China's Cramped Cashflows

It would be nice to have something calming to say about China's Jan-Feb industrial and profits data released today, but in truth, they are awful both in general and in detail. At face value, they confirm what the monetary and banking data has been indicating for several months now – that China's corporate cashflows are now cramping very badly, and that this is showing up both in profits and in flows to and from the financial sector.

And I see no reason not to take them at face value, although they are tricky to interpret primarily because 2011 was the first time that they were released on a monthly basis: before that we got them only four times a year. As a result, the analytical community has only a limited history upon which to judge them. However, fools rush in where respectable buy-sides fear to tread, so here goes. . .

During the first two months of the year, industrial sales were up 12.9% YoY, but industrial profits fell by 5.2%. The rise in sales seems about right: during the same period, Rmb exports were up 2.2% YoY, retail sales were up 14.7%, bank lending was up 14.9% and bank deposits were up 12.5%. The problem is that China's extraordinary sustained investment spending means it's capital stock is growing at around 19% a year (estimated by discounting all investment over a 10 year period). So if topline growth falls much below 19% YoY, the result is that asset turns must fall, and with it, most likely, will fall RoE and cashflows.

This is recorded in the 5.2% YoY fall in profits. The collapse in profits to around 5%, down from 6% in the same period last year. This margins squeeze is not yet quite of the scale we saw in late 2008, but the similarities are obvious to see, and are not explained simply by seasonal factors. 

(A word of warning: China began publishing this data monthly only last year. Before then, it was issued once every three months. Therefore, period to 2011, the monthly line has been produced by interpolating between the three-month data points. We don't know what impact this interpolation has had on the monthly line, but it will have had none on the 12m line.)

That's not all: the cashflow crunch shows up in other ways too, most worryingly in the rise in receivables. In the year to end-February, the receivables recorded by China's industrial sector rose by 1,077bn yuan, whilst total sales rose by 1,378 bn yuan. On that data, it seems that on a net basis, the rise in receivables is equivalent to 78% of the rise in sales: only 22% of the marginal increase in sales during the year to February has been paid for in cash. Receivables are likely to be a highly seasonal number, but if anything the situation seems to be getting worse. Between November 2011 and February 2012, receivables fell by 473.1bn yuan: during the same period in the previous year, receivables fell by 720.1bn yuan.

There is a similar story in inventories of finished goods, which were up 19.6% YoY by end-Feb. Moreover, between November 2011 and Feb 2012, they had fallen by only 91.4bn yuan, which compares to a fall of 172bn yuan in the same period in the previous year. In short, inventories of finished goods have risen relative to sales, and they continue to clear the market at roughly half the pace they did last year.

So the story is: slowing sales, falling margins, surging receivables and rising inventories. Apart from that, everything's fine.

China Money Too Tight to Mention

Since China's policymakers have a close knowledge of the pressures in the financial system (local govt loans, property loans etc), and since they also have the money squirrelled away to deal with them (the 16.76tr yuan in reserved deposits), a hard landing should be avoided. That judgement depends, of course, on policymakers doing the right thing at the right time.

The overall message from February's monetary data is that the time is getting shorter. The immediate worry is the renewed collapse in M1 growth, which fell to just 3.1% YoY in January, and managed only the limpest of recoveries to 4.3% in February. These are the lowest growth numbers in China's recent economic history (including the worst days of 2008/09), and reflect a genuine sequential fall rather than a high base of comparison. What we're looking at is a collapse in liquidity preference which in turn reflected a collapse in transactional and speculative demand for money. Further along the logic-line, this shows up in sharply slowing retail sales (they rose only 14.7% YoY during Jan-Feb, down from an average of 17.1% last year).

But the more pressing worry is that the slowdown in broader money totals signal a real deterioration in the underlying cashflows of the private sector. One can see this most easily by looking at the cashflows of the banking system, simply by measuring the difference between changes in deposits (cash in) and loans (cash out).

As the chart shows, since the middle of last year, the 12m measure of cashflow (before changes in reserve requirements) deteriorated sharply, from around +4.5tr yuan to under 2tr yuan currently. In fact, on a 3m basis,banks' cashflows have been persistently negative since September, and on a 6m basis have been negative since November.  

But that's not the end of the story, since for the last few years, PBOC has simply commandeered that cashflow by raising (or lowering) deposit reserve ratios. Once those actions have been taken into account, we discover bank cashflow was negative throughout 2011 and has remained sharply negative in 2012. Only with the lowering of reserve ratios has this been (very modestly) reversed over the last three months.

Squeeze banks' cashflow enough, and the message gets through not only to the banks but to their customers too. The result? I construct a monetary conditions indicator for China which takes into account monthly deviations from trend or long term averages for monetary aggregates, real interest rates, the yield curve and for movements in the Rmb (vs the SDR). Here's what it looks like now:  

Although the plunge has been less dramatic, the squeeze of the last year has led Chinese monetary conditions to a place as bad as we say in late 2008. Policy reversal is needed, and soon.  

