Eurozone Credit - A Squeak of Life for Italy and Spain?

Over the last few weeks, a crop of data from Italy and Spain has surprised consensus and broken trend positively: last week that included Spanish mortgage markets and Italian consumer confidence; before that we'd had surprises from Italy's industrial output, sales and orders surprised, and its current account deficit was small enough to break trend. In addition, Spain's exports are beginning to pick up sequentially once again.  Italy and Spain are not the most obvious places to look for signs of commercial life in the Eurozone. So what is happening?

The headlines of the Eurozone Feb money data were unremarkable – M3 growth of 1.3% yoy was exactly as expected, and in any case is hardly striking when compared against a base of comparison which is rapidly becoming easier.  But it was nonetheless a strong figure, with the 0.2% mom rise 1.2SDs above historic seasonal trends.

This surprise sent me back to the Eurozone banking data, where  to my profound surprise, I also found signs of life – something I had discounted owing to this year's forthcoming ECB stress tests.  In particular, loans to the private sector, though they inched down 0.1% mom and were down 3.6% yoy, are now beginning to moderate the extremely negative trends of the last five years.  Thus although Feb's private sector loans fell marginally, this was fully 1.3SDs better than the average Feb fall of the last five years.  Nor is this a one-off, there have been gains vs trend in each of the last six months, leaving the 6m momentum at 0.7SDs above trend – this is the highest it has been since August 2011, and it is still rising sharply.

The problem is that the underlying trend is so sharply negative that even these new levels of outperformance will still leave overall lending contracting quite sharply this year.  If the outperformance of the last six months is maintained throughout the year, private lending lending will end up falling 2.9% in 2014, with loan book down Eu305bn. That's better than the 3.6%, or Eu395bn contraction of 2013, but still a fall. So what we have is simply a moderation of the pace of contraction, not a reversal – a second-derivative change, not yet a change in direction. 

But the Eurozone encumbrances an impossibly diverse set of economies, so we should expect the overall moderation of trend to incorporate substantially diverse credit trends.  Perhaps the overall modest improvement is hiding substantial improvement in individual economies? The first cut tells us that the improvement vs trend in lending to the private sector is found mainly in the Big Four economies of Germany, France, Italy and Spain, which account for just over two thirds of the Eurozone loan book. There the first break into positive momentum came in mid-2013,  with a sharp acceleration during four months to February. By February the 6m deflection above trend was running at 1.04SDs, and the loan book was contracting by 1.9% yoy. 

It's a different tale for the rest of the Eurozone, where the nadir of contracting lending came only in September 2013, and where the 6m trendline broke into positive territory only during February. For these economies the loan book was contracting 6.9% yoy in February. The improvement in current trends means little for them: loans fell 5.6% in 2013 and are likely to fall 5.4% again in 2014.  

Looking more closely at the Big Four:

• The biggest 6m deflection against trend by far is from Spain (1.2SDs). There, pace of decline of credit has been essentially held steady since June 2013. Even so, on current trends, it still seems likely the total loanbook will contract by a further 8.3% this year (vs 9.6%  in 2013). 
• The second largest recovery against trend is found in France, where in February the loan book for corporations and h'holds actually expanded by 0.9% yoy, and 0.6 Sds above trend. Again, however, the underlying trend is sufficiently grim to make any significant credit growth this year unlikely – current trends would suggest a growth of 0.4% (vs 0.8% in 2013). 
• By February German loan growth was running at 0.3% yoy, and the 6m momentum trendline was 0.3SDs above reasonably negative historic trends.  On current form, we can expect no loan growth in 2014 in Germany (vs 0.2% in 2013). 
• Finally, Italy's loan book was down 2.7% yoy and was only 0.2SDs above trend. However, interestingly, the improvement in current trends would cut that fall to just 0.2% yoy in 2014, which represents a modest recovery from the 4.1% yoy fall in 2013. 

A very rough summary, then, is that there is no significant loan growth in either Germany or France, and recent data gives no grounds for expecting any in 2014.  Recent data, however, gives us evidence that there is already a significant moderation of negative trends in Italy,  and that conditions in Spain, though grim, are no longer deteriorating.  Perhaps the fact that the Eurozone's credit vice is no longer intensifying its grip on these economies is allowing a squeak of commercial life.  Meanwhile, credit conditions remain essentially unchanged, and sharply negative for 'The Rest'. 

US Capital Goods Book to Bill - On the Brink

The 1.3% mom fall in Feb's orders for capital goods (non-def ex-air) threatens to snuff out a re-tooling cycle which, though currently feeble, has been the best bet for a swing factor to push 2014 GDP growth above the 2.7% of current consensus.

