China: No Rebound, No Backing Down

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%.

Shocks & Surprises, Week Ending June 22nd

·        Early June industrial data shows the US ‘soft patch’ getting softer and deeper, and lasting longer than previously expected. Labour market data has disappointed for the third week out of four, gnawing at the underpinnings of domestic demand. Labour market weakness is consistent with the worry the US economy’s is growing only at the ‘stall speed’ of around 2%. With the Eurozone crisis also undermining business confidence, economists will start cutting their forecasts of a 2H pickup.

·        The resurgence in intra-Asian trade is the one unequivocal bright spot in the world economy just now. Japan’s May confirmed what we’d already seen in China’s trade data. For Japan, the surge in imports from Malaysia, Philippines and Vietnam represents the first impact of supply-line diversification away from domestic, Chinese and Thai production, after last-years disasters and disruptions. But it is bolstered also by pent-up SE Asian demand, as signalled by the doubling of car-sales in Thailand.

·         Only immediate disaster can sink below European expectations now, whilst even severely bad news can pose as an unexpected surprise. Within these parameters, Germany’s expectations about its own economy shocked this week, but French Services PMI and UK order books, though both contracting, were better than expected.

Fear Itself

The relative insouciance of non-Europe financial risk prices in the face of the Eurozone's grinding catastrophe may partly be owing to the time non-Eurozone financial institutions have had to tiptoe quietly away from direct involvement. But there's another reason too: all over the world, the anticipation of Europe's financial crisis finally getting completely out of hand is stopping businesses investing and hiring, and in turn that is stopping households spending. In short, everywhere in the world, private sector savings surpluses are on the rise once again.

And this is despite the fact that bond yields remain far below 'fair value' – a pricing which in the past has been effective in discouraging excessive saving, whilst encouraging corporate investment. Fear itself is financing the retreat in financial risk pricing.

This unanticipated new surge in private sector savings surpluses was noticeable first in the US, partly because the US reports its data early, but also because the rise defied other usually reliable cyclical indicators. When we search for the reasons behind the 'soft patch', this is what we discover: during 1Q12, the PSSS jumped to 7.5% of GDP, up from 4.5% in the same period last year. The change was just big enough to inflect the 12m curve upwards.

In the Eurozone, the story is less clear-cut (and less securely accounted for by official data). However, my best estimate is that during 1Q the Eurozone's PSSS climbed to 5% of GDP, up from 4.5% in 4Q11 and 4.8% in 1Q11. This is only a fractional rise, but it occurred during a time when the Eurozone's financial system was still feeling the short-term relieving effects of the ECB's Long-Term Refinancing Operation. Throughout the first quarter the fall in European CDS rates reflected the momentary retreat of the Eurozone crisis – they fell from a peak of around 632bps in early December 2011 to a low of around 365 in late March.

But of course, the crisis is back. Currently CDS rates are around 480bps, and every survey of European consumers, businesses or investors tells the same story of dramatically collapsed confidence. So we can assume the Eurozone private sector savings surplus is also surging. And whilst we cannot yet make the calculations (because we don't know the details of what's happening on the fiscal side), the result isn't in doubt. During March and April this year, the Eurozone's current account showed a Eu10.36bn surplus, compared with a deficit of Eu3.95bn in the same period last year.  

What about Asia? The quarterly charts tell us that during 1Q, surpluses in both China and Japan were in smooth retreat: China's 12m surplus fell to 3.5% from 3.9% in 4Q11, whilst Japan's fell to 5.2% from 5.9% in 4Q11. In both cases, this fall underpinned Asian domestic demand (consumption and investment spending) whilst moderating the (still positive) inflow of cash into Asian financial institutions.

But as with the Eurozone, it seems very likely that this is now reversing. We can see this in the trade data: 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. In Japan, the fall of the PSSS during the past 12 months has been more dramatic than in China, but as the next chart shows, that fall has already stopped on a 12m nominal basis. The chart runs to the end of April, but May's trade data suggests the stasis is continuing. So too do the downturns in Japan's domestic demand data (starting mid-May).

We can therefore observe that a non-cyclical upturn in private sector savings surpluses emerged in the US during 1Q, spread at first moderately and more recently fiercely to the Eurozone in 2Q, and is now arriving in both China and (to a lesser extent) Japan. Since this is happening against the background of extremely low global bond yields – yields far lower than 'fair value' and thus historically likely to discourage net savings – it's reasonable to assume this change in behaviour is a response to collapsed confidence.

