.
  • A reduction in inventories over the last year or two.
  • China’s frequent bubble-creating massive savings.  

All of those factors, except for the last one, will eventually reverse sometime in the future.  Savings deposits are around 200% of GDP and trapped in the country due to capital controls.  That immense liquidity will continue to inflate asset market bubbles of all kinds, including housing, within China for a long time, as we have recently witnessed in China's commodity futures markets.

Household Debt as a Percent of GDP

Source: McKinsey & Company

The most important of those factors seems to be a boost in mortgage financing.  Mortgage lending accounts for 26% of all 2016 real estate investment, up from 18% at this time last year.  In 2016, mortgage borrowing has risen 54% from last year after Beijing reduced required down payments from 25% to 20% for first-time homebuyers, and from 40% to 30% for second homes.  The PBOC has also driven down interest rates over the last year and a half.  

The mortgage market is still underdeveloped in China.  All household debt combined accounts for only 38% of GDP, low relative to global peers (see chart).  In the US, mortgage borrowing alone accounts for 77% of GDP, as high as 98% in 2009.  China’s households up to now have been pretty debt averse.  The country’s much-publicized debt burden lies on the shoulders of corporations and state enterprises, roughly 125% of GDP.  A mortgage boosted housing market could have a long way to run.

The real wild card is existing inventories
The biggest conundrum in China’s recent real estate boom is, how can a country with millions of unused properties be going through a double-digit increase in construction starts and skyrocketing prices?  My guess: According to the IMF, China’s housing glut is primarily a lower-tier city problem.  Inventories in the wealthier cities along the coast with larger GDP contributions are relatively tight given China’s urbanization rate.  The recent price rises have come from the top tier cities with fewer inventories (see map).  Those sizeable price moves have set off a new boom that is starting to spread beyond the top-tier regions.  There is also plenty of uncertainty around just how big China’s housing glut actually is, and how fast real demand is growing.

There is no shortage of data and information on construction and house prices in China, from both official and private sources.  But, information on inventories and vacancy rates is virtually nonexistent.  That, unfortunately, leaves plenty of room for speculation.  Vacancy rate estimates vary, but the most often quoted rate is 22% (about 50 million units), a number used by the Wall Street Journal, the St Louis Fed, and the China Daily.  That compares with 3% in the US at the peak of the housing bubble in 2006, and Japan’s current rate of 13.5%.  China appears to have a large housing glut, but there are three big differences between China and global peers.  

First, urbanization is likely to move over a hundred million people into urban cities over the next five years, and they will all need housing.  Second, wealthy Chinese view property as an investment and many of those unused properties will remain empty for a long time on purpose.  And lastly, speaking as someone who lived in a Chinese apartment years ago, China’s housing stock needs updating.  China’s last census revealed that 28% of Chinese homes did not have showers, and 16% did not even have toilets.  With disposable incomes rising over 7% a year, there is a constant demand for upgrading in the housing market.

My point is, China’s housing surplus is unknown, but also unknown is the extent of future housing demand.  China's housing market has significant oversupply, but due to uncertainty about the actual housing stock and potential for massive future demand, we should view that oversupply as a ceiling on any renewed housing booms, and not a catalyst for an impending US subprime-like crisis.  So, the current double-digit pace of construction and sales are unsustainable in the long-term, but there is already enough in the pipeline to boost growth for some months to come.

Going forward
The future of China’s economy will continue to be an uneven slowdown, whereby old economy industries that once drove the “miracle economy” forward drag down future prospects.  But, for a short time, those industries – materials, machinery, energy, steelmaking, mining, and others – will get a reprieve from the latest real estate boom underway.  That will provide a window of stability and decent growth prospects for the broad economy.  Given the investment and construction in the pipeline already, the boost should last for at least the rest of 2016.  But, uncertainty over China’s existing housing stock make predictions beyond that time horizon very challenging.