The arrival or absence of a proper capital goods cycle is the crucial swing factor for 2014 US GDP. In 2013, non-residential investment added just 0.31pps to the average GDP growth of 2.6% - ie, it accounted for just 12% of US GDP growth. This is a significant underperformance: since 2010, nonresidential investment accounted for 30% of US GDP growth, on average. It is also an underperformance which, if corrected, could be expected to add 0.3-0.5pps to 2014 GDP growth. As a result, the monthly durable goods orders data is currently among the most important in the world.

Feb's 1.3% mom fall was bad enough, but when taken in conjunction with the 0.5% mom rise in shipments, it threatens the tepid cycle already underway. It means that the nominal level of orders have once again very nearly fallen to the level of shipments. The orders/shipments ratio is a sort of crude book-to-bill ratio: in normal expansionary time, the ratio is comfortably over 1, but when it falls below 1 one can be fairly certain that the cycle is turning down. February's results have cut this ratio to 1.01, down from the 1.04-1.06 range which normally prevails in expansions. We're not yet there, and there's still time for things to improve, but it puts us on the brink of a capital goods downturn.

The sectoral details were also bad: machinery fell 1.5% mom, communications equipt fell 2.7%, electrical equipment fell 0.9% and computer products fell 0.5%. In the key machinery sector, although shipments rose 1.6% mom sa, when one strips out the seasonal adjustment, there was no growth at all in yoy terms. 

It is astonishing that the cycle could be about to peter out, because there are many excellent reasons to expect an acceleration of capital investment. First, a strengthening is long overdue. For every country I look at, I estimate changes in capital stock by depreciating all fixed investment over 10yrs, and I generate a signal for directional changes in return on that capital by expressing GDP as a product of  that capital stock (a sort of asset turns measure). On this basis, ROC in the US is currently about as high as during the peak of the early 1990s, but capital stock is still growing only 1.8% a year in nominal terms even though gross private fixed capital formation grew by an annualized 5.3% in 4Q13.  By historic standards, the recovery has been both feeble and late, and a rebound is well overdue. 

This is broadly confirmed by monthly industrial data, which shows that capacity utilization rates have recovered to 78.8% in February. This is half a standard deviation above the post-2000 average, and approaching the 79%-80% levels which formed the pre-crisis plateau during 2005-2008. Since there's no obvious disequilibrium between industrial supply and demand which might trigger any downturn in the short-term, utilization rates are likely to continue to grind higher, in the absence of accelerated capital spending. 

This may not be a problem for individual companies, but it is for the economy as a whole.  For the number of people employed rose by an average 1.7% yoy in 2013, which meaning that capital per worker is virtually static, as is output per worker deflated by capital per worker.  Plainly, the lack of investment is now a ceiling to productivity rises, and thus to the potential GDP growth rate. 

After all this, it is worth repeating: Feb's data puts the US capital goods cycle on the brink of a reversal. All things considered this is not only depressing, but counterintuitive.  The odds must remain good that March and subsequent months bring better news. 

Japan's Happy SMEs?

In Japan, large companies and their SME suppliers co-exist in a symbiosis which is traditionally deeply uncomfortable for the smaller party. And so it continues.  In calendar 2013, large companies (Y1bn+ in capital) accounted for 43% of Japanese sales and, with OPM of  4.8%, took for 55% of corporate profits.  Meanwhile, small companies (Y10-100mn in capital) accounted for 38% of sales, but with OPM of 2.8%, took only 29% profits.  Because small companies form the the protean industrial substructure which support Japan's giant companies, they also are first to know when conditions change. This is why the Shoko Chukin SME business confidence index tends to be closely watched.  

In March the index jumped 2.9pts to the highest levels seen since 1989. On the face of it, this is extraordinary: in the very near future consumption taxes will rise to 8% from the current 5%, and although there has been no noticeable rush to shop before prices rise,  there is nevertheless a common worry that demand will take at least a temporary hit after prices rise.  And yet not only did the index for non-manufacturers rise 3.7pts (vs 2.2pts for manufacturers), but in addition, the biggest bounces in sentiment came precisely from retailers (up 5pts), wholesalers (up 4.5pts) and truckers (up 6pts). These are exactly the sectors which stand to be worst hit if tax rises bite into domestic demand.

At this point, the most important thing to realize is that this index is not seasonally-adjusted, and that SME confidence always jumps in March, which is the end of the fiscal year.  I do not know why the end of the fiscal year cheers SME spirits so much, but the track record is unequivocal: in the last five years, the monthly gain in March has averaged 3.8pts – rather more, actually, than was achieved this year. The chart below shows that regular March bump.  It also shows that it doesn't usually last – we can expect to see most if not all of the gain reversed in April.

