Quarterly Publication - July 2017
Whither China? - July 2017
As we enter the second half of 2017, China is easily the biggest wild card in the global economic outlook. On the one hand, mainland growth has proven to be very resilient; local consumer demand is strong, corporate earnings have rebounded and buoyant import spending has provided a much-needed tailwind for its Asian neighbours as well. On the other, since the beginning of the year the government has placed renewed emphasis on deleveraging and balance sheet control, sharply curbing excessive financial flows and tightening credit.
That is not all; China also faces an unpredictable political environment, as the upcoming 19th Communist Party Congress will allow president Xi Jinping to reshuffle the top leadership ranks and consolidate his power. If successful, many feel that the removal of weaker and opposition players could lead to meaningful changes in policy direction.
Finally, markets are continually worried about financial risks. Chinese debt ratios have been rocketing this decade, and the renminbi already experienced one sudden and sizeable ‘run’ in 2015/2016. How does this all play out for the rest of the year and beyond?
Here are four trends investors should consider:
For starters, there is no question that China is tightening. Emboldened by the strong economy and the visible upturn in corporate profitability over the past few quarters, the government has encouraged financial regulators to ‘go to town’ in curbing the banking and credit excesses that characterised the previous two years. This included wild balance sheet expansion in the form of opaquely structured investment products, essentially hidden loans intermediated through non-bank financial institutions; dramatic growth in interbank borrowing and lending as well as wholesale funding from shadow banks; and an explosion in direct local government borrowing via bond issuance to banks.
All of these items grew rapidly in 2015 and 2016, but since the beginning of this year new issuance of all has dropped nearly to zero. The result is a sharp drop in the volume of total ‘effective’ credit extended; Emerging Advisors Group’s own flow credit impulse measure is now approaching the lowest recorded level in the post-2009 era, which makes this a serious policy shift indeed.
What impact will this have on the overall economy? Balance sheet retrenchment particularly affects local governments and their affiliated development- and infrastructure-related corporate entities, and in the second half of the year China should see a visible slowdown in new project starts and ongoing investment activity. More important still, there will also be an effect on private property markets. The relationship between aggregate credit flows and new housing sales is one of the strongest in China, and it is hardly surprising that residential demand has already started to tail off over the past few months. As the property market continues to weaken, there will also be a gradual but steady drop in related construction activity, reducing the use of steel, cement and other basic materials.
Add to this our jaundiced view of the sustainability of the current global trade upturn – which has provided tremendous support for the Chinese recovery of the past three quarters in its own right – and by the end of this year China will have gradually moved from an economy firing on all cylinders (infrastructure, property, exports) to an economy firing on none. We are not talking about a growth collapse by any means; mainland consumer demand is relatively protected by the lack of leverage exposure in the household sector, and this lends China a strong element of stability. Nonetheless, from nearly 7% year on year currently, we would expect most private estimates of growth to fall well below 6% by the fourth quarter of 2017.
FADING SUPPORT FOR GLOBAL MARKETS
This, in turn, has big implications not only for China but for other emerging markets as well, in two ways.
The first is through weaker commodity prices. Global prices for ‘China-related’ ores and materials – not oil per se, but coal, iron ore, copper, aluminium and steel – have fallen about 12% on average since January peaks on the back of tightening fears, and the downturn is likely to continue through the second half of 2017 as China’s real economy slows as well. Needless to say, this has big implications for exporting countries from Brazil to Indonesia to SA.
The impact is not limited to commodity producers. There will also be a negative effect on Asian neighbours that supply capital goods and semi-manufactured products into the Chinese industrial machine. The rest of Asia has been a big export outperformer in volume terms over the past few quarters, with almost all of the increase coming from mainland demand. China’s own import trade volume data are notoriously volatile and unreliable, but available trade figures from major partner countries show a clear trend: from outright contraction in the beginning of 2016, Chinese real import spending was up by an eye-popping 20% year on year by the end of last year, making this the biggest recovery of the decade.
But of course that import recovery has been driven by a combination of strong domestic upturn in property and investment along with the cyclical improvement in global manufacturing export demand – and again, both of those trends should be fading away in the coming quarters. As a result, we expect Chinese import volume growth to fall to the low single digits by year-end, which implies a broad macro slowdown across Asia as well.
