China’s stock markets have dominated the news recently, but the main risks for H2 2015 growth prospects are the headwinds to Beijing’s stimulus policies. Q2 GDP came in on target, running at 7% growth overall. But, the industrial component, important to commodity demand and China's economic passthrough to other economies, slowed meaningfully to 6.1%.
Quick Data Update: Q2 GDP grew at 7%, driven by a strong service sector.
Quick Data Update: Trade data improves in June. The improvement is much better than the headline numbers imply.
China trade activity improved significantly in June, in a positive sign for growth prospects in H2 2015. Exports rose 2.1% from last year. 2.1% may not seem like a big number, but given the yuan's rally vs. major trading partners (up 19% against EUR, and up 18% vs. JPY), it is a very solid number. Rising exports after a massive currency appreciation is a pretty big feat.
Imports dropped 6.7% from last year on a value basis, much better than the 18% annual decline in May. But, factoring in the drop in commodity prices over the last year, import volume was probably up around 3% on the year. Much of the improved import number was due to the reduction in consumer goods tariffs in May. Commodity demand was mixed.
Things to note about China's trade numbers:
- Exports to the US rose 12% from last year.
- Exports to Europe declined 3% from last year.
- commodity import demand was mixed: Iron ore 0% change from last year, copper down 2%, but crude oil imports surged 27% from last year. Coal imports dropped 34% from last year.
- Most of the export gains went to countries along the Asian manufacturing supply chain, in a positive sign for Asian growth prospects.
- Imports from commodity countries continued to drop, primarily on price declines.
- Import tariffs were cut for a number of consumer goods in May, adding to June import demand.
How does this happen in the world's second largest stock market? Chinese firms halt trading in their shares to stop the price declines.
Chinese companies have found a way to keep their stock prices from declining: Halting trading in their shares. Roughly 1000 Chinese firms have now halted trading in their shares as of Tuesday's market close, a third of the market according to Bloomberg.
Corporations can use any number of reasons to request a halt on trading: Restructuring, planned share placements, or a pending release of a "significant matter", for example. Most firms have recently cited "significant issues" as the reason to halt trading. According to regulatory rules, companies can suspend trading for up to three months.
Firms that halt trading without good cause will face fines. But, companies that have removed shares from trading must have found the fines favorable to potential double-digit declines in market values.
Many mainland retail investors are viewing the share trading suspensions positively. Some trading halts would potentially stabilize the market, but I can't help but think that a third of the market removed from trading will dramatically reduce confidence. The Shanghai exchange opened with an 8% drop, but as of this posting the losses had moderated to 4%.
China stock market interventions are a setback to reforms.
Policymakers that seemed to be making headway tackling financial system risks and pushing market reforms forward now seem ready to create a brand new structural risk where none had existed before. The choice to intervene in the stock market may damage efforts to reform the financial system as well as potentially create future risks.
The stated bailout at this point appears to be small, $19 billion USD (0.23% of stock market capitalization). The PBOC also announced it will "provide liquidity assistance" (no amounts specified) to brokerages via the China Securities Finance Corp., directing funds to non-bank financial intermediaries for the first time. The precedent is significant. The PBOC is now supporting brokerages. And, policymakers have set a line in the sand for stock market losses that may force them to take greater action going forward.
Does it make sense to bail out a stock market up 81% over one year? If you are concerned with stability above all else, then maybe yes. But, in bailing out shareholders, Beijing has created another perceived implicit guarantee for one more market, on top of credit and property markets.
The market correction will have limited effects on the real economy over the near-term. The stock market spectacular rise and fall is less than a year old and has had very limited effect on the real economy to date (see my blog posts:China's stock market surge by the numbers., and China stock market returns and the real economy. Just how disconnected?).
But, by backstopping share prices, Beijing has significantly damaged its efforts to force market discipline into the financial system. Reducing shadow banking activities, decreasing local government debt risks through the swap program, allowing firms to default and fail, slowly opening the capital account, and refraining from devaluing the currency have all been tough-love policies for the better. Intervening in the stock market is a setback to reforms.
China's potential reasons for intervening in the stock market seem plentiful.
- Beijing could be worried about consumer confidence. But, stocks are held by a small minority of the population. And, investors are probably postponing consumption spending in order to buy shares. A sharp drop in prices may convince them to stop.
- The bull market has made it easier for innovative service and technology firms, important sectors for China's future, to obtain funding. More share price declines jeopardize that funding.
- Beijing was probably in favor of an extreme bull market in order to allow indebted firms to swap out debt for IPO money. If IPOs dry up, access to non-bank financial intermediation is reduced.
- Beijing could be worried that wealth destruction for urban middle class households will cause problematic social instability.