Nevertheless, if March's bounce is a fiscal year-end phenomenon, it has peaked still higher than any since 1989.  And when one looks at how the various aspects of corporate experience and expectations are changing, it does seem that SMEs perceive real improvements in their operating environment, measured on a yoy basis. One particularly striking result is that SMEs now see the capacity situation as favourable (albeit by the narrowest of margins). For an economy which has routinely reported excess capacity for decades, this is rather startling. In addition, financing conditions, which have historically also always been seen as unfavourable, have nudged up to nearly neutral.  The profits situation is still seen as marginally unfavourable, but this is a far better reading that in March 2013.  Finally, SMEs are also seeing the first signs that the margin squeeze imposed by the depreciation of the yen is beginning to relax very slightly.  

Conclusion? March's reading isn't the breakthrough it seems, but nevertheless the index is grinding higher on the back of a slow improvement in business conditions:  maybe Japan's SMEs are catching some trickle-down from the gains finally being enjoyed by exporters as the J-curve impact of the yen devaluation  finally begins to emerge. 

US Taper and Foreign Investors - Part 2, Wary and Tactical

Last month, I wrote about how net foreign investment in long-term US instruments recorded an unprecedented US$133bn capital out flow during 2013 – something that has only happened once before in post-Cold War financial history. Since changes in fundamental financial behaviour are rare, it raised the question of whether this was merely a trading response by international investors to the prospective end of the Fed's taper, or whether it represented a fundamental re-assessment of the role of US dollar markets in the global financial system. The stakes could hardly be higher.

We now have data from January, which extended the trend: in January, net long-term foreign capital inflows came to just $7.3bn, which is $20bn less than in January 2013, and which takes the 12m net outflow to $157bn.

But closer inspection of the composition of this shortfall reveals that the origin and targets of the outflow are not as simple as merely a reaction to Fed's tapering. And as a result, the strain put on the dollar, and and dollar asset markets, is probably less than it appears. Finally, there is also evidence that insofar as the exodus from US bond markets is motivated by the announcement of Fed tapering, the exit has been tactical rather than strategic.  Overall, the detail belies the impression that the world is quietly removing itself from the dollar-standard.

The first surprise is that despite the headline deficit, there has been no foreign net selling of domestic US securities. Rather, in the 12m to January, foreign investments cut their buying of US domestic securities by $567bn yoy to just $15.4bn – a massive drop in buying, but not actually net selling.  The collapse in net buying was shared by both private investors (down $311bn yoy to just $16bn net buying in the 12m to Jan), and official investors (down $255bn yoy to a net $0.6bn sold in the 12m to Jan).  What pushed the entire balance into deficit was a net selling not of US securities, but rather of securities of foreign companies and institutions floated and traded in the US – there was net selling of $173bn of these securities!

So foreign net buying of US domestic long-term securities fell by $567bn to just $15.4bn: what were the major portfolio changes? As expected, the main driver was a reluctance to buy new treasuries: on a 12m basis, net buying fell $350mn yoy to just $10.5bn in the 12m to Jan.   But the biggest actual net selling was in equities: foreign investors sold a net $52.1bn in the 12m to Jan,  compared with net buying of $110.5bn in the same period the previous year. This is consistent not just with caution in bond markets, but also modest profit-taking in equities.  Foreign investors bought $53.6bn of agency bonds (down $72.7bn yoy), and $3.4bn of corporate bonds (up $18.6bn).

The combination of bond caution and profit-taking in equity markets looks much more like a tactical trading strategy than a wholesale decision to exit US asset markets.  And this suspicion is bolstered by a further detail: at the same time as foreign investors were cutting their holdings of US securities, they were building up unprecedented levels of deposits in  the US banking system.  (To be precise these are banks' liabilities to foreign investors – since they cannot be either bonds or equities,  I am assuming they are deposits.) To put some numbers on it: in the 12m to Jan, foreign investors sold a net $157bn, but raised their deposits in US banks by $541bn.  The change in behaviour from the previous year is stark: in the year to Jan 2012, foreign investors had bought a net $528bn in securities, but raised their deposits in US banks by just $79bn.

Now take a look at the chart below, which tracks 12m changes in foreigners' net purchases of US securities, and net deposits in US banks. The first thing to notice is the offsetting relationship between changes in holdings of securities and bank deposits which seems to have been fairly consistent since 2011.   Since then, when purchases of securities have dried up, bank deposits have risen, and conversely when securities buying is booming, bank deposits run down.  The most obvious explanation for this is simply that foreign investors are tactically trading in and out of securities markets without at the same time trading in and out of the US financial system, or the US dollar.  Which perhaps explains why the lack of impact on the dollar from the net sales of US securities.

But notice also that this pattern is new: prior to the crisis, there was no obvious offsetting relationship between securities purchases and bank deposits – both tended to move in the same direction both in and out of the dollar financial system.  This suggests an underlying change in the overall pattern of foreign investor behaviour in dollar markets, with a far greater sensitivity to market conditions and a far greater willingness to trade. The pre-crisis willingness simply to pile rather indiscriminately into dollar assets has been modified.

