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Quick Update: PBOC Pledged Supplementary Loans (PSL)

The PBOC said it has disbursed 263 billion RMB ($42 billion) worth of pledged supplementary loans (PSL) so far this year to the end of May.  For information on how the PSL program works, see my PBOC infographic.  PSL activity should be viewed as targeted stimulus, not broad easing.  The PSL activity this year has been used to support China's urbanization, according to the central bank.

263 billion RMB amounts to roughly 0.19% of total outstanding credit, and compares to 1.8 trillion RMB (if fully utilized) of easing from the two RRR cuts so far this year.

Through the PSL this year, specific banks have borrowed money against collateral at 3.1%, compared to 4.5% last year, reflecting the PBOC's efforts to bring down rates this year.

PSL activity this year will have little impact on overall growth and credit in comparison to other PBOC actions, but will be a modest positive for urbanization efforts and infrastructure spending.

Quick Data Update: May PMI, Modest Improvement, but Still Weak.

The official manufacturing PMI came in at 50.2 for May, up very modestly from April's number of 50.1.  Although a slight improvement on the month, as seen on the chart below it is not clear that we are seeing a significant pickup in activity.  New orders PMI (50.6) does not show a clear pickup in activity either, although it has modestly improved as well.  The numbers are a bit better than last month, but the dial has barely moved.  It will still be a couple of months until the PBOC stimulus drives activity meaningfully higher. See my post "Things will get worse before they get better." for details.  Employment PMI came in at 48 - below 50 - and probably no comfort to Beijing policymakers who ultimately want to keep employment stable.

The worrying number is the non-manufactuing PMI.  At 53.2, non-many PMI is still above 50 and showing expansion.  But, the direction and the speed of the slowing number needs monitoring.  The service sector has been keeping GDP on target as the industrial sector slows below 7%.  If non-manu PMI goes below 50, then GDP growth will have a hard time staying above 7% this year.

Here are all PMI component charts:

http://laohueconomics.com/charts/#/urban-avenue/

Quick Data Update: Iron Ore Inventories

Iron ore inventories have fallen dramatically this year, in tandem with weak imports.  Iron ore prices are up 22% from the low point in early April this year.  This is promising data for the growth outlook, as well as the outlook for import demand in H2 2015.  We expect construction to pick up in late Q3, which will add to the inventory drawdowns and import demand.

Be vigilant over indebted Chinese firms, but don't freak out about China's debt load.

China has a sizable, well-documented debt burden.  It has led to growth headwinds for sure, as debt-burdened non-financial corporates have had to divert resources to paying and rolling debt. China's debt problem lies squarely with non-financial corporations, comprising 125% of GDP, as seen below.  Households, local governments, and the central government have debt burdens that are relatively low by global comparisons.  

Debt as a % of GDP by Source

Source: McKinsey Global Institute, LaoHu Economics Blog

China's debt is a persistent topic that is often dominated by dire warnings.  But, if we take a step back and answer two questions, we can see that China's debt burden requires much greater monitoring of individual firms and sectors than in the past, but is not a source of alarm for the whole financial system and economy.

1) How does China's debt and level of investment compare to global peers?

To answer this I will use two charts.  The first is a comparison of total debt (excluding financial) as a percent of GDP from the McKinsey Global Institute 2015 report on global debt (page 4) vs. per capita GDP.  This number includes non-financial corporate, household, and government debt; everything but financial intermediaries.  Including financial debt would introduce double counting.  I excluded the country names to make a point.  I will add them back in a later blog.  Looking at this chart it may be difficult to pick out China.  China's real economy debt level given the country's level of development does not appear to be an significant outlier.

The next chart shows capital stock per worker vs. per capita GDP.  If China had been borrowing  in order to fuel over-investment, then capital stock measures would show China as an outlier with more capital stock than it needs for the country's level of development.  If it is not an outlier, then China has invested an appropriate amount for its level of development. Again, without labels it is difficult to say China's investment in the past has made it significantly different from global peers.  So, debt levels to the real economy and the country's investments to date don't stand out as alarming vs. global comparisons.

Including the debt from financial intermediaries adds double counting to the debt to GDP calculation, and also makes it difficult for comparison across highly varied financial systems.  But, here is the chart with debt to GDP including financial intermediaries.

In my opinion, China's debt load and investment stock does not appear to deviate significantly from global peers for its level of development, though that is obviously not a widely held view.  The risk of a system-wide crisis is low.  China's high debt load is primarily shouldered by indebted corporations that are struggling to operate and invest while diverting resources to pay that debt.  

Here are the charts with country labels: Charts With Labels.

 

2) China's non-financial corporate firms have a debt burden of 125% of GDP.  What sectors and firms are most at risk?