Whatever the reasons, by backstopping the $8 trillion dollar stock market, Beijing has harmed efforts to force discipline on investors. Lack of market discipline, whether in the property market, wealth management vehicles, or other credit markets, is the primary source of many of China's risks and structural problems.
More guaranteed risk taking in the financial markets may have negative consequences in the long-term and could require more complicated and difficult policymaking to fix market distortions in the future.
China's stock market volatility is crazy, and who knows where we go from here.
After a spectacular rise of over 150% in one year, adding $6.5 trillion dollars in wealth to China's investors, China shares have fallen 28% from their peak as of July 3rd. It is not clear when the decline will end.
Beijing has accelerated intervention to stop the market decline. Over the weekend, China's 21 largest brokerage firms announced a plan to spend $19.3 billion USD to attempt to stabilize the markets after weeks of free fall. The firms will directly buy stock funds as long as the Shanghai composite is below 4,500. The plan could add a floor to the market by boosting sentiment in the short-term, but it is hard to know whether $19 billion, 0.23% of total market capitalization, will have a measurable effect beyond a temporary boost in sentiment. The PBOC also announced it will "provide liquidity assistance" to brokerages via the China Securities Finance Corp., directing funds to non-bank financial intermediaries for the first time. Additionally, IPOs have been delayed in order to keep liquidity in the market to help stabilize share prices.
The primary reasons for China's spectacular stock market volatility are: 1) Most of the surge has been driven by new investors piling into the market. 2) Stock prices have been highly disconnected from the real economy, driven nearly completely by behavioral factors. 3) Margin debt has skyrocketed and fallen, first adding leverage and then forcing sales. 4) China has $21 trillion in savings deposits and a very limited history of investment losses; a lot of investable capital and limited risk aversion.
China's equity markets are operating in the realm of extreme behavior driven investment. The markets have disconnected from the real economy (see my blog posting" China stock market returns and the real economy. Just how disconnected?") and rational behavior seems to have been overwhelmed by exuberance, greed, and panic. Making a forecast on where share prices will go from here in the short-term would be pure speculation as irrational behavior is impossible to predict. See my blog posting "China's stock market surge by the numbers." for more info.
That being said, given the share price disconnect from the real economy, a continued stock market decline may have very limited consequences on the real economy. Consumption and stock prices have been negatively correlated for the last year. Many Chinese have put off spending to divert money into the hot stock market. Losses (up to a certain point) may introduce risk into the market and convince Chinese consumers to divert income back to spending. Production and investment have also decelerated during the market surge over the last year. $6.5 trillion USD of wealth creation had no positive effects on real economic activity over the last year. In fact, that massive wealth creation has inhibited consumption growth. It is likely that a loss of some of that wealth will not drive down that same economic activity.
Some interesting points on China's stock market roller coaster ride:
- Bloomberg estimates that individual investors accounted for 80% of recent stock market transactions. As of the end of May, new market investors increased 83% from the previous year, according to Blomberg. 4.4 million brokerage accounts were opened in the last week of May.
- Margin debt reached a total of $330 billion in June, and over the last month has fallen to $220 billion USD as the market collapse forced selling.
- The value of all of China's shares from May 2014 to early June 2015 increased by a total of $6.5 trillion USD, nearly as large as the combined GDP of Germany and the UK. $6.5 trillion USD equates to a paper wealth increase of $4,800 for every person living in mainland China over the last year. That number has fallen to $4.2 trillion in wealth created over one year to July 3rd. $6.5 trillion of wealth gained in a year, and $2.3 trillion of that wealth lost in one month.
- China now has roughly 90 million stock investors, roughly 8.5% of the population.
- In the first 6 months of this year, 188 new companies listed on the Shanghai and Shenzhen exchanges.
- The Shanghai index trades at 15 times earnings, compared with 11.9 times for the MSCI EM index, according to Bloomberg.
- According to Capital Economics, foreigners own 1.5% of China's shares. The volatility and pain from losses will be primarily felt by domestic investors.
- Retail sales and Shanghai stock prices have been negatively correlated by a measurable amount over the last year as consumers delay spending and divert funds to stock purchasing.
Quick Data Update: PMIs show manufacturing is stable but still weak; services rebounded.
Bottom line: Manufacturing remained weak in June. New orders are flat, hinting at a weak July. Employment PMI remains below 50, a worry for Beijing's primary economic policy goal of employment stability. But, services look much better in June, new orders in particular. Given my GDP trackers are running around 6.7% so far in Q2, the improved service PMIs hint at a modest improvement in June and a Q2 growth number around 6.7-6.8%. But, we will certainly need to see more data to increase our confidence in that number.
China's June manufacturing PMI was unchanged from May at 50.2, a weak but stable reading. New orders remained flat at 50.1. Employment came in below the 50 level, implying a contraction, at 48.