And, finally, this is reflected in overall investment patterns (of securities and bank deposits). Whilst the 12m to Feb 2014 still showed an overall inflow of $383.2bn, the total has been in steady and unspectacular decline since 2011.  In 2011 the net inflow was $754bn; in 2012 it fell to $563bn, and in 2013 it fell again to $394bn.  This is clearly a different pattern of behaviour from the steady pre-crisis build-up, or the rout  experienced during the crisis. A willingness to hold dollars remains, but that willingness is less enthusiastic than before, and evidently more qualified by tactical trading opportunities than before the crisis.  The world's investors have not abandoned the dollar, but the relationship has changed.

China: Tactical Reversal

China’s strategic economic aims remain unchanged, but the tactics deployed to achieve them have reversed. This reversal of tactics will make a direct impact on the rest of Asia, and if pursued sufficiently hard, on the rest of the world too. 

Last year, China’s revealed policy was to tolerate rapid overall credit growth to accommodate a ‘stealth liberalization’ of interest rates via the ‘shadow banking’ system, whilst letting a steady rise in the Rmb to do the heavy lifting in the fight against inflation. Now that policy has reversed, with accelerating interest rate reform, a continuing roll-back of the ‘shadow banking’ experiment, and the resulting financial squeeze mitigated via a weaker Rmb. 

The implications for the rest of the region depend on how aggressively this policy reversal is pursued. At its simplest, it means China will be a tougher competitor in export markets. At the limit, a sharp depreciation of the Rmb could result in China exporting deflationary pressures to the rest of Asia and to the rest of the world, acting in much the same way as Japan’s post-1995 yen devaluation. 

Four developments in China over the last couple of weeks demand a reassessment of assumptions about strategy and policy.  The four developments are:
i) the belated but almost ritualistic repetition of annual targets for growth, trade, inflation and money supply, unchanged from 2013;
ii) the announcement of CPI and PPI numbers significantly below those targets;
iii)  weak industrial, domestic demand and financial data for the first two months of the year; and
iv) an unexpected fall of the Rmb against the dollar, accompanied by PBOC doubling the daily trading band to 2% either side of a daily fixing, from the previous 1%.

Taken together, they point us to a changed understanding of China’s reform efforts, and a recognition that if the strategic aims remain the same, a U-turn in tactics is underway.

Let us first consider the announcement of formal economic targets for 2014 made by premier Li Keqiang in his work report to the National People’s Congress: GDP target of about 7.5%, CPI around 3.5%,  M2 growth of around 13%, trade volumes  to grow by around 7.5% and 10mn more urban jobs to be created, all accompanied by a ‘proactive fiscal policy and prudent monetary policy.’  The key point about these targets are that they unchanged from last year: for all the emphasis on reform at last November’s 3rd Plenum, Li Keqiang’s underlying message is that for the time being need have no macro-economic consequences at all.

This runs directly counter to the view that whole point of reform was to overhaul systems of political and financial patronage in order to discover a less-inefficient allocation of resources. Such a re-allocation of resources implies at the very least a transitional period of economic volatility, which in turn implies a toleration of slower growth in the short to medium term.  Now that Li Keqiang has nailed his colours so firmly to the mast, those assumptions are fatally undermined.

At this point, it may be worth quoting an editorial in the CCP’s Global Times, which appeared right at the end of the NPC: 'Do officials at provincial and township levels have the same determination as the top leadership in carrying out comprehensive reforms? To be honest, society is not as confident as officials at the top.  Reforms are bound to intrude into the interests of certain groups, and redistributing those interests is risky. Some senior officials are not able or willing to undertake the risks.

'When the public points their fingers at interest groups that stand in the way of reforms, they usually mean civil servants and SOEs. Actually, when reforms are carried out, they will touch upon the interests of nearly all Chinese people. The opposing voices will eventually mount for the govt.'

The reiteration of the usual economic targets also looks like a promise that the boat is not to be rocked too violently. And it is this light that we must look at the other three developments. First, the industrial, demand and financial data for Jan-Feb clearly shows a slowdown is underway. Industrial production growth slowed to 8.6% yoy (from 9.9% in the same period in 2013), and exports fell 1.7% yoy (vs a rise of 23.6% in the same period of 2013);  for domestic demand, urban fixed asset investment slowed to 17.9% (21.2%), and retail sales slowed to 11.8% (12.3%); for finance, bank lending growth slowed to 14.2% yoy in Feb, and the monthly addition of total aggregate financing fell to Rmb 938.7bn yuan in Feb vs Rmb 1.066tr in Feb 2013.  Although market reaction to these numbers was severe, it is worth trying to put the weakness in context: the chart expresses the 6m momentum trendline for industry (output, exports, electricity generation), domestic demand (retail sales, urban investment, auto sales, real estate conditions, passenger traffic), and monetary conditions (money growth, real interest rates, yield curve and currency movements). It confirms the slowdown, but also emphasises that, so far, the volatility remains, in Chinese terms, unspectacular.