This change in financial behaviour has markedly different financial and economic effects. For the financial system, the private sector's private sector savings surpluses represent accelerated net inflows of cash into the system. Because, by definition, the banks cannot recycle this into private sector credit, this cashflow must go to buy either government debt or foreign assets. Such forced buying of government debt can be expected to depress yields and consequently risk pricing.

But those private sector cashflows are only generated by deferring spending on consumption and investment. The non-cyclical savings behaviour in turn becomes precisely the motive factor stripping demand from the world economy and tipping it into a cyclical downturn.

Whilst Europe's national political leaders evidently consider 'protecting the Euro' a more important goal than securing national economic survival, there's no reason the rise in Europe's private savings surpluses

should abate. But if financial institutions and financial centres in the US and Asia have in fact spent the last couple of years quietly quarantining Eurozone financial institutions, the best hope of abating the rise in private sector savings surpluses is probably for Europe's crisis to come to its head sooner rather than later.  Since, outside the Eurozone, it's fear itself which is now doing the damage.

  

The Unreported Nonchalance of Global Finance

The disconnect between dominant media narratives and one's personal experience is one of the disconcerting characteristics of our time – suggesting as it does that no-one knows much, and loads of people are bluffing. Right now, we are both wearied and terrified by the imminence of the collapse of European civilization after the epoch-defining failure of its political leaders.

Etcetera.

Or maybe not. Consider a couple of measures of financial risk. First, here's what's happening to global banking risk pricing, according to the 5yr region-wide CDS averaged for Asia, Europe and the US. Today (it turns out), that global average has fallen below a 100-day average which itself is falling. Very often, crossing the 100-day average one way or another tends to define a medium-term trend. This market, then, seems to think that global financial risk is probably slightly in decline.

Then there's the capital risk premium embedded in US 10yr Treasuries (calculated by subtracting 10yr TIPs yields from 10yr Treasury yields). As the chart below shows, although this measure of risk tolerance has been tracking down steadily since mid-March 2012, it remains firmly embedded in 'normal' territory. So far, at least, there is not merely no suggestion of a repeat of the post-Lehmans breakdown, but also no price signal of the sort of distress generated by the first two waves of Euro-crisis (summer 2010, August 2011). In fact, this measure of financial risk-aversion is currently almost exactly at the average is has sustained since the end of 2009.

Of course, this proves nothing, except that generally speaking, the financial world hasn't yet fully bought into the imminence of its own doom. But perhaps there's a good reason for that: I have repeatedly (here for example)  tracked the way in which the major international financial centres have spent the last couple of years attempting to ensure balance-sheets and net cross-border exposures involving European banks (in particular) are restructured to minimise systemic risks. If successful, such sandbagging will provide some short and medium term financial mitigation (though less economic mitigation) from the impact of Europe's banking problems.

But right now, there's an added bonus – risk-pricing for the banking systems of Asia and the US has managed somewhat to decouple from European risk-pricing. We can track this by measuring movements in the 30-day correlation coefficient between daily movements in CDS pricing between Europe's banking system, and banking systems in the US and Asia.  

I started this chart at the beginning of August last year because one can very precisely time the onset of this phase of the Eurozone crisis to that week (see this). And what's striking is that right now, even as we are told  that Eurogeddon is imminent, those correlations have fallen: the correlations with the US financial system are now half a standard deviation below the post-August 11 average; correlations with Asian banks are slightly higher, but nonetheless, at 'normal' levels and falling.

Mainstream narrative notwithstanding, the market is pricing nonchalance. 

Shocks & Surprises - Week Ending June 15th

·        Economic shocks are no longer concentrated in Europe or Asia, but in the US, where industry, labour markets and consumer data all disappointed this week. Financial institutions outside the Eurozone have had time to tiptoe away from a Euro banking melee – companies and households much less so. As it develops, the Euro crisis will emerge as an economic problem as much as a financial crisis for the rest of the world.

·        China's strong May trade data (exports up 15.3% yoy) could be a game-changer: in particular, the recovering strength of inter-Asian trade tells us Asia's inter-connected production base has not given up on world demand.

