China's 6.7% yoy 1Q GDP - The Price and the Cost

China’s 1Q GDP result was good news, but was bought at a cost. If China is to maintain progress towards its stated structural goals, as I expect, then the front-loading of government investment and monetary accommodation which built this positive 1Q result will be reversed shortly after it becomes clear that the global trading environment is warming.

The 6.7% yoy GDP growth reported by China for 1Q16 neatly met the universal expectation, so sends the signal ‘nothing to see here’. So as polite guest commentator on China’s economy,  I will ignore it, and turn instead to the much more interesting nominal growth.

Nominal GDP growth accelerated to 7.1% yoy, up from 5.8% in 4Q, and with a very slight gain on underlying momentum. This was actually more impressive than it might seem, because the trade surplus is no longer a major contributor to growth. In 1Q China’s trade surplus amounted to Rmb 823bn, and rose only 8.3% yoy, adding only 43bps to the nominal GDP growth rate.  That compares with an average contribution to nominal GDP growth of 235bps during 2015. Subtract the trade surplus from China’s nominal GDP and we get some idea of what happened to domestic demand: it rose 7.1% yoy, which was the quickest nominal achieved since 2Q14.

This is the point at which to emphasize that even a modest growth in nominal GDP growth at this point is far better news than is generally acknowledged or realized. That is because the legacy of China’s extraordinary surge in investment spending during 2003-2011 has in its fifth year of retreat, allowing one to see on the horizon the long-lost possibility of profits growth.  If one depreciates capital investment over 10yrs, one finds the growth of China’s capital stock is slowing fast: .on this basis, I estimate that in 2015, China’s capital stock was growing by approximately 10% yoy in nominal terms, rather than the 15%-20% pace we’ve been used to since 2003.  My expectation is that capital stock will be growing even slower by the end of 2016. So if China’s nominal GDP sustains the very modest gain against momentum seen during 1Q, we begin to reach the time where nominal GDP is at least keeping pace with capital stock growth, and possibly overhauling it. At that point, asset turns are rising, dragging with it return on capital and profits. For many investors, this will be something they have never seen before.

So there is genuinely good news: but it was bought at a real cost, paid by fiscal policy, monetary policy, industrial policy, investment policy and overall strategic direction. Acknowledge these costs as real, but, crucially, do not be fooled into thinking that China’s authorities have abandoned their strategic goals. Rather, assume those goals will pursued with renewed intensity when the authorities think a suitable economic environment is encountered.

The first cost is a further downturn in the efficiency of finance. In the 12m to March 2016, each increase of 100 Rmb in bank credit was associated with a gain of only Rmb 33 in nominal GDP - that’s down from Rmb 44 during the same period last year, and is approaching the lows associated with the credit splurge of early 2009.  It gets worse: every Rmb 100 of new aggregate financing was associated with a gain of only Rmb 24.5 in nominal GDP in the 12m to March, down from Rmb 30.1 in the same period last year.  Improving the efficiency of financial allocation is absolutely at the heart of China’s longed-for structural reforms. It took a sharp backwards step during 1Q16.

The other obvious cost was the deterioration of the public finances. So far we have fiscal data only for Jan-Feb, which showed only a modest deterioration yoy (a surplus of Rmb 621bn in 2016 vs a surplus of Rmb 685bn in 1Q15). However, the underlying trends were worsening steeply, and if they were maintained during March, I expect the surplus one normally expects in 1Q will have all-but disappeared. If so, the published data suggests China is already running a budget deficit slightly above the 4% of GDP floated as a possibility in PBOC’s research. 

It is not difficult to see how central this fiscal spending is to the 1Q recovery. Also released today was Jan-March urban asset investment: stripping out March on its own, investment rose 11.2% yoy, but with private investment rising just 4.9% whilst public sector investment jumped 23.4%.  And it shows also in the industrial breakdown: the big gains were primary industries +25.5% yt, led by public facilities +31%, water production +26.8% and power & heat +20.9%. Meanwhile, secondary industries - that’s manufacturing - rose only 7.3% ytd. 

That’s not the sort of efficient investment pattern China needs if it is to make the epically-difficult traverse from a financial repression/capital building/surplus production model of economic growth to an efficient saving allocation/return on capital/consumer spending model. It is, in fact, a relapse. 

The danger, however, is to believe that China’s authorities have therefore forgotten or abandoned their strategic goals, or don’t appreciate how the rescue act of 1Q has put those goals in jeopardy.  It is much more likely that they view the 1Q retreat as necessary to safeguard the political environment needed to pursue those reforms in the medium to long term. If so, when the global economic temperature warms, expect the stimuli which supported 1Q to be withdrawn and reversed.