Unspectacular, but this loss of momentum is still a threat to the Li Keqiang’s ‘normal’ targets, and so demands some sort of policy response.

This is where the next two developments come in.  February’s CPI inflation retreated to 2% yoy, the lowest since Jan 2013, whilst PPI fell minus 2% yoy, the most disinflationary since July 2013.  With money growth slowing, China’s 3.5% yoy CPI target for 2014 looks likely to be undershot: the trends of the last five months suggest inflation falling to around 2% for the whole year, at spending most of the second half of the year below that rate.  So the 3.5% CPI target starts to reinterpret what a ‘prudent monetary policy’ might be.

Consequently, there is room to allow, or encourage, a depreciation in the Rmb to offset the tightening discipline in China’s broadening banking markets. For all the current unease about likely credit problems emanating from China’s ‘shadow banking’ system, it is worth remembering how and why its growth was tacitly encouraged last year.  The rise of the ‘shadow banking system’ can also be seen as an experiment in banking reform, amounting to a ‘stealth liberalization’ of China’s interest rate regime, since trust loans and entrusted loans both escaped PBOC’s interest rate regime.  China’s banks began to price credit whilst still conforming the formal policy-demands of PBOC, ensuring that there was no sudden diversion of resources away from the traditional recipients/beneficiaries of bank credit.

Whilst this allowed the experiment to be undertaken without disadvantaging core political clients, it also meant that total credit expanded fast –  formal bank loan-growth rose 14.1% in 2013, but I estimate the stock of aggregate financing rose by 17.3%.  Clearly, the heavy-lifting of inflation control was not being done by the banking system, formal or shadow: rather, that work was done by allowing the Rmb to rise unspectacularly but uninterruptedly.  During 2013, the Rmb rose 2.8% against the US dollar, and about 3.5% against the SDR.  The combination was evidently successful in taming inflation whilst maintaining economic growth.

And it is this tactical solution which is now being reversed. With formal interest rate reform now clearly fast-tracked over the coming two years (PBOC chief Zhou Xiaochuan: 'We will let the market play its due role in interest rate liberalization. That's for sure’), the ‘stealth liberalization’ no longer has a role to play, and can be wound back. Just as its expansion meant an overall loosening of credit conditions which needed to be disciplined by a strengthening Rmb, so the wind-down of the shadow banking system tightens credit conditions, and this can be at least partly offset by a depreciation of the Rmb, particularly given benign inflation trends.  And so the combination of relaxed inflation prospects, foregrounding of interest liberalization and a determination that the current slowdown should not develop into something more threatening, reveals the change in policy.

For the rest of Asia, a weakening Rmb is a direct step-up in competitive pressures, since China now accounts for just under 59% of total NE Asia exports, and a weaker yuan will encourage China's exporters to cut prices to win market share and improve cashflow.  Those of a nervous disposition will remember what happened when after the sharp devaluation of the yen post-1995 – at the beginning of which Japan accounted for about 51% of total NE Asia exports.

China Debt Dynamics: Part 2, Measuring the Burden

Rapid accumulation of debt in China is nothing new: between 2000 and 2013 the stock of bank debt rose at a compound annual average of 15.7%.  And on the face of it, that rate hasn't changed much – as of February 2014, bank lending was growing 14.2% yoy.  And that accumulation of debt has, of course, also financed dramatic economic growth: in nominal terms, GDP grew at 14.7% on a CAGR during the same period. So the question arises, what's changed? Is China's debt problem significantly worse than it used to be, and if so, what impact is it likely to have?

The purpose of this piece is simply to provide metrics which may be useful in thinking about the changing role debt finance is playing in China. It is worth, perhaps, anticipating my conclusion: the credit splurge of 2008 really did change China's financial structure, and for the worse.  The debt burden China's economy is currently carrying is dramatically more challenging than it used to be, and is certainly enough to impair current growth prospects. Moreover, as we shall see, it also means that the financial reform which China's central authorities are undertaking is absolutely necessary.  But at the same time, it poses a challenge to that reform, since the current levels of debt mean any significant rise in interest rates – which one would expect under interest-rate liberalization –  is likely be sharply punitive for those sectors encumbered with debt.

But – and this is crucial – China's cashflows as a whole remain positive, so, barring policy or political accidents,  a credit meltdown is unlikely any time soon. And that's the problem: my reading of China's shifting debt position is uncomfortable because although it clearly points to the need for change, it does not make it inevitable. China's economy can struggle on for some time under current policy-settings: that's the problem.