Three important things to note about China's April trade data:

Three important things to note about China's April trade data:

  1. Imports and exports of manufactured goods point to a decline in the global supply-chain as global growth remains sluggish.  Supply-chain trade saw steeper declines than trade for domestic purposes.  Imports for trade processing dropped 21%, and exports for processing and assembly fell 13%.  Imports from key manufacturing suppliers - like Malaysia, Philippines, and Korea - have fallen more than key commodity countries (see chart on the right).
  2. Commodity imports remained robust but weaker than the big demand surge in March.  YTD, many of China’s key commodity imports, like copper and crude oil, are in the double digits.  That is consistent with the recent rebound in investment and construction data that should keep commodity demand higher than in the last two years.  But, the sustainability of the recent commodity demand boost is questionable in the long-term.
  3. Imports from Hong Kong rose over 200%, indicating that capital outflows hidden in trade invoices in order to escape capital controls has not stopped.  Outflows have slowed, but efforts are still being made on the mainland to sneak money out of the country.


China April PMI Numbers Modestly Lower, but Point to a Rebound in Old Economy Sectors

China’s April PMI numbers modestly declined from March but remained in expansion territory for the second month in a row.  Most PMI numbers fell slightly lower in April after jumping higher in March.  But, large firms, the construction PMI, and expectations subcomponents all point to a property-driven rebound temporarily boosting China's struggling old economy sectors.

As mentioned in previous blog entries, China's main economic story so far in 2016 is a rebounding property market poised to add to the broad economy this year after dragging growth lower for the last two years.  Within the numbers, construction PMI was up 1.4 points to 59.4 in April.  Property is a large chunk of the economy and indirectly has an impact on consumption through both the wealth effect and construction employment.  The renewed property and construction surge while unsustainable in the long-term will likely give a boost to the economy this year.

Here are some other key points in China’s PMI data:

  • New order PMIs for both manufacturing and services were lower in April, 51.0 from 51.2 and 48.7 from 50.8 respectively.
  • Expectations are on the rise.  Expected production and activity PMI came in at 60.3 in April, up from as low as 44.6 in December.
  • Manufacturing PMI for large firms was 51.  Medium-sized firms are also showing expansion at 50.  Small firms had a PMI of 46.9 in April.  That is an indication that large state-affiliated heavy industries are doing better recently while smaller manufacturers are still struggling.
  • Employment PMI in the service sector rose to 49.2, while the manufacturing employment PMI declined to 47.8.  The employment outlook for industry this year will continue to be negative as Beijing forces contraction of overcapacity in large heavy industries, like mining and steelmaking. Layoffs will likely be in the millions over the next few years.  Beijing is banking on new economy sectors to absorb the jobless.
  • Raw materials purchase prices came in at 57.6, almost 10 points higher than last year as commodity demand begins to rise.

Here are the data charts:

What can China protests tell us about the state of economic stability?


Recently, much attention has been drawn to China's increasing labor protests.  According to the China Labor Bulletin (CLB), a Hong Kong-based NGO, 2015 saw over 2,700 incidents of worker strikes and protests, up from just under 1,400 in 2014.  Those numbers are a sizable leap from 185 incidents in 2011 after Beijing gave an unofficial nod to allowing worker strikes at foreign car companies in 2010.  Wage disputes and labor issues have risen as bloated, old-economy firms struggle through China's economic transition.

In fact, protests and civil dissent of all types have been on the rise in China over the years.  Heavy-handed crackdowns and policy shifts have followed.  The source and nature of dissent and concerns vary, from small local labor protests over wages, to tens of thousands marching in the streets in order to stop polluting factories from setting up shop in town.  But, left unchecked by Beijing, all sources of dissent could eventually lead to nationwide political movements, posing a threat to the supremacy of the Communist Party of China (CPC).  A look into sources of social unrest and Beijing's response to dissent might give us an insight into the state of China's economy.

China tightly controls the types of dissent around the country, increasing pressure on sensitive areas that would spread to a wider national political movement.  Most protests in China are not political, but instead directed at very specific grievances like residents evicted by local leaders, homeowners bamboozled by unscrupulous developers, or parents in fear of polluting factories.  It is the broader, larger protests that risk turning into political movements that frighten Beijing.

According to the Pew Research Center, corruption and pollution remain the top sources of discontent within China, and the Party has attacked those two issues to the detriment of growth.  Both corruption and pollution have motivated protests and online traffic enough to worry CPC leadership.  Worries over jobs and the economy probably do not pose a big enough threat to Beijing to pile on the crackdowns and political shifts to the detriment of growth and restructuring efforts.  Dissent over unemployment and the workplace are growing but remain localized and isolated to specific sectors.  Beijing will probably not turn back restructuring of bloated old economy sectors just yet.  If we start to see a broader and political workers movement, then we may see Beijing take a more assertive approach.