Services rebounded to 53.8 from 53.2, well above 50. Service new orders have bounced back to 51.3 The service numbers hint at a modest improvement in overall activity in June.
New Infographic: Capital Flow Schemes
China's capital account has been highly controlled and regulated by Beijing. Over the last decade, China has started a growing number of schemes to open the country to foreign investment and allow citizens to invest savings overseas.
Schemes officially allowing investment capital in and out of the mainland include: QDII, QFII, RQFII, Shanghai-HK connection, and will be expanded to QDII2 and a Shenzhen-HK connection soon. Capital account liberalization is happening at a rapid pace but has a long way to go.
The potential for Chinese overseas investment is massive. China bank deposits now stand at $21 trillion USD, double the size of China's GDP. That massive savings will have implications for the investment world as money flows out of the mainland. In the US for example, Chinese citizens have recently replaced Canadians as the largest foreign investors in the housing market.
The success of recent investment programs, like the Shanghai/Hong Kong stock exchange connection, has illustrated the potential for investment inflows into the mainland from overseas investors.
The new infographic below explains the details of each of China's investment inflow/outflow official programs.
Quick Data Update: Benchmark rates cut again. These rate cuts are different.
- 1 year benchmark deposit rates cut 0.25%, to 2.00%
- 1 year benchmark lending rates cut 0.25%, to 4.85%
The PBOC cut key benchmark rates over the weekend by 0.25%. But, it is what they did not do that was important. The last few deposit rate cuts in this cycle included an increase in the allowable range around the benchmark deposit rate. The mandated ceiling on deposit rates remained unchanged with each cut. For that reason, the last few rate cuts were as much about laying the groundwork for deposit rate liberalization as they were about easing.
The rate cuts this weekend did not include an increase in the allowable range. So, the cuts were all about monetary easing this time.
Whether the stock market plunge was a consideration for the rate cuts is debatable. The cuts were made in tandem with targeted reserve changes to agricultural and small business lenders, which would imply that these measures were planned well ahead of the market plunge. But, the cut will have a positive effect on market sentiment regardless of whether that was the intention.
Real rates are still relatively high on a historic basis, implying that monetary policy remains too restrictive. Inflation, money supply, and growth are outside of targets, and the year is almost halfway done. The cuts were most likely a modest easing measure to nudge growth higher and indicators closer to targets and roll-back restrictive policies (see chart on the right).
A broad RRR in my view is still the most potent easing measure in the PBOC toolkit, but also the most dangerous for potentially fueling investment excesses. This rate cut is a possible sign that more potent RRR cuts are not imminent, and easing measures may be taken in more modest steps.
All in all, the cuts are good for sentiment and will provide modest help to sluggish investment growth, one of the main impediments to growth prospects. The cuts push back broad RRR easing prospects, but should improve Q4 prospects even more than I previously expected.
What if I am wrong about a hard landing? What countries are at risk and what countries should we not worry about?
I have for some time held the view that a dramatic and sudden drop in China's economic growth rate, a hard landing, is highly unlikely. Growth is decelerating to some sustainable long-term rate, but in a very managed and gradual manner. Xi and Li have unleashed a tough love policy to rein in excesses and encourage market-based growth, but Beijing has no desire to suffer the fallout from massive sudden unemployment and a dramatic decline in perceived economic well-being. There are many impediments to the success of economic restructuring, but I think the odds on at least a modest success in restructuring are higher than zero success.
But there is certainly a risk that I could be wrong in evaluating a number of widely documented risks, including debt, malinvestment, asset bubbles, etc.. This blog post briefly looks at how a sudden drop in China growth (a sudden drop to 3% for example) affects the rest of the world. I ran some scenario models on selected countries to help with this exercise.
China dependent and non-dependent countries.
Many warnings on China hard-landing scenarios focus on countries with direct trade ties to China. Commodities and capital goods are China's main imports (see my China trade info graphic for details), and countries that supply China will feel the effects of a drop in China demand. Countries such as Australia, Brazil, and Korea are commonly cited as countries at risk due to their sizable direct trade links to China.
But, China accounts for 14% of global output. Therefore, it is important to not overlook economies highly sensitive to global growth, even if the direct links to China are limited. If China drops, the global economy will slow significantly, and the effects will be felt by economies sensitive to global growth. Czech Republic is a good example. Czech is a workshop for Germany's massive manufacturing export machine. Exports are 80% of economic output in the Czech Republic, and many of these exports are components that end up in China and countries tied to China. Czech Republic growth will suffer significantly in a China 3% growth scenario, more than many other countries, even if it is halfway around the world with limited direct links to China.
Countries directly tied to China's trade demand are at risk. But, countries with high sensitivity to global growth and commodity reliant economies are at risk as well, even with no direct trade links to China.
The chart below shows the results of my scenario models forecasting the potential growth outcomes for selected countries.