The fact that China's nominal GDP has grown at 14.7% CAGR this century whilst bank lending has grown at 15.7% immediately tells us that the build-up of debt/GDP has been less steep than is commonly assumed. On 2013 bank debt/GDP stood at 122%, not dramatically higher than the 116.4% of ten years earlier. China's problem lies not so much in the stock of debt per se, but rather in the falling economic efficiency of debt. One way of measuring this is to look at the amount of extra nominal GDP associated with a extra debt. One can contrast the pre and post 2009 credit-splurge periods. In 2004-2008 (the five years before the credit splurge), every 1 yuan in extra bank debt coincided with an extra 1.28 yuan in nominal GDP: in 2009-2013 (the five years after the credit splurge), evey 1 yuan in extra bank debt yields only 0.68 yuan in extra nominal GDP.  The marginal efficiency of bank lending as it related to GDP growth effectively halved.

This is the beginning of an argument not its end – one can and should question why it happened, and even whether it was a necessary adjustment. This piece is not that argument, it merely seeks to demonstrate that the economic role and impact of credit in the last five years is not the same as it was in the previous five years.

Does this declining efficiency of credit matter and if so, why? It matters because it allows us to start putting numbers on the economic burden of China's debt stock. In particular, it allows us to estimate how the financial cost of stimulating an economy by extra debt has risen. If one multiplies the average debt-stock by the average lending rate, one finds the proportion of GDP which must be committed to paying debt interest. One can then use the economic efficiency of marginal debt to calculate how much extra debt as a % of GDP would be needed to earn that amount. What this captures is the escalating effect of relying on ever greater inputs of ever-less-efficient credit in order simply to pay debt interest.

And this is where the problem really shows up: not in the rate of growth of credit per se, or in the rise in the debt/GDP ratio, but rather in the combination of these with the falling efficiency of credit. In 2004-2008 the fact that a yuan of extra credit would seemingly produce a more than an extra yuan of GDP meant that even though nominal interest rates were higher, the economic burden of servicing that debt was not increasing: taking on more credit simply made economic sense. In the 2009-2013 world, however, that has changed, with the economic burden of servicing debt more than doubling, and it making no economic sense to borrow more in order to generate the income to service that debt. 

But bank credit is no longer China's only source of finance: aggregate financing (including the 'shadow banking' which so scares commentators) has also been rising rapidly, at a CAGR of 18.7% over the last decade.  The story of declining efficiency and consequently sharply rising economic burden of the stock of financing is essentially the same as for bank credit, only in every aspect worse. I estimate the stock of aggregate financing stood at 140% of GDP in 2003 and 198% of GDP in 2013. Repeating the same calculations, the economic efficiency of aggregate financing fell from 0.8 in 2004-2008 to 0.37 in 2009-2013, and the amount of new aggregate financing needed notionally to service interest payments on the rising stock rose from 11.3% of GDP in 2004-2008 to 30.9% in 2009-2013. 

The deterioration seems extreme. So it's worth remembering three things:

1. China's private sector is still producing a sharp savings surplus, equivalent to 5.2% of GDP in 2013, I estimate. This represents (and is) the net flow of cash from the private sector into China's banks. Whilst these positive cashflows exist, systemic risks to China's banks will remain speculative.
2. Excess credit itself is likely to erode the marginal efficiency of credit, and conversely, new credit discipline can be expected to improve the efficiency of credit – and this effect can be dramatic if asset turns are forced higher.  So these numbers are less predicting an outcome than projecting a trend. And we know how well that sort of thing normally turns out. 
3. A sensible and informed China analyst will want to ask serious questions about why the efficiency of finance fell so sharply over the last five years, and will almost certainly not be fobbed off with the answer 'look at all those ghost cities.' At some stage, there are legitimate and important questions to be raised and answered about China's capital deepening. 

Nevertheless, I think the numbers do establish two things: first, the role credit plays in China's growth is fundamentally different after the 2009 credit splurge than before it; second, the scope for repeating the post-2009 credit-splurge is  limited, since  any repeat is likely to be much less effective economically and leave a much worse hangover.  China's leaders have put reform centre-stage for the next seven years, and one of the central planks of that reform is financial reform. You can see why.  

US Machinery Sales - When Seasonal Adjustments Fail

Today's news that wholesale sales fell a shocking 1.9% mom sa, with key machinery sales down 0.2% mom should be treated with some caution, because it's possible that the seasonal adjustment process is doing quite as much damage to the data as the weather, or the underlying wrinkles in the US capex cycle.