Significant pollution fighting underway

As pollution reaches deadlier levels (see my blog posting Recent Study: 1.6 million deaths each year across China can be attributed to air pollution.) protesting has heated up, like last summer when tens of thousands of protesters in Shanghai took to the streets for days to protest plans for contrcution of a paraxylene processing plant.

In 2013, pollution rose to the top of the list of reasons for protest.  That year a number of incidents known as "airpocolypse" pushed the environment to the top of the list of reasons for public dissent, beating out land expropriation as the number one cause of protests. In 2014 Li Keqiang announced China's "war on pollution" to counter rampant deadly pollution and appease a population increasingly worried about the environment.  That war will be costly, and has lead to the most ambitious green energy effort in history.  China's response to pollution will cost hundreds of billions, if not eventually trillions of dollars to fix over time. 

Massive sums and economic costs of fixing pollution problems are seen by Beijing as well worth it.  Air and water problems are a common and widespread source of discontent, and threaten to evolve into a more organized national movement.

Significant corruption fighting underway

Corruption is the primary complaint among China's population.  Local leaders stealing land from rural residents, young princelings flaunting Ferraris, and rich influential men seemingly above the law all have been widely publicized online.  Corruption is pervasive, well known, and highly publicized online. 

The population's concerns over corruption have not gone unnoticed.  Xi has made anti-corruption fighting one of his prime objectives since taking control in late 2012.  Anti-corruption purges of officials have been a win-win for Xi's regime, removing powerful officials like Zhou Yongkang and Bo Xilai from rival political camps in order for Xi to amass the most concentrated political power since Deng Xiaoping, and disarm concerns over corruption at the same time.

Corruption fighting has not been a zero-cost policy.  Consumption numbers and infrastructure investment have both been hit hard by the efforts.

Xi's high profile corruption fighting seems to be paying off with the population.  Corruption is seen as a problem, but Xi has convinced much of the population that his regime will fix it.  According to Pew, 63% see corruption improving in 5 years, with only 18% saying it will get worse.

Economic concerns and discontent are localized and not broad

Labor protests in China have accelerated as the economy is forced through a difficult transition.  Labor protests, much like the big drivers of China's broad growth, have diverged between the rapidly-growing and undevedevloped consumer and service sector, and the bloated and inefficient traditional industries that have kept millions safely employed years beyond the point of sustainability.

One-third of 2015's labor protests came from Guangdong (China's biggest manufacturing center), Hebei (China's biggest steelmaking region), and Henan (with its massive mining reserves).  One such protest happened in Heilongjian province's Shuanyashan mine.  Thousands of miners took to the streets, unhappy over claims of unpaid wages and pay reductions to 800 yuan a month from 1000, as reported by Rueters.  Due to the rapid drop in coal demand and Beijing's efforts to force overcapacity reduction, the mine's owners have reported losses since 2012 and have plans to cut its workforce by nearly 100,000.  

2016 will see labor unrest grow as leaders downsize debt-laden old-economy firms.  Reuters, citing anonymous sources, put the number of planned firings at 5-6 million over the next two years.  Forced mergers, deleveraging, and planned reductions of "zombie" firms will result in a continuous flow of jobs out of old-economy sectors.  Beijing's plan is to spend billions to retrain old economy workers for new-economy employment, similar to South Korean policies over a decade ago.

Incidents of labor protests in the service and retail sectors are minimal.  There were only 11 protests in retail all of last year, according to the CLB.  Out of Guangdong's 414 reported labor protests in 2015, only 42 came from the service sector.

Worries over jobs and the economy seem overstated outside of China's borders.  Unemployment remains on the bottom of Chinese lists of grievances, still overshadowed by corruption, pollution, and even traffic.  According to Pew, in 2008, 66% of all Chinese described their personal finances as good.  Last year that number was 72%.  Seventy-seven percent view their finances as better off than five years ago, with only 4% saying they are worse off.  