According to economists at the Hong Kong Institute for Monetary Researchers and the IMF, China's corporate sector does not appear to be over-levered in the aggregate.  But, certain sectors and ownership structures have worryingly high debt burdens.  

SOEs, for example, have significantly higher debt ratios than private firms.  And, debt ratios at SOEs have increased, while private firms have de-levered over the last few years.  Property companies in particular have a significantly high debt burden. McKinsey estimates that 45% of all non-financial corporate debt is directly or indirectly related to real estate.

It is important to note that mortgage debt in China is extremely low vs. global peers.  Homeowner debt is not an problem (see chart at the top), but real estate developer debt is a risk.

Sectors with worryingly high debt burdens: Real estate, industrials (particularly SOEs and sectors with overcapacity), utilities, and materials.

Sectors with low debt ratios: Health care, IT, energy, and consumer.

Expect more defaults and view them as good for the economy.

This year 2 Chinese firms have defaulted on USD denominated debt.  A coal importer missed a 13 million dollar payment in May on its 309 million dollars of debt. Kaisa, a homebuilding firm, missed a 23 million dollar payment in January. These were two small non-systemically important firms in some of the weakest and most indebted industries. There will be more defaults and firm failures to come, in a break from past implicit policies of bailing out all weak firms in one way or another.

Defaults and firm failures will instill discipline in the markets, and help to force structural changes.  defaults will also help with reducing the country's overall debt burden.  Credit is still growing faster than nominal GDP, so defaults are one of the few ways to reduce the overall debt burden on the economy. Of course, none of these will take place unless Beijing is indeed ready to let firms fail.  Most signs point to yes.

Beijing has been preparing for potential financial system turmoil for years, setting the stage for defaults.  

  • The PBOC has created new lending facilities to help banks cope with turmoil.  
  • Deposit insurance was rolled out in May for 99.6% of all bank depositors.
  • This year Beijing began a process for local governments to swap shadowy high interest debt (much of which is on the books of banks) with more transparent bonds.  This plan has the potential to significantly reduce local government debt risks to banks.  
  • Banks have 18.5% of deposits in reserves.  
  • Most debt is held domestically (90%), and a significant amount of it between state-owned firms and state-owned banks.  
  • The central government has a very low debt burden (22% of GDP) and vast resources (potentially 350% of GDP, see chart on the right).  
  • Beijing firmly controls the central bank, much of the traditional media, nearly half of the banking system, and the judiciary, and can therefore pick and choose which firms to bail out and which firms to let fail.  And it seems that there is now a willingness to let firms fail.  

Beijing will use its resources to evaluate failing companies on a case-by-case basis, bailing out systemically important firms (or firms that are important to policymakers), and letting others fail.  So, beware of small unimportant firms in weak indebted industries.  Beijing may use their failures to clean house.

Expect more corporate defaults by non-systemically important firms going forward without significant risk to the financial system as a whole, and view most of those defaults as a good thing for structural change in China.  More scrutiny than any time in the past must be employed when assessing Chinese corporations.  Risk is growing in some industries, and many firms are doomed.

 

Charts with labels.

Here are the charts from my previous blog entry, with countries labeled.  China's debt load is not a significant outlier for its level of development when compared to the 47 countries in the McKinsey Global Institute debt report.  China's 217% of GDP total debt to the real economy will not sink the financial system nor the economy.  But, the 125% of GDP debt load on corporations will certainly remain a headwind on growth as firms divert resources to pay debt costs, and highly levered weak non-systemically important firms are in trouble (and many will fail).


A quick update on recent IMF comments.

China's CNY is no longer undervalued after years of appreciation and reforms, according to the IMF in the latest Article IV report on China. This development will help pave the way for China to be included in the IMF's Special Drawing Rights (SDR) when the allocation decision is made in November.

The IMF comments on the CNY, along with the appreciation over the years (see chart below) will make it much more difficult for political arguments that China is a currency manipulator. 

CNY % Apprication vs. Major Currencies Over Last 10 Years

CNY % Appreciation vs. Major Currencies Over 1 Year

More importantly, the developments put the CNY closer to becoming a major reserve currency. SDRs only constitute 5% of reserve assets, so flows from inclusion in the SDRs will not be as meaningful as the acceptance of the CNY as a major reserve currency.  Standard Chartered Plc. expects the IMF endorsement to lead to $1 trillion in reserve assets to be shifted to CNY over five years. A flow of $1 trillion amounts to 8.6% of the $11.6 trillion in global reserve assets.   

It will take a long time before the CNY has the potential to unseat the US dollar as the world's dominant reserve currency (see chart below). China's financial markets are not large and deep enough to replace the USD as a safe haven during times of crisis.  Much more financial and capital account reforms are needed. But, China's fast track push to be a dominant reserve currency will serve to expedite market-based reforms.