One of the least conspicuous victims of the great financial crisis has been the quality of Western economic data, or, to be absolutely specific, the reliability of seasonally adjusted economic data in the US and Europe.  Seasonal adjustment mechanisms are all predicated on the usually-correct assumption that most types of economic activity are distributed unequally throughout time – more people work in the day, more people go shopping at Christmas, and more financial analyst roadshows take place in October-November than any other time of year.  So seasonally adjustments work by looking back over the past few years to work out the usual patterns, and then deflate accordingly.

Most of the time this works well enough, but sometimes events can be so unexpected and so violent that they displace the normal pattern of activity.  For example, Japan's 2011 earthquake/tsunami/meltdown disasters over-rode normality; and so too did the great financial crisis of 2008/09. These dramatic disasters throw huge rocks into the pool of economic activity, and the way seasonal adjustments are calculated mean they are pretty much guaranteed to ripple throughout the next few years.

But there's one check you can make: seasonal adjustment should merely redistribute activity around the months of the calendar year, it should never significantly add or subtract to the totals accrued for the year in question. When there's a significant difference between the annual total (or growth) of seasonally adjusted data, vs non-seasonally adjusted data, you know for certain something's wrong.

When it comes to wholesalers' machinery sales, things started to go wrong in 2011, when the seasonally adjusted dollar total came in 1.8% lower than the non-adjusted total. In 2012, things got worse, with the seasonally adjusted total coming 2.9% lower than the non-adjusted total. Although things improved considerably in 2013, the impact of the errors was still showing in the yoy comparisons, with seasonally adjusted sales claiming a rise of 12.3% in 2013, when the non-adjusted count actually came to only 9.3%.

(At a total wholesalers sales levels, there was no similarly large discrepancy – the wholesale trade as a whole evidently didn't take such an asymetric hit as the demand for capital goods.)

These errors will diminish with time, and eventually pass out of the system, and 2014 may be the year in which the seasonally adjusted data finally reconciles with the unadjusted data. But for the time being, it's worth understanding that  there's another way of reading today's wholesalers data:

1. Wholesale sales rose 3.6% yoy, on a monthly movt which was 0.3SDs above historic seasonal trends
2. Wholesale sales of machinery rose 11.6% yoy on a monthly movt which was 0.8SDs above historic seasonal trends. 

As the chart below shows, stripped of its seasonal adjustment, January's wholesalers' machinery sales show not significant slowdown.

Corporate Japan's Persistent Comfortable Defensive Crouch

Japan's Ministry of Finance's quarterly monster survey of private sector balance sheets gives us the most detailed breakdown of corporate Japan's behaviour that there is. If Abenomics really is to have the power to fundamentally change expectations, and so change private sector economic and financial behaviour, it's here that it'll show most unequivocally.

There was so much to like about the 4Q survey that it takes a moment to appreciate why there's no substantial pick-up in capital expenditure – capex rose just 4% yoy in 4Q, which was significantly weaker than expected.  Ironically, to a large extent it is Japan Inc's strengths that bar the way to any early rejuvenation of Japanese industry.

For the details show us just how corporate Japan is doing what it does best: securing margins, and using the cashflow to pay down debts even at a time when topline growth is insufficient to allow a rise in asset turns.  What this playbook emphatically does not include is any sudden rise in capital stock, or any one-off rise in workers' compensation.  The message from corporate Japan, rather, is this: topline growth will have to be seen and sustained before the working practices learned in such a hard school since 1990 are revised.

First, consider the good news: sales grew 3.8% yoy (though fell 0.5% on a 12ma basis), but operating profits jumped 28.5% yoy and 16.1% on a 12ma.  Return on assets rose to 4% annualized, which was the best quarter since 1Q08, and the 12ma of 3.55% was the best since 3Q08. Similarly, ROE rose to 11% annualized, the best since 2Q08, and the 12ma of 9.8% was the best since 3Q08.

What's driving those profits are operating margins, which rose to 4.09% in 4Q, the best since 1Q07, with the 12ma rising to 3.76%, the best since 3Q07. OP margins rose 0.5pps qoq, with the gain being generated almost equally by a 0.2pp fall in cost of goods sold/sales and a 0.3pp fall in SG&A. Better still, the fall in SG&A/sales comes from ex-labour expenses, ie, falling management and admin costs.

But the usual suspects continue to offset the gains made by expanding margins. Financial leverage (total assets/equity) rose to 2.77x in 4Q, leaving the 12m unchanged at the record low of 2.77x. Net debt/equity ratio fell to 59.3% in 4Q from 60.4% in 3Q – another new low.  And although 4Q asset turns (sales/total assets) rose to 0.97, this was best since 1Q12 only, and the 12ma of 0.943 was unchanged, again at a record low.