For now, localized labor dissent has been quelled by arrests and negotiations, and confined to old-economy sectors.  If labor unrest shows signs of becoming an organized and national political movement, as human rights and corruption have, then Beijing will probably use stronger medicine and contemplate roll-backs of reforms along with crackdowns.  But for now, social disorder is primarily localized and specific to downsized sectors.  On a broader level, worry over joblessness is on the bottom of a long list of concerns, indicating that worries over an economic crisis are overstated.

China's Housing Boom 2.0 Continues. Construction Activity Improves.

China's housing market continues to boom as Beijing stepped-up support for the sector, and money was diverted away from stocks and into property after recent market turmoil.  The big change so far this year seems to be the improvement in construction activity.  After over a year of contraction in construction dragging down overall growth, the surge in house prices and sales have potentially spread to new housing starts and real estate investment.    

China's housing policies have been very supportive recently.  Last month, Beijing dropped the minimum required down payment on mortgages for first-time homebuyers to 20% from 25%.  That minimum was lowered last fall from 30%.  Down payments for second properties were reduced to 30% from 40%.  Combined with PBOC easing, the result has been a 22% rise in mortgage lending.  China’s mortgage market is relatively underdeveloped, comprising only 13% of all property investment.

The housing market gains have been driven by the top tier cities, as lower tier cities - where excess inventory stands in the form of massive ghost towns - are still seeing downward price pressures. 

Construction activity declined in 2015 and much of 2014 as a result of slowing investment.  Developers have been slow to build in a market swamped by empty properties constructed in the years following China's massive post-financial market stimulus free-for-all.  

2015 was a reversal of that trend.  New housing units completed declined 8.8% from 2014, roughly 1.2 million housing units fewer.  Residential property sales boomed towards the end of last year, ending up 6.9% higher than the previous year, roughly 1.2 million units more than 2014.  2015 was the first year in many where demand possibly outstripped supply.  So far this year, house sales are over 30% higher than last year at this time.

The dip in housing inventory, combined with Beijing policies to boost mortgage lending, central bank easing lowering borrowing rates for developers, and money diverted away from stocks may prove to be a short-term boost for housing and construction.  That would give some relief to the pain felt in construction related industries, like steelmaking and cement, that are being forced to reduce overcapacity.

Data Update: Seasonally Adjusted Trade Data For Feb 2016

China Exports as % of Total Global Exports

Source: World Bank

Both exports and imports were solidly negative in both February and January (see the chart on the right).  If we look into the numbers, the bad China trade data was mostly driven by weaker global demand (declines in the global manufacturing supply chain) and commodity price declines.  The declining trade data was partly driven by weaker domestic demand in China’s industrial sector, which is to be expected as the industrial sector will slow more than overall growth.  There may be some headwinds from the currency, but that is up for debate.  I don’t think the currency is much of a headwind to trade very recently.  The yuan has declined vs. most major trading partners over the last year, so the currency should have been a positive for exports (to Japan in particular).  The CNY REER hints that the yuan is overvalued, but China’s growing share of global exports points to China’s growing trade competitiveness (see chart to the right).  The large surge in imports from Hong Kong is an indication that cash outflows disguised as trade flows persist.  The chart on the right has trade data adjusted for the seasonal holiday.

Here are some key points in the numbers:

  • Commodity import volumes for key commodities were pretty positive (See the bottom chart).  Much of the weak import number was due to YoY commodity price declines.  Imports were probably -7.9% YoY, adjusting for commodity prices.  Given the rising commodity import volumes, that would mean import weakness is primarily due to manufacturing imports. 
  • Exports and imports to and from manufacturing economies would point to a decline in the global manufacturing supply chain (See charts below).
  • Weak exports to developed economies have been an issue for some time as demand in those economies remains weak. 
  • Imports for processing declined 21%, a deeper slowdown than overall imports.
  • China does not import much in the way of consumer goods.  Most manufacturing imports meant for the local market are capital goods and industrial machinery.  Weaker domestic demand for those goods should be expected as the industrial sector and construction slow more than overall growth.
  • The poor export numbers would explain a good deal of the lower PMI data we have seen recently.
  • Factories traditionally pick up in March, after the local holiday.  We may see more activity then.
  • The currency should have been a positive for exports on a YoY basis as it has fallen vs. most trade partners.  The yuan has fallen 11% vs. the yen, 6% vs. the EUR, and 4.4% vs. the USD over the year.