Only if irresistible political necessity demands it will we see anything like a repeat of the 2009 credit splurge. Much more likely is an acceleration of reforms in the financial sector, coupled with continuing modest monetary policy loosening. The message is this: China is embarking on one of the most difficult traverses in economic history – moving from an exogenous growth model to an endogenous growth model. Most economies that try it fail: China is under no illusions about that. But there is no choice but to make the attempt. Which is why we had better get used to growth under 8%.
From almost all sides
(government, media, financial industry) we are invited to believe
that China's downward cycle is at, or very near, its inflection
point. The Bloomberg consensus forecast embodies such a view – GDP
in the first half will average around 8%, but this will recover to
8.5% by the end of the year, and accelerate further during 2013.
Before we start
thinking about the possible motors for such a revival, understand the
maths of those forecasts. The consensus holds that after slowing to
7.9% during 2Q, China's underlying growth will revert to the average
seasonal patterns observed in the recent past: that's how you get to
8.5% by year-end. If, by contrast, China's growth continues merely to
underperform in the same way it has done during the last 12 months,
we should expect growth of around 8% in 2H. If it underperforms as
it has in the first half of the year, mark that down to 7.6% in 2H.
If things get worse. . .
Structural Impediments: ROC and Cashflows
So much for the maths
of it, what about the economics? First, let's remind ourselves first
of the fundamentals, and then at how recent indicators are
performing. The fundamentals are discouraging: with China's stock of
fixed capital growing at slightly over 19% a year (assuming a 10yr
depreciation), whilst nominal GDP growth slowed to 12.1% yoy in 1Q12,
we can be certain that China's asset turns are falling. If so, then
return on capital is almost certainly still falling, unless the fall
in asset turns is offset by increases in financial leverage, or
operating margins. Neither seem likely: bank loan growth is running
at 15.7% yoy, and both the details of PMI surveys and export pricing
(April and May pricing of US imports from China) have nothing to
suggest pricing strength. More, even China's data shows industrial
profits falling 1.6% yoy during the first four months.
The corollary of
falling ROC is not merely falling profits, but drying cashflow. And
we can witness this from the balance sheet of China's banking system:
during the first five months, China's banks took in 580bn yuan more
in deposits than they lent out in new loans – during the same
period last year, the net deposit inflow was 1,980bn yuan. In other
words, about three quarters of the net cash inflow to China's banks
has gone missing so far this year.
Falling ROC also
catches up with the efficiency of bank lending as a motor of economic
growth: lower ROC means lower income from any particular investment,
including bank-financed investment. Consequently, China's monetary
velocity (M2/GDP) has retreated to the lows it saw in 2010, in the
aftermath of China's lending splurge.
So not only are bank
cashflows deteriorating, but the money available to lend also
generates a diminishing amount of economic activity. (I have
previously written about how this also effects China's export
industries.) These fundamentals furnish no compelling reason to
expect an early cyclical upturn – rather they illustrate how
China's savings/investment intensive exogenous growth model is
blowing itself out.
Cyclical Indicators
What about more
immediate cyclical indicators? I track momentum changes in indicators
for domestic demand, the industrial sector and in monetary
conditions, all expressed as standard deviations away from
seasonalized historic trends. As the chart below shows, both domestic
demand momentum and monetary conditions remain as negative now as
they were during the latter part of 2008, before the fuse was lit for
2009's dramatic credit splurge. The difference is that the industrial
sector has regained some modestly positive momentum over the past few
months.
The domestic demand
indicator tracks retail sales (up 13.8% yoy in May, still losing
momentum); auto sales (up 22.9% yoy in May, with momentum 0.5 Sds
above trend); urban fixed investment (up 21% yoy during Jan-May,
+0.29 Sds from trend); the real estate climate index (1.3SDs below
trend). Overall, the last six months, momentum has fallen in five,
including May.
Monetary conditions,
though negative, may possibly be flattening out, although growth
momentum of monetary aggregates remains 0.9SDs below trend.