·        Falling commodity prices are setting the pace for disinflation, and pit-propping margins. This showed up in producer price disinflation in US, Germany and Korea, and it was there also in improvement in international terms of trade for US and Korea. For now, input prices are falling faster than output prices, and the reduced pressure on margins slightly offsets the anticipated fall in asset turns. Disinflation also makes more room for policymakers – room used when China cut interest rates this week. 

I am experimenting with a four-page weekly analysis/commentary on the week's shocks and surprises. Whilst it is under development, it needs all the advice, criticism and commentary it can get. If it is worth doing, it must be the most direct, useful and time-efficient production of its kind available anywhere - and for that I need your input. If you feel you could spare the time to look over this product-in-development and contribute your criticism, please let me know. Thanks in advance.  

Shocks & Surprises, Week Ending June 2nd

So much for 'normality'! This week delivered enough shocks to torpedoed the notion that the underlying strength of the US economy would prevail in the second half of the year after enduring a short-term 'soft patch' enabling industry to adjust to an anomalous uptick in savings surpluses during the first quarter (detailed here and here).

Data from both Europe and the US force a change in that complacent view. First, early in the week, the Eurozone's monetary aggregates confirmed that the money-go-round initiated by the ECB's LTRO operations (detailed here), had run out of steam. M3 growth slowed to 2.5% in April from 3.2% in March , and although credit to governments expanded 7.7% in April, credit to the private sector was flat yoy.

The Eurozone's financial institutions have no capital to buy or create risk assets, so credit to the private sector has dried up even as holdings of government securities rise. More, the deterioration in economic and industrial sentiment tracked by the EU's indicators confirms what we'd already been told by the ECB's quarterly banking conditions surveys – there's no appetite for new debt anyway. Service sector sentiment readings in May hit the lowest since October 09; general economic sentiment was the worst since Dec 09, and industrial sentiment the worst since Feb 2010.

And the Eurozone's corporate sector isn't generating much cashflow anyway: corporate deposits fell 0.8% yoy in April, and deposits by non-monetary financial institutions (mainly insurance and pension companies) fell 1% yoy.

It is hoped that Southern Europe can generate positive cashflows despite carrying a severely mispriced currency, and despite quite serious fiscal tightening. It would be nice to think there was even the faintest sign that Europe's policymakers understood how one can disaggregate the sources of profits. If so, they would know that of the three principal motors of profits generation:

1. exports minus imports;
2. government spending minus taxes; and
3. consumption spending minus wages);

the determination to stay in the Euro scuppers I) and fiscal austerity measures scupper ii). The de facto collapse of Southern Europe's banking systems mean that the private sector must necessarily generate positive cashflow, so the entire burden falls on iii – somehow cutting wages even faster than consumption.

This can't be done. So whilst current policies, institutions, preconceptions and political personnel cling on in the Eurozone, the Southern half of the Continent is condemned to a genuine Depression, the political consequences of which are unknowable. History will not be kind to this generation of policymakers.   

The three major shocks came in areas central to the health of the domestic economy:

1. Labour Markets, where the rise in May's non-farm payrolls came in at 69k only, against a consensus expectation of 150k with a 1 SD range of 129 to 173k. This poor news was accompanied by an unexpectedly trimming of the average workweek from 34.5 hours to 34.4 hours, and a rise in weekly initial unemployment claims back to mid-April levels.
2. Real Estate markets, where pending home sales fell 5.5% mom in April, led by falls in the West and South. This weakness found an echo in the labour market data, which showed construction sector employment fell by 13k mom.
3. Consumer confidence, which retreated unexpectedly to the lowest levels since January, with sharp downgrades on both the current and likely future economic situation.

Meanwhile, China's policymakers appear still to be underestimating the extent to which cashflows are cramped – perhaps not fully understanding that when a decade or more of excessive investment has left you with a capital stock growing at around 18%, when industrial production growth slows to 9.3% (as it did in April), with exports growing only 4.9% (as they did in April) asset turns must necessarily be collapsing, taking profits and cashflows with them. This last week brought shocks from China's official manufacturing PMI and HSBC's revision of its manufacturing PMI. The message of the two isn't absolutely identical (the official version has manufacturing stagnating, whilst HSBC's has it contracting), but the message is clear: output is slowing, but new orders are contracting faster, leading to a building up of inventories of finished goods and a contraction of order backlogs. Chinese companies are therefore slowing purchases of inputs, and (probably) firing staff, whilst deflationary forces intensify.