Currency as a Percent of Total Global Reserve Assets

China's acceptance as a major reserve currency will give Beijing more prestige globally. But more importantly, it could have two positive effects on China's economy. 

First, a reserve currency push could speed up financial liberalization already in the works and expedite reforms. The rates markets in China are on the doorstep of full liberalization (deposit rates are close to being driven by the market). The investment flow quotas into and out of China increase regularly. Second, an inflow into CNY assets over the next 5 years as the currency becomes a major reserve currency may keep interest rates relatively low. The inflow may also relieve the PBOC's need to liquidate foreign reserves when it wants to keep the CNY stable.

 

China Outlook in a Nutshell: Growth, Housing, and Trade

Here is a brief summary of views on China's growth outlook for the remainder of 2015.  I am restricted by my employer from giving investment advise, so I will stick to broad fundamental views.  For views on PBOC activity, reforms, and policy, see other blog entries.

Growth outlook:

My economic growth outlook is based on three main factors:

  1. Economic activity, especially industrial activity, will continue to soften for some months before Beijing's stimulus measures kick in (see my blog positing "Things will get worse before they get better.")
  2. RRR cuts and fiscal measures will probably begin to boost activity - mostly in the industrial sector - sometime in the summer (see my blog positing "Beijing's stimulus steps so far: what do they mean for growth prospects?")
  3. Construction activity will finally begin to rebound and contribute to growth in the early fall (see my blog positing "Some housing data the only good data in April's ugly economic release.").  This will compound the effects of the fiscal and RRR cut measures in boosting Q4 growth.

Q1 grew at 7.0%, right on Beijing's 2015 target.  Assuming things get softer in Q2 before stimulus kicks in, I am forecasting growth moderating to the high 6%s.  Activity will be boosted in Q3 by the PBOC and fiscal stimulus, along with a consumption boost due to the wealth effect from house prices and equity market gains.  By Q4 property construction will begin to contribute and be additive to growth.  Most of the fiscal and PBOC stimulus will provide support to industry, so most of the pickup will take place in the industrial sector portion of GDP.

Here are my quarterly forecasts:

2015 GDP Forecasts by Quarter, Full Year GDP of Forecast 7.1% in 2015

Q1 is Actual GDP

Housing and construction outlook:

It will be extremely difficult for the Chinese economy to maintain robust growth rates without a positive contribution from the property market.  25 - 30% of the economy is tied to real estate directly and indirectly (urbanization infrastructure, steel, glass, cement, furniture & appliances, and the wealth effect.)  According to the IMF, real estate creates at least 14% of China's urban jobs.  The sector is stuck with oversupply, but with ten million new urban residents each year looking for housing, and significantly low-quality old housing being demolished, inventory can be used quickly when construction declines.  Construction has tanked over the last year. 

We have seen some positive signs from China's housing market (see my blog positing "Some housing data the only good data in April's ugly economic release.").  Sales and prices have turned positive in April after steep declines in the last year, which where in turn followed by declines in construction.  A drop in new units and the roll-back of mortgage restrictions in March has improved prices on an month-on-month basis.  Whether the renewed housing market driven partly by Beijing's efforts to ease mortgage lending will help the market in the short term at the expense of more long-term structural problems is up for debate.  In the short term however, the housing market is looking modestly better, and construction and resource demand will eventually look better this year.

Much of the housing weakness this last year came after a surge in supply in early 2014 (see chart below), exacerbating oversupply built up over years (perhaps 500,000 to a million units of excess supply annually beyond demand and a 20% vacancy rate).  New starts and construction have tanked over the last year.

Improved housing will have two main effects:

Home Ownership Rate

  1. The wealth effect from increasing prices will stimulate consumption.  Over 60% (according to Goldman Sachs) of household assets are held in property and homeownership rates are high (see chart on the right).  Historically, housing is one of the few investment options available in China, so ownership rates are high and investment properties are plentiful.  The improvement in prices should lead to a boost in consumption in Q2.
  2. Sales and price increases will eventually lead new starts, which will be a boost for construction.  This will in turn be a boost to commodity imports, iron ore in particular.  Heavy industries like cement and steel will improve.  Sales lead new starts by 6 months, so expect a construction pickup in the Fall.  Nearly half of all steel consumption goes to construction.  Construction is about a quarter of copper consumption.  

Trade and external position:

Going forward, the CNY will be flat and stable vs. the dollar, requiring continued liquidation of USD foreign exchange reserve assets.  Beijing will try to keep the CNY stable vs. the dollar for various reasons including lobbying the IMF to include the yuan in the special drawing rights (SDR) and maintaining economic restructuring plans.  Considering the PBOC is still easing while the Fed is ending its easing, growth is weak, and investment cash is flowing out of China, significant amounts of reserves will need to be sold to keep the CNY stable.