Additional monetary loosening is being partly counteracted by the
strength of the Rmb against the SDR (waning now, but still up about
6.5% during the last 12 months), and the rise in real rates as
inflation retreats. Overall conditions, however, are still
punishingly tough. In the near future, it is pretty clear that
sharply rising bad loans (see this article) and stalling credit demand will provide a stiff headwind against
which a loosened monetary policy must bustle.
The industrial sector,
though, can lay claim once more to a positive momentum, mainly thanks
to recovering exports. May exports rose 12.1% yoy in Rmb terms (and
in sequential terms were 2 Sds above historic seasonal trends), and
13.3% yoy in volume terms (1.1 Sds above trend). The underlying 6m
trendline for China's exports inflected upwards in March, and is
still climbing. The Commerce Ministry is talking up June's export
performance, and sounding confident that China will achieve double
digit export growth this year (I agree – see this piece). But that's the brightest part of the picture: industrial output
has slowed to single digits, and is only intermittently hitting its
trend sequential growth rate. Worse, a recovery which is outpacing
the recovery in domestic demand risks piling up inventories – as
the latest PMI subindexes reveal. It seems that when a major
issuance of bankers acceptances made in March (not directly captured
by money or bank lending data) relieved China's cashflow problems, a
proportion of the resulting production remained unsold.
And this provides a
hint of the problem: relieving the cashflow problems of the
industrial sector is unlikely by itself to give a sustained stimulus
to the domestic economy. Such a stimulus can only come from a major
loosening of monetary conditions, and then with a lag – probably of
about three months. Even if a very major monetary policy loosening
were made right now, even with a following wind one would not expect
a similarly dramatic turnaround in the domestic economy until 4Q12. Too late.
Even If Policy Loosens Now
But even if monetary
policy were dramatically loosened this week, it would have to
overcome the the financial caution which now prevails in China (as
well as the structural issues – who really wants to invest when
ROCs are falling?) I have previously written about how in the last
few months China's private sector has set about rebuilding its
savings surpluses (this piece). “China's
trade surplus during 1Q was a very modest US$1.15bn, compared with a
very modest deficit in US$706mn in the same period last year.
However, during the next two months the surplus burgeoned to
US$37.12bn, up 34% yoy, even as domestic demand indicators continued
to soften. “
But one can see it
unambiguously in the continuing unprecedented collapse of liquidity
preference (M1/M2): the Chinese people have perhaps never kept so
little of their cash on hand in order to make purchases or
investments.
The Inescapable
Conclusion
The conclusion is
inescapable: China's economy has slowed for good structural reasons
to do with the limits of the (previously wildly-successful)
savings/investment intensive exogenous growth model. It has also
slowed for good cyclical reasons: the central bank has spent two
years with its foot firmly on the brakes. This has slowed the
domestic economy and exposed the structural stresses still more. The
state of global demand does China's economy no favours, but its
exporters are likely to do as well as expected – but by itself this
is insufficient to spark a new business cycle upswing. There simply
are no grounds, absent major fiscal and monetary stimulus, to expect
a sustained rebound in any time soon.
And here's the rub: I
believe the Chinese government understands that the economy is
pressing up against the limitations of the
savings/investment-intensive exogenous growth model it has deployed
so triumphantly for the last 15 years or so. A massive policy
loosening is still technically possible (by releasing the reserved
deposits back into the system, and damn the credit consequences). In
the short-term it would once again rescue headline GDP growth, but in
every other way would magnify those structural problems with which
the government is already wrestling. The willingness over the last
two years to sacrifice a real estate market which many believed too
politically and fiscally important to touch, suggests the Party has
not yet tired of slaying sacred cows. What reason is there to believe
that growth of 8%+ is protected?
Only if irresistible
political necessity demands it will we see anything like a repeat of
the 2009 credit splurge. Much more likely is an acceleration of
reforms in the financial sector, coupled with continuing modest
monetary policy loosening. The message is this: China is embarking on
one of the most difficult traverses in economic history – moving
from an exogenous growth model to an endogenous growth model. Most
economies that try it fail: China is under no illusions about that.
But there is no choice but to make the attempt. Which is why we had
better get used to growth under 8%.
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