US Consumer, and the 2Q Slowdown

Barrels of analytical ink have already been spilled over the disappearance of US growth in 2Q.  The line generally taken is that it is explained mostly by bad luck: first the weather was foul and inventories were building a bit; then oil prices spiked because of the Arab Spring (and then Libya); and then the global auto industry discovered just how utterly dependent it was on a few parts plants in Tohoku, Japan, knocked out by earthquake/tsunami/power-outs.  All true, no doubt, but the best economists on the Street reckon even this combination doesn't account for much over half the slowdown.

Something else was going on as well. Can we understand it, and by tracking it get a heads-up on the likely direction for the rest of the year.

I think we can. In an economist's ideal world, national flow of funds tables would be published on a weekly basis, so we could track just what's happening to balance sheets. In that way, we could hope to get a better fix on cashflows.  But alas, the Fed serves them up on a quarterly basis. Still, they still have a story to tell.

And the most important, epoch-making story they tell is of a great restoration of 'normality' to US household balance sheets. Take a look at the following chart - it shows the net position of the US household sector with credit markets (including banks) between 1970 and 1Q2011.

Actually, this chart is one of the two mainsprings of the world over the last 50 years (the other being China's emergence). And it neatly divides into three parts. The first part is 1970-1991, during which time the US household sector behaved exactly as household sectors are historically expected to do: i.e., they save, bank the savings,  and the banks then allocate those savings to industry. (Well, that used to be the theory.)  By 1991, these net deposits amount to just under US$1.5 trillion - the equivalent then of 25% of GDP.   But that year is the pinnacle: for starting in 1991, we have an absolutely startling change in financial behaviour: the US household sector starts to run down its net bank savings systematically and increasingly rapidly. By  1999, it's spent the lot, but, being 1999 the party continues.  In fact, the recession of the early 2000s merely accelerates the trend, and by 2Q2007, the US household sector owes credit markets a net US$2.97 trillion, equivalent to 21% of GDP.

And that's it - that's the bottom.  Since then, the sector, voluntarily or otherwise, has improved its net balance with credit markets by US$1.5 trillion, and as of March 2011 its net debts had contracted to US$1.42 trillion, or 9.5% of GDP.

The chart tells you that one way or another, this is a fundamental, one-in-a-generation change in financial behaviour.  It is also the central fact that is dominating US economic growth, and, most likely will continue to dominate it for years to come. This household deleveraging - which, incidentally, is as much a function of diminished appetite for financial risk as represented by equity investment as it is of blunt debt-repayment - is the financial driver of the 'new normal'.

When we track its evolution via the flow of funds tables, we can make a very good guess at what the missing element was that sabotaged US growth in  2Q, coming so hard on the heels of comparative over-achievement in 4Q10 and 1Q11.

Take a look at this chart, which tracks changes in this net debt situation on a quarter-by-quarter basis - i.e., it gives the fine grain detail to the broad sweep of the first chart.

It doesn't look much, does it - another damned dull chart, in fact. But stifle your yawns, take a moment, and  you'll see that although this deleveraging seems to have a marked seasonality, with most net changes taking place during 1Q,  this year the deleveraging barely occurred. During 1Q2009, the household sector's balance improved by US$454 billion; during 1Q2010 it improved by US$288 billion; but during 1Q2011, it improved a paltry US$55.6 billion.

When I model US domestic demand momentum against underlying financial conditions (a model that's fraying heavily at the edges, to be honest),  we saw a marked and inexplicable over-performance in 4Q10 and 1Q2011.  My belief is that that over-performance was the result of a lapse in deleveraging behaviour which, by 2Q2011 was being noticed, regretted, and reversed.

Until the 2Q2011 flow of funds tables are issued (Sept 16, mark your diary!) we won't be able to prove it. As I say, ideally flow of funds tables would be published every week. They aren't - but bank balance sheets are, and we can use those to give us a good idea of what has happened since.  I do this by simply looking at how many deposits are coming into US banks, vs how many new loans are being made - in ridiculously simplistic terms, this is a cash in vs cash out measurement.  Here's what it looks like, up to early July:

And the picture does indeed tell the same story as the flow of funds charts: perennial negative cashflow (more loans going out than deposits coming in) is replaced in 2008 by massive and sustained deleveraging. The pace of that deleveraging declines (though remains positive) throughout 2001 and into the first quarter of 2011.  And then. . . . well, the pace is picked up again in 2Q, and appears now to be stabilizing. 

In terms of the domestic demand, that means a strength of demand in 2010 and into 1Q11 which runs slightly ahead of underlying 'organic' growth (which is also why we get a mini inventory-cycle), followed by a correction in 2Q2011. 

End of the earth? End of the cycle?  By no means - but growth with deleveraging is the new normal in the US, and that's not going to change.  Anytime it looks like it has abated, assume it hasn't. And watch carefully the swings in banks cashflows - at least until they get round to publishing flow of funds tables on a weekly basis.