Exports have declined, as the CNY has appreciated nearly 20% vs. the EUR and 15% vs. the JPY over the year, dramatically reducing export competitiveness.  Exports will continue to stay weak for much of the year due to the currency policy coupled with subdued global growth.

Imports will continue to decline on a value basis, but expect the stimulus-boosting measures to improve import volumes. Copper, oil, heavy machinery, and consumption goods imports will get a boost in the summer from improved investment and the wealth effect.  Iron ore will see a pick-up once construction rebounds.

Year to Date % Change for Selected Commodities vs. Last Year

Crude oil: Crude import demand is expected to increase in H2 2015 for three reasons. First, cheaper oil and the wealth effect from better housing and share prices will improve consumption on a volume basis. Second, domestic production is expected to decline about 120,000 bpd as firms cut capital spending. Third, vast storage containment will come online in H2 2015 to fill China's strategic petroleum reserves. New strategic storage facilities with 50 billion barrels of capacity will be completed in H2.  Refiners are also expected to restock inventories in the tens of millions of barrels over the second half of the year.

Iron ore: Nearly half of China's steel production goes into construction.  A pick-up in the housing market will push iron ore demand higher by Q4.  On top of that, inventories have fallen significantly over 2015, and mining firms have cut investment and production.  Beijing's stimulus will help import demand for iron, but a construction rebound later in the year will bring about a significant pick-up considering the inventory drawdowns so far this year.  

China Copper Consumption % Breakdown

Copper: Copper import demand is expected to grow.  Demand this year is expected by Platts to run around 4-5%.  A pickup in construction will improve demand by the fall.  Beijing's expanded fiscal budget and the "war on pollution" will contribute further to a pick-up in demand.  

Copper stock levels are low, according to Platts, and an 11% decline in imports by volume YTD so far would imply that an import surge is inevitable sometime this year.

 

 

 

 

 

Some housing data the only good data in April's ugly economic release.

Housing prices are looking much better after significant declines over the last year.  Housing sales rebounded in April.  Those two data points where some of the only positive news in April's ugly economic numbers.

Construction and housing sales have been negative most of the last year after significant oversupply hit the market early in 2014.  This is potentially good news for future growth prospects.  Housing has been a huge drag on many sectors of the economy recently.

But, construction remains soundly in the negative.  New construction is still declining, and we won't see a pick-up in heavy industry until construction rebounds.

So, if housing sales are indeed rebounding, how much longer until we see developers increasing construction activity?  About 6 months is the historical time frame in which sales lead new construction, as seen in the chart below.  Housing will probably be a drag on the economy until the Fall.

Important things to note about housing and why you should pay attention to it:

  • By most estimates, the property market  in China constitutes 25% of the economy.
  • Property is a significant source of household investments due to the lack of financial investment alternatives.  Real state is over 65% of household assets.  There is a significant wealth effect from housing prices flowing through to consumption.  Changes in housing prices = future changes in consumption.
  • Debt is not a problem for homeowners (household debt is only about 35% of GDP).
  • Almost half of steel production goes into construction.
  • Housing demand is around 7.5 to 8 million units annually, and supply 8.5 million.  Oversupply, yes, but only modest downside risk for current production.
  • Estimates put urban housing vacancy rates at roughly 20%, compared to 18% in Japan and 2% in the US.

 

China/Brazil trade and investment deal. What's in it?

Li Keqiang and Brazil's President Rousseff announced the signing of a number of trade and investment deals on Tuesday during Li's official visit to Brazil.  This comes on the heals of a number of recent China trade and investment deals in the developing world.  China became Brazil's largest trading partner in 2009, but is currently only the 12th largest investor in the country, so the investment plans are an important development.  This continues China's foray into Latam, where the country lent more than the World Bank and the Inter-American Development Bank combined last year.

Brazil will benefit from an economic fundamental standpoint, but for China the agreements are modest when compared to the overall economy.  For China this is a continuation of checkbook diplomacy and soft power, as well as investing in infrastructure to insure raw commodity supply into the future.

What is in the deals?

Brazil Exports to China % Total

Trade: $27 billion in trade agreements, including an announcement to buy $1.3 billion in Embraer commercial planes and a lift of the 2012 ban on beef imports into China.  

China's exports to Brazil constitue roughly .40% of GDP, so an increase in exports will have only a modest effect on fundamentals. Brazil exports 2.4% of its GDP to China, meaningful, but not as much as some of its Latam neighbors.  These deals should help the terms of trade eventually, which hit a decades low in March and continues to decline.  See the chart to the right for the make-up of what Brazil ships to China.

