China in 4Q: Tactical Reverse Delivers Modest Victory

China's release today of December's monthly data and 4Q GDP results contain enough information to give us answers to two distinct questions:

• To what extent have China's authorities succeeded in halting the slide of the first three quarters?
• How much progress has been made in 2014 towards steering China towards a less resource-inefficient model of growth?

The answer is that it's reasonable to believe the slowdown in China's economy was indeed brought under control and in some respects reversed. But there is a price: virtually all measurements suggest China made no progress at all in 2014 in discovering a more efficient growth-model.

December Data and 4Q Growth

There was just enough in December's industrial and domestic demand data to suggest the underlying loss of momentum continued to moderate. For the industrial sector, the 7.9% yoy rise in output was a surprise exactly big enough to offset the fall to 7.2% recorded in November.  It included a 2.6% yoy rise in electricity generation which also just about kept that indicator conforming to trend.  Similarly, the 9.5% yoy growth in US dollar exports (9.8% yoy in Rmb terms, and 9.4% in volume terms) was very modestly greater than historic seasonal trends would expect. So the industrial sector ended 2014 in much the same state as it has been since 2012 - oscillating in a narrow range around, and usually just under, trend momentum.

Domestic demand has been the greater challenge as, broadly speaking, it tracked fluctuations in monetary conditions.  And December's data was collectively strong enough to show positive momentum for the first time in a year, which pulled up the 6m trendline slightly, although it is still solidly negative. The strongest signal was from car sales, which rose 16% yoy and were 1.5SDs above trend. In addition, retail sales growth of 11.9% yoy was 0.4SDs above trend for a second successive month. But these gains were offset by still-slowing urban investment (15.7% yoy ytd), and the continuing deterioration in employment conditions as tracked by the official manufacturing PMI.

My momentum indicators suggest that the deterioration of 1H has been mildly but successfully reversed in 2H, and particularly in the last quarter. And,  perhaps surprisingly, the quarterly nominal GDP results suggest the same thing.  This is not immediately obvious: nominal GDP growth slowed to 7.8% yoy in 4Q from 8.5% yoy in 3Q.  When one strips out the impact of the trade surplus (Rmb 917.3bn in 4Q14 vs Rmb554.3bn) in 4Q13 in order to get an idea of domestic demand, nominal GDP growth actually accelerated very mildly, to 6.1% yoy in 4Q from 5.7% in 3Q14.  Going further, one can also strip out the fiscal position, to get closer to movements in private domestic demand: we have the fiscal data only for October and November, but  judging from those two months, it seems clear that, despite the public commitment to supporting economic growth, the fiscal position actually tightened slightly during the quarter. (In the 3m to Nov, revenues rose 8.4% yoy and spending rose only 1.9%, and the Rmb 350.8bn deficit compared to a deficit of Rmb 540bn in the same period 2013).  As a result, when you exclude the impact both of the net trade position and the fiscal position,  I estimate the remaining private sector domestic demand grew 8.2% yoy in 4Q, up from 5.2% in 3Q and 5.8% in 2Q. In short, the deterioration was checked in 4Q.

That conclusion is also supported by my proxy for  the private sector savings surplus, comprising the trade surplus minus the fiscal position.  As the chart shows, the huge build-up of private savings surpluses which accompanied the slowdown throughout most of 2014, stabilized during the last few months of 2014, as confidence stabilized enough to cap the rise in precautionary saving. We do not yet have current account data for 4Q, but during the 12m to September, the PSSS rose to 4.6% of GDP from 3.5% in 3Q13.  For the time being, it seems likely that the ratio did not rise more in 4Q14.

Structural Issues - The Challenge Ducked

The evidence suggests that the government's attempts to avert a spiralling slowdown met with modest success during the latter part of 2014. But there has been a price: there has been no obvious sign that China is edging towards a more resource-efficient growth model. Rather, the longer-term deterioration has continued,  with the marginal improvements since the middle of 2013 scuppered in 4Q14.

My return on capital directional indicator expresses nominal GDP as a flow of income from a nominal stock of fixed capital, and I calculate movements in that capital stock by depreciating nominal gross fixed capital formation over a 10yr period. We do not yet have the formal by-expenditure breakdown of GDP for 2014, so 2014's 7.7% yoy investment spending is modelled from the 15.7% yoy rise in urban fixed asset investment.  This may prove a conservative estimate of investment spending in the national accounts, but even so, it implies China's capital stock is growing around 13.3% yoy - far faster than the c8.2% growth in nominal GDP. As a result, there is absolutely no sign that the fall in the directional indicator is easing up.

Perhaps it might be argued that after the huge investment frenzy of the last 20 years, it is quite unreasonable to expect a rapid turnaround in this indicator. However, it is difficult to see any improvement in other indicators, such as monetary velocity (GDP/M2): although the pace of deterioration has clearly moderated, it has probably not yet improved. (Monetary velocity may be interpreted as indicating changes in marginal output/capital ratios once the effect of changes in the credit cycle are accounted for.)

More directly, one can look at the economic efficiency of finance, tracking how nominal GDP has reacted to the addition of 1 yuan of bank lending, or more broadly 1 yuan of neg aggregate financing. At the beginning of 2014 there were signs that this was finally beginning to recover from the falls of 2008-2009 and 2012. However, developments in 4Q appear to have snuffed out that recovery: in 2014 one yuan of bank lending was associated with just 0.53 yuan of GDP growth, down from 0.77 yuan in 4Q13, and dipping back to the lows of early 2013.  Calculating the similar ratio for aggregate financing, one yuan of aggregate financing was associated with marginal GDP growth of just 0.30 yuan in 2014, down from 0.40 yuan in 2013.

None of this is to write the obituary on China's efforts to re-cast its growth model. But such a traverse is tremendously difficult at the best of times, and in 2014 China's authorities evidently discovered this was not the best of times. The economic strategy no doubt remains, but 2014 was a year in which economic tactics took precedence.