And that's the problem right there – asset turns are not yet improving, and until they do, there is little ROE incentive to add capacity. In fact, cashflow for calendar 2013 was down 25% yoy, even though 4Q was a sharp and positive reversal from the cashflow drain of 4Q2012.   For the year, cashflow was only 3.2% of sales, which is not impressive for Japan – the long relationship is 3.9% of sales.   That, and the fact that asset turns are still at historic lows, helps explain why capex is so low – up just 4% yoy, which means, for calendar 2013, investment is only just enough to cover the depreciation claimed!  What we have, is stasis still, not expansion.

There is a second problem too: the good margins work is not yet being passed on to the staff. In fact, the number employed fell 2.9% yoy in 4Q. In addition, and compensation per employee fell 0.5% yoy in 4Q whilst sales per employee rose 2.3% yoy.  Sales as a multiple of employee expenses consequently rose, to 7.77x, the highest since 4Q10. The problem is that on a 12m basis, that ratio is the highest only since 1Q13! In other words, as far as Japanese management is concerned, what's going on is simply a recouping of the margins previously sacrificed to labour in the immediate aftermath of the disasters of 2011. And there's no reason to believe the process is complete, or to expect an outbreak of corporate largesse.

China Debt Dynamics: Part 1 - Government Debt

This is Part 1 of a two-part series. This piece was originally carried in the Shocks & Surprises Global Weekly Summary for week ending 3rd January 2014. 

Holiday seasons are generally a convenient time to slip out bad news, and so it happened that China published its latest and best effort to tally government debts on New Year's Eve 2013. A serious effort this was as well, with 54.4k auditors deployed to ferret out the liabilities of five levels of government – central, provincial, prefectural, county and township administrations are all counted. The total as of June 2013 came to 30.27tr yuan, equivalent to a not-so worrying 56% of GDP, but also to a distinctly worrying 248% of total govt revenues (tax and non-tax) for the 12m to June 2013.

Even the maximalist 30.27tr yuan tally comes to only 56% of GDP, which by itself is hardly an alarming proportion. Despite the headlines, this number is not directly comparable to the previously announced 10.7tr yuan estimate of local govt debt as of end-2010 – that tally accounted for only for provincial, prefectural and county govt debt. Even though the debt total is sharply higher than previously thought, this is still not debt-meltdown data. But it ought to alert us to the way this larger-than-expected debt total is likely to bear on policy-choices and policy-making.

The key weakness, and therefore potentially a key policy-constraint, is that the debt is large relative to China's ability to raise taxes: 30.27tr is equivalent to 248% of total central and local revenues, including both tax and non-tax revenues.  That means that every one percentage point rise in financing costs has the potential of attracting (over time) a rise in interest payments equivalent to 2.5% of total revenues.   Now, in the 12m to September 2013, China's fiscal deficit of 811mn yuan was equivalent to 6.5 percent of total revenues. In other words, whether China likes it or not, current fiscal policies are now significantly leveraged to financing costs.

The obvious conclusion from this is that PBOC probably faces more constraints on raising interest rates than previously thought.  And from that, we should also expect that 2013's experience of allowing a rising Rmb to exert increasing economic discipline is likely to be extended in 2014 and beyond. The strong Rmb may be painful for exporters, but their interests are unlikely to outweigh those of the government.

The second obvious conclusion is that China is going to need to raise its government revenues relative to GDP. In the 12m to September, revenues were equivalent to 22.6% of GDP. This proportion has been largely unchanged since 2011, and has interrupted the steady progress made in raising this ratio since 1998 at least (when it was just 11.7% of GDP).  Evidently, for the last few years, the tactical need to support the economy over-rode the strategic need to raise the tax-take.  At some point, that strategic issue will have to be addressed.

The renegotiation of tax raising powers and responsibilities between the Centre and the Provincial governments outlined in the 3rd Plenum were always going to be one of the tougher reforms to deliver. These numbers make those negotiations tougher – a lot tougher – as well as more urgent. Quite possibly this is the single biggest and toughest reform upon which the rest of the package will stand or fall. [So far this year (as of early March) it has not featured significantly as a topic of discussion.]

And there is a third thought: if the debt-total highlights the government's unexpected sensitivity to rising financing costs, then it also raises the classic Chinese question:  who pays?  In this case, it's not difficult to imagine that sections of the financial industry – banks in particular – will find themselves picking up some of the costs involved in keeping the apparent financing costs down, even if market rates rise.  The temptation to extend financial repression – ie, by keeping deposit rates negligible  - even in the face of liberalizing lending interest rates is likely to be strong.  Similarly, we can imagine that the Ministry of Finance is rather more attached to those 20% deposit reserve ratios than previously thought – commandeering deposits is, after all, the cheapest source of financing of all.

And there is this final thought: although it may seem that New Year’s Eve is a suspiciously quiet time to slip out such important data,  the fact that is was published at all is important. It is a message from China’s leadership of the seriousness of their intentions, and the limits of their room for manoeuvre.