Investment: China will invest $53 billion in Brazil through various infrastructure projects.  That sum amounts to 2.25% of Brazil's GDP.  Direct infrastructure building has already started, with China State Grid beginning work on 2800 km of transmission lines.  The two countries also agreed on conducting a feasibility study for a rail line linking to Peruvian ports and allowing Brazil to avoid the Panama Canal.

This agreement will be a bit of a boost to Brazil's economy and help with the the country's declining terms of trade.  It will also help China continue to build its position in the world via soft power and keep the commodity pipeline flowing smoothly.

 

The "Li Keqiang" Index: Why is that still a thing?

Some years ago WikiLeaks leaked a memo from 2007 where the future Premier of China, Li Keqiang, stated that he didn't trust the GDP numbers in his province of Liaoning, and used electricity numbers, rail transport, and loan growth to measure economic activity.  Those measures would have been good indicators of activity in Liaoning over ten years ago, but the three have less relevance in China's current broad GDP.  Shortly after the WikiLeaks memo around 2010 a number of outlets began publishing various Li Keqiang based indices that track the changes in those three Li favored measures over time in one combined index.  For an example, see the chart at the bottom.

After seeing a column make mention of the "Keqiang" index recently, I wondered why anyone would still be using it.  Here is why:

Rail transport numbers:

Rail freight was roughly 8.7% of total freight traffic by the end of last year.  Rail trails road and waterway freight by a wide margin.  So, it doesn't represent a broad reflection of the whole economy.  On top of that coal is roughly half of total rail freight tonnage. As coal use declines, so does rail volume.  Forcing coal fire plants and inefficient industrial firms to shut down for the "war on pollution" exacerbates already slowing coal demand.

Electricity numbers:

First, 70% of electricity comes from coal burining, so you are doubling up on your coal exposure with the Li Keqiang index.

Second, heavy industry accounts for more than 60% of electricity usage.  Services and consumption are only about 10 to 12% each.  Many of those firms in heavy industry production are highly inefficient.  As heavy industry slows and firms shutter overcapacity, electricity slows much faster than overall growth.  

Third, efforts to increase energy efficiency have added to electricity usage slowdowns as well.

Bank loans:

Bank loans comprise the largest share of outstanding credit, but other forms of credit are growing in importance.  The growing bond market, shadow banking, share issuance, and other forms of non-banking credit would not be included in the index, leaving out key growth drivers.  

State owned banks also often give priority to state owned inefficient firms, so the index would be biased to tracking state owned enterprise activity.  46% of bank loans go to state owned enterprises.  Only 23% of bank loans go to small enterprises, a group that constitutes 60% of the economy.  The bulk of the economy gets lending from non-traditional sources, not represented in the "Keqiang" index.

So the index is mostly a measure of coal usage, and additionally a measure of heavy industry.  The measure also relies on traditional bank lending in a banking system dominated by state owned firms.  If you export coal or are concerned with heavy industry and smelting activities by state owned firms, then this is the index for you.  But, there is more information value in some of the components of industrial production for monitoring coal and heavy industry.

The "Keqiang" index is a bad index to follow, especially for an economy that now gets most of its growth from the service sector, 49.5% currently, with 42% coming from industry.  There is no meaningful information about services and consumption in the "Li Keqiang" index, another major flaw.

There are much better alternative measures of China's economic activities out there.  Check out my GDP tracker in the "charts and tables" page, as an example of one.

When using the "Keqiang" index to illustrate that China's GDP number is not believable, keep in mind that rail, electricity, and bank loan numbers come out of Beijing as well, and could also be subject to manipulation.  

This is not an endorsement of China's data.  But, if we are going to call into question China's data, the Li Keqiang index is the lazy person's smoking gun.  The issue deserves more statistical rigor than simply bunching together three simple numbers.

And as a side note, there was a Fed paper written a few years back on the reliability of China's GDP numbers, and the conclusion was that the numbers are reliable.  Here is the link:

http://www.frbsf.org/economic-research/publications/economic-letter/2013/march/reliability-chinese-output-figures/

The subject of China data reliability will be included in a future blog.

Li Keqiang chart on the right: Did China really grow at 30% in 2010 and 20% in 2005?  If so, GDP is currently understated and debt to GDP is only 165%. 

My GDP trackers use a more robust statistical analysis.  Here they are:


Things will get worse before they get better.

