China's Economy "Bottoming Out"? - Not So Fast!
While China's equity index continues to plumb new depths, the macro data of the past two weeks has been the crutch for US equity bulls losing faith in the fiscal cliff negotiations - growth is up, investment is up, and inflation is down - with analysts hailing the news as evidence that the Chinese economy has "truly bottomed out." As Michael Pettis, of China Financial Markets, notes though "I think we need to be very cautious and refrain from allowing ourselves to get too caught up in the huge sigh of relief that the sell side is heaving. Growth rates in China will continue to slow dramatically in the next few years, and if there are temporary lulls, as there must be, these do not represent any sort of “bottoming out” at all." His perspective is simply that Beijing cannot afford 'politically' to allow the transition/adjustment/reforms to take place too fast - and occasionally needs "to step on the investment accelerator." The bottom-line, he notes, is that "you can get as much growth as you like if you expand credit, but once expanding credit has become the problem, it cannot also be a permanent solution to slower growth. The country’s balance sheet continues to deteriorate – and the most recent growth spurt implies faster deterioration – and this, ultimately, is the main constraint of the Chinese growth model."
SHCOMP vs HSI or Industrial Output vs PMI
Via Michael Pettis, China Financial Markets:
The big news in the past two weeks has been the slew of economic data suggesting that China has firmly turned the corner on its economic closedown.
I think we need to be very cautious and refrain from allowing ourselves to get too caught up in the huge sigh of relief that the sell side is heaving. Growth rates in China will continue to slow dramatically in the next few years, and if there are temporary lulls, as there must be, these do not represent any sort of “bottoming out” at all. They simply represent the fact that Beijing cannot afford politically to allow the adjustment to take place too quickly, and from time to time Beijing is are going to step on the investment accelerator to speed things up temporarily.
Doing so of course will only make the adjustment longer and more painful, but given how difficult politically the transition to a balanced economy is likely to be, we would be crazy to expect otherwise.
You can get as much growth as you like if you expand credit, but once expanding credit has become the problem, it cannot also be a permanent solution to slower growth. The country’s balance sheet continues to deteriorate – and the most recent growth spurt implies faster deterioration – and this, ultimately, is the main constraint of the Chinese growth model.
Within the banking sector we are seeing all kinds of strains as companies and banks stretch for liquidity. Large-company receivables are growing quickly, as are payables (no one, it seems, wants to part with cash), loans simply are not getting repaid, and deposits are no longer growing, perhaps because flight capital is more than enough to offset China’s very high trade surplus.
Remember that thanks to disguised flight capital and commodity stockpiling the surplus is almost certainly a lot larger than reported, and yet banks are still feeling the liquidity squeeze. And for all their happy noises, the authorities nonetheless are worried, at least about certain parts of the banking system.
Most worrying of all Charlene Chu, perhaps the only analyst who actually understand what is happening in the banking system, released a new report with Fitch Ratings that is described in a Reuters article:
Fitch Ratings says faster growth of broad credit in Q312 was one factor behind the recent improvement in Chinese economic data. In a comment published today, the agency highlights that, after slowing from Q411 to Q212, broad credit is back on track to surpass CNY17trn (USD2.7trn) in 2012.
Fitch’s measure of broad credit includes shadow and offshore sources omitted from the central bank’s official total societal financing metric.
“This marks the fourth year in a row that net new credit will exceed one-third of GDP,” said Charlene Chu, Head of Chinese banks’ ratings at Fitch. At current growth rates, by 2013 China’s banking sector assets will have expanded by nearly USD14trn since 2008. This is equivalent to replicating the entire US commercial banking sector in just five years. Such massive balance sheet expansion has limits, according to the agency.
You can accelerate investment forever
It is, to me, astonishing that China in just five years is “replicating the entire US commercial banking sector”, and yet so many analysts are expressing delight with China’s return to growth. Of course you can generate growth if you force such a tremendous expansion in credit, but this is simply unsustainable.
I know I’ve said this many times, and I apologize for boring regular readers, but while I expected that politics would require a jump in growth over the rest of this year and the beginning of the next, this “good growth” tells us nothing about the health of the underlying economy. It only tells us how difficult politically the transition is likely to be.
My guess is that the more difficult the consolidation of power, the longer the period of above 7% growth – so the happier the sell-side analysts are, the more worried long-term investors should be. At some point growth will start dropping rapidly again, and of course the same analysts who are now hailing the return to rapid growth will assure you, when growth begins to slow sharply again, that this was part of Beijing’s plan and was fully predictable. China is slowing because Beijing wants it to slow, they will say, and that’s a good thing. Meanwhile the fact that China is speeding up is also a good thing.
I also published for Foreign Policy last week a longer piece on the challenges facing the new leadership in China. My main argument in the Foreign Policy piece is that both historical precedents and a common sense understanding of the rebalancing process suggest that politics, not economics, will determine China’s success. So far Beijing has succeeded largely because of its ability to collect and control the total savings of the country, and unleash waves of investment whenever necessary.
Many countries have done the same things, but once credit expansion is no longer efficiently invested, few countries have made the transition to a different growth model. Powerful groups who benefitted from the old growth model – in China they are referred to generically as “vested interests” – have always succeeded in diluting or preventing the necessary reforms.
The rebalancing always occurs anyway, either in the form of a debt crisis and negative growth or in the form of a long period of no growth and slow rebalancing. Some times – very rarely – the country completes the rebalancing and then moves swiftly on to becoming a developed country, but this doesn’t happen often. Of the dozens of developing economies that have experienced investment-driven growth miracles in the past 100 years, the only ones that have managed the transition to developed country status are South Korea, Taiwan, and maybe Chile. This is a pretty limited success ratio.
China’s previous success, in other words, tells us noting about how it will manage the next stage, and the precedents give us little reason to assume that the country can’t help but advance to the next stage of development. In fact the more confident Beijing is that it will manage the transition successfully, the less likely it is to succeed, which is why I am delighted that policy advisors seem so much more pessimistic than sell-side analysts. What happens to China will be determined largely by the political decisions it will make in the next few years, and it is foolish to assume we know how things will turn out.