RENEWED EASING CYCLE IN 2018
That is the picture through to the end of 2017. What about next year?
The answer, for us, lies in renewed policy easing.
This may come as a bit of a surprise for those who follow the current political calendar. Remember that the Chinese Communist Party undertakes its congresses in a five-year cycle, with a spate of leadership changes across the party structure in the opening year of each congress. The upcoming 19th Congress will take place towards the end of the year, and while there is no doubt that president (and party secretary) Xi will remain in his post for a second term, there will clearly be a number of big changes directly under him at the Politburo and Politburo Standing Committee level.
The common assumption in the global press is that this midterm leadership transition represents a major watershed for the Xi administration. Once he has sent off a number of retiring senior opponents and ensured that his handpicked supporters take their place, thus cementing his political position once and for all, the argument is that Xi will show his true colours, putting less emphasis on growth and more on reforms – even if it means potentially serious pain for the economy.
The reality is almost certainly the opposite. To begin with, there is little evidence to suggest that president Xi is a closet economic reformer. To the extent that he has weighed in on economic topics at all, he has vocally and often repeated that his main priority is for steady, relatively rapid growth, at a minimum of 6.5% per annum in order to achieve a doubling of real incomes during his tenure. Indeed, this was the driving reason behind the massive stimulus-fuelled balance sheet expansion in the first place.
Yes, Xi has been happy to give in to demands from the central bank and from regulators to carry out tightening this year … as long as the growth numbers are more than comfortable. But as the economy slows through the second half of 2017 and into 2018, leading to renewed worries about corporate health, profitability and employment, we fully expect the policy pendulum to swing back in favour of pressure on banks to lend out via all available channels to support the pace of expansion.
NO FINANCIAL CRISIS … (YET)
On a final note, what about the much-touted crisis scenarios? China has added more than the equivalent of 100% of its GDP in financial debt in the past eight years alone, an astounding figure by emerging market standards – and one that takes overall debt levels close to developed-country levels (again virtually unheard of for a low- or middle-income economy). Is this not a bubble, fraught with tremendous risks in the banking and corporate sectors?
There are risks, no question, and our own long-standing conclusion is that China will not escape this debt boom without pain. Moreover, as tightening continues this year we are likely to see some signs of financial and corporate fragility.
However, we need to stress that 2017 is not the year that China’s financial system falls apart, in the sense of major funding crises or true Minsky shocks.
Why? Because what really matters for financial fragility is not debt itself but rather the funding structure of the debt – and here exposures are building more slowly. China will still reach an eventual crisis point if the government continues to pump credit into the economy indiscriminately, but by our estimates true systemic fragilities will only start to appear three or four years down the road, at the beginning of the next decade.
This is all the more true given that while the authorities may be pursuing a regulatory crackdown on credit and quasi-credit activity, they are not pulling liquidity wholesale from the system. In the past six months, there have been some of the strongest policy tightening rounds since 2009 in terms of new credit flows, but still one of the weakest in terms of the behaviour of short-term interest rates, which remain profoundly low as we write. Simply put, the central bank is doing everything it can to avoid any hint of illiquidity in the system, which significantly lowers the near-term risk profile.
The same analysis holds for the exchange rate. China had a sizeable renminbi scare in 2015/2016, with large, sudden capital outflows that caused the country to lose nearly $1 trillion of its $4 trillion foreign exchange reserves pile. Since then, however, the authorities have made an all-out frontal attack on outflows in the form of sharp restrictions on capital convertibility and an intensified commitment to broad stability against the trade-weighted basket. This programme will not hold off currency pressures forever – indeed, no peg/ quasi-peg could possibly survive the exponential growth of domestic liquidity against the backdrop of flat or falling foreign reserves. However, once again, our analysis suggests that true flash points are still a number of years away on the exchange rate front, and until then things are likely to be relatively quiet.
In sum, investors do need to be vigilant and aware of risks in the Chinese economy. But there is no ‘run for your life’ moment coming any time soon. For the time being, it is all about a gradual slowdown over the year to come.