Expect China's economy to get worse before it gets a boost from the PBOC's recent easing and the expanded fiscal budget.  China's fixed investment has slowed dramatically, to 9.6% YoY in April.  Credit growth is running at the slowest pace in decades.  The slowdown in credit and investment, as well as the negative import data (see previous trade data post) point to weaker economic activity for some time before the RRR cuts begin to boost growth

CreditLag.png

 

It takes roughly 4 months or so before RRR cuts boost activity via credit growth and investment.  This means that we probably have a couple of months of ugly economic data before things start to turn around.

The first RRR cut was in February. Assuming we see more fiscal spending to help with the monetary policy boosts, then it will be Summer before growth picks-up.

Here are what my forecasts show for import demand from select countries for the next three months.  Commodity exporting countries will see terms of trade deteriorate.


Beijing's stimulus steps so far: what do they mean for growth prospects?

There are two major economic factors to keep your eye on this year: Beijing's monetary and fiscal stimulative policies, and the property market.  I will make a few comments on Beijing's policies here, and discuss property later.

There has been a constant flow of news about the PBOC trying to stimulate growth, and the central government's plans to step up fiscal spending.  As I wrote in a prior blog entry, lending facilities are intended to minimize rate volatility and liquidity disruptions, so I will not estimate their effect on stimulating growth.  Lowering benchmark rates are much less effective than they once were, because technically they have not been mandated lower and more rate liberalization steps this year will make the effects uncertain.  Benchmark rate cuts will probably have some effect on growth, but I will not try to estimate that effect, because I think it will be very modest.  Mortgage down payments have been lowered, but until the demand for housing improves, I will not estimate the effects of mortgages.

The two most important interventions out of Beijing are the RRR cuts (See PBOC tools infographic for details) which should free-up money for lending, and the increase in fiscal spending which should increase underlying demand.

The PBOC has cut the RRR twice this year.  We are assuming that the PBOC does one more reserve cut this year, probably in the Fall.  

How much will Beijing’s measures boost growth?

PBOC’s broad easing measures so far this year (not including activity meant to stabilize interest rates and benchmark rate cuts) amounts to a 1.3% expansion of credit if fully utilized, not accounting for a multiplier effect.  I estimate that this credit expansion would result in a contribution of 0.3% to real GDP growth, if historic relationships hold.

Beijing announced an expansion of the budget deficit to 2.3% from 1.8% in 2014. The central government's budget expansion would mathematically amount to another 0.5% if fully utilized, not accounting for multiplier effects.

What pace would we estimate ex-intervention growth?

Assuming underlying growth maintains its deceleration trend (I estimate ex-intervention slowing of .25% per quarter) and without intervention slows to 6.25% by Q4, that would point to 6.6% growth in 2015.

A very simple rough estimate of stimulus boosting by Beijing:

6.6 + 0.5 + 0.3 = 7.4%

This is not to say that 2015 will see growth of 7.4%.  Last year the central government underspent its budget target, so we may not see the full fiscal expansion.  And, over time the effectiveness of credit growth on broad activity has declined, so historic relationships may not hold.  But, my point here is that growth can run over 7% this year, even if the existing stimulus is half as effective as in the past.  Given that consensus is 7% for 2015, I think that there is a good chance that forecasters are underestimating the stimulus measures, and the balance of risk falls on an upside surprise by year’s end.  Also, as growth gets worse into the summer, we may see more downward revisions to growth forecasts, and consensus will fall further.  

Beijing's measures to boost growth will take time, and things will get worse before they get better.

When will we see things turn?

I have calculated that it takes roughly 4 months for PBOC boosted credit growth to translate into economic activity.  3 months after a credit increase you may see some signs, but 4 months seems to be when the bulk of credit growth spreads to the overall economy. That would imply a pickup from the first reserve cut starts stimulating growth this summer, with the second larger reserve cut boosting activity by the fall.  A third RRR cut, assuming it falls later in the year, will boost 2016 activity.

Economic growth probably 6.6% in April.

China's GDP probably grew at 6.6% in April, according to my GDP tracker.  The service sector grew at 7.6%, and the industrial sector at 5.9%.  Data was slow across the board, from production to consumption.  This number will probably get worse before it gets better, due to the time lag between the RRR cut monetary stimulus and its lagged effect on a broad growth boost.

The industrial sector is still slowing significantly. Crude steel production is still declining, and electricity output weak, indicating that heavy industry is still one of the primary drags on broad growth.  Construction related material production, like plate glass and cement, continues to decline.

Real retail sales were much slower than trend, indicating that household consumption was not spared in the broad slowdown. Services also weakened slightly according to my service sector GDP tracker.  

Housing sales were just about the only good data point out of the April number release, growing at 7.6% YoY after some significant declines.  This is possibly a result of the rolling back of housing restrictions, such as lowering the mortgage down payment requirements.


Will China's share issuance help fix China Inc's debt problem?

China's stock market gains have led to record share issuance this year.  Up to May 14th share sales reached 252 billion RMB for the year.

With a 125% of GDP debt burden, business enterprises in china are the main culprits of the country's debt problems. Household debt and government debt are modest by global comparisons. Debt overhang is a significant burden for corporations in China.

There has been talk that record share issuance will help with the debt burden.  Some market commentators have concluded that sales of new shares are helping companies cut debt levels. That is in fact true, but here are the numbers:

New share issuance to May 14th raised 252 billion RMB. If that pace continues, the 2015 total will be 680 billion. 

If we use McKinsey Global Institute's total debt to gdp number of 217%, then at current trends 2015 year end debt to GDP in China will probably be 226% (assuming debt growth of 13% and nominal GDP growth of 8.5%). 

If all new share sale cash goes to pay down debt and we deduct 680 billion from total debt this year, debt to GDP will be 225% by the end of 2015. So, share issuance at a record pace has the ability to reduce China's total debt load from 226% of gdp to 225%. Lower, yes. Meaningful, probably not.

With credit growth still outpacing nominal GDP growth and assuming PBOC efforts to boost credit this year are successful, the only way China's debt burden (as a % of its economy) will be reduced is through defaults of non-systemically important inefficient debt burdened firms.  

Beijing has been preparing for potential financial system turmoil for years.  The PBOC has created new lending facilities to help banks cope with turmoil.  Deposit insurance was rolled-out in May.  Banks have 18.5% of deposits in reserves.  Most debt is held domestically, and a significant amount of it between state owned firms and state owned banks.  The central government has a very low debt burden (22% of GDP) and vast resources (potentially 350% of GDP).  

Expect more corporate defaults by non-systemically important firms going forward without significant risk to the financial system as a whole, and view most of those defaults as a good thing for structural change in China.

PBOC continues to roll-back restrictive policies of the last few years.

China's PBOC has been very active over the last six months, using every tool in the toolbox (See infographic page for information on PBOC tools).  The recent stepped-up PBOC activity and easing is not a shift back to the easy money policies of the late 2000s, but instead is a normalization from very restrictive policies starting in the early 2010s to rein-in the excesses of the post-crisis surge in debt and overcapacity.  As the chart below shows (as well as a dramatic slowdown in outstanding credit growth, seen on my debt chart and table page), rates are relatively high vs. inflation.

The most important tool to watch is the reserve requirement ratio (RRR), and here is why:

  • Many PBOC activities are being employed to minimize rate volatility and reduce liquidity distortions.  China does not have an overnight target rate, like the Fed and ECB, resulting in short-term rates driven mostly by market forces and seasonal disruptions (for example, during Chinese New Year huge numbers of depositors take money out of the banks for gifting, and that cash then returns to the banking system sometime after.  This causes seasonal volatility in rate markets). China's short-term interest rate volatility has been nearly 50 times the rate volatility in the US and 10 times South Korea over the last 5 years.  Direct lending through the SLF and MLF (again, see infofraphics for details) are tools created to limit volatility and disruptions, in a restrictive monetary environment in particular.  These tools are not intended to stimulate broad growth prospects, as their tenors are relatively short-term and therefore meant to manage temporary disruptions in liquidity and before the cash is given back to the PBOC.
  • Lowering the deposit and lending rates are much less effective than they once were.  The mandated lower limit lending rate was already removed for all but property loans. Lending rates are technically set by the markets.  And as deposit rates are lowered, the ceiling for the deposit rate has remained the same because the allowable range above the mandated benchmark rate was increased.  Deposit rates haven't technically been mandated lower.  Private banks can keep deposit rates unchanged, as state-owned banks probably feel obliged to lower them.  Changes to the benchmark lending rates are more about laying the groundwork for rate liberalization & making private banks more competitive than stimulating broad growth.  We are 5 months removed from the first benchmark rate cut, and economic activity has been unfazed.  Lowering benchmark rates will have some stimulative effect, but as rate liberalization takes place the effect is uncertain.
  • Lowering the RRR releases funds for lending potentially for many years to come.  Coupled with expansion of the budget announced in March, we should see a meaningful stimulus to broad growth from RRR cuts.  As far as the PBOC toolbox goes, the direct lending facilities are like a chisel, meant to smooth.  Benchmark rate cuts are like a mallet, meant for specific tasks, but nowadays less useful for big jobs.  The RRR (as long as there is stimulus on the demand side) is like a sledgehammer, heavy enough to get the job done. 

 

New service and industrial sector GDP trackers developed.

China’s GDP is widely expected to grow around 7% this year.  But, 7% does not mean the same thing to all stakeholders.  After decades of rapid growth in nearly all sectors in tandem, within China’s economy divergences are growing dramatically as Beijing reins-in some sectors and stimulates others to force restructuring.

China’s service sector and consumption continue to outpace the industrial sector.  This is important to note, because China’s demand of goods and services from the outside world is dominated by commodities and industrial machinery (why would the world’s biggest maker of things need to import consumer goods from outside).  See my trade info graphic for details on China's import composition.  The effect of rebalancing on demand from the outside world will be asymmetrical.  There are limited beneficiaries from a robust service sector and increased household consumption, but no shortage of China suppliers suffering a significant slowing of commodity and industrial machinery demand.

If you are concerned with negative China headlines roiling markets, then 7% might be the number you want to follow.  If you are concerned with China’s growth rate on fundamentals of companies and countries outside of China that feed China's demand for raw materials and machinery, then a more granular analysis is required.  7% is not the number you want to watch.

For this purpose I have split my GDP tracker into two parts: services and the industrial sector.  As you can see from the chart below the industrial sector has been weakening much faster than services.  For most of China's suppliers, China’s growth might as well be closer to 6% (a significant drop from 14.5% five years ago), not 7%.  If you are a coal or metals exporter, China’s growth might as well be negative or in the very low single digits, as most heavy industries have decelerated much faster than overall industry.  If you supply the raw materials for China's construction market (almost half or China's iron ore demand is used for construction), then demand will continue to decline until we see a pickup in new starts. 

As consumption driving reforms unfold and the service sector continues to outpace industry the divergence will grow.  It is probable that the industrial sector slows to the a rate in the low 5%s over the next year or two, as the overall GDP number moderates only slightly from its current 7% pace.  And as mentioned, that low 5% growth rate will be the effective of growth for most of China's suppliers.


Weak trade data in April '15. Fx and slow commodity demand primarily to blame.

Trade numbers were in the negative YoY in April.  Much of the export decline can be explained by a strong currency vs. trade partners, as Beijing has refrained from weakening the CNY to boost competitiveness. The CNY was up roughly 19% vs. the EUR and 15% vs. the JPY over the last year, feeding through to the declines in exports. We should expect to see weak exports for months to come, which will be a drag on overall growth prospects this year.

Imports, one of the best gauges of short-term activity outlooks, declined significantly, -16% from last year.  Much of this is a result of commodity price declines, but after accounting for price declines the underlying import number is probably somewhere around -7-8% on the year.

Commodity exporting countries continue to feel the brunt of China's import demand weakness.  This will continue until Beijing's fiscal and monetary stimulus reach the broad economy, and/or the housing market turns back to the positive.

My import and commodity demand forecasts are still hinting at continued declines over the next few months.

Commodity imports on a volume basis:

Soybeans -18% YoY, iron ore -4% YoY, copper -5% YoY, crude oil up 9% YoY.

 

Quick Update: With its credibility on the line, the Beijing pushes forward easing

Last month Beijing intervened in the stock market and in doing so added to the list another market to support - along with property, credit, and the CNY (see my posting China stock market interventions are a setback to reforms.).  As China's shares went into free fall, Beijing had to step in to maintain its credibility.  The result has been the biggest monetary boost of the year.  The broad RRR was cut 0.50%, potentially unleashing $100 billion into the market for lending, and the lending and deposit rates were cut 0.25%.  Beijing has stopped its targeted easing and unconventional stimulus in favor of a broad traditional cut in rates and RRR.  Its has unloaded its biggest guns to shore up confidence.

With the cuts came the long awaited liberalization of China's deposit rates.  Historically, China controlled the rates banks could pay depositors.  The overnight actions by the PBOC removes some this control, giving the market sway over the majority of bank rates in the economy.  The move was probably a concession to reformers.  Banks will still have political pressure from Beijing when setting rates, but the move will allow more competition in banking.

As mentioned in earlier blogs entries, PBOC easing cycles historically see at least three reserve cuts each cycle.  Many, including myself, expected the cuts to come later in the year, but the stock market declines forced the PBOC to move those cuts forward.

The easing measures have stopped the global market sell off, and should provide some modest support for growth.  But, as mentioned in past blog entries, monetary easing measures have been offset by Beijing's reining in of shadow banking and cleaning up of local debt (see my blog post Reflation Troubles.)  These measures will probably do more for growth later in the year, and have a lower impact than monetary boosts in past years.

The primary growth boost we will see this year - from both fiscal spending that has been slow in arriving and a property market rebound - will arrive this Fall.

Overall, the cuts have been good for stopping the global sell-off, but we should be cautious in forecasting what the cuts will mean for the real economy.  In the near-term, after intervening a second time and putting its credibility on the line again, Beijing will be stuck supporting the markets for some time.