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%.

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.  

Shocks and Surprises, Week Ending August 26

The whole point of Shocks and Surprises is to spot how the consensus is likely to change by tracking where current assumptions and forecasts are being proved wrong.

Judging from the last fortnight's Shocks and Surprises, it seems we may have got to the point where economists' assumptions (and by extension stockmarket pricing) are proving overly pessimistic. In my round-up last week I noticed that signals from the world's industrial economies were now more often surprising on the upside than shocking on the downside. The same was true this week, and particularly for Europe and the US – generally perceived as the most vulnerable parts of the world economy.

Take Europe: this last week gave us a rash of PMI readings for the Eurozone – readings which economists had by and large expected to show significant deterioration. Some did – France's manufacturing PMI, and Germany's services PMI, for example. But most simply didn't. Not only did the Eurozone Composite PMI, the Eurozone Services PMI, Germany's Manufacturing PMI and France's Services PMI turn out to be better than the range of surveyed expectations, but they almost all actually told a tale of market conditions which had improved during the month. The message was repeated outside the Eurozone, with British order books and consumer confidence readings beating both consensus and the range of expectations.

Something similar, but a little less dramatic, happened in the US, where durable goods orders jumped 4% MoM (and popped the S&P about 20 points) unexpectedly, where 2Q personal consumption growth was revised up from 0.1% QoQ to 0.4%, and where continuing unemployment insurance claims fell unexpectedly (a result obscured by a rise in initial claims generated by industrial disputes). On top of that, the Chicago Fed National Activity Index also came in far stronger than expected – though grazing the ceiling of the most optimistic expectations.

In all, then, the West produced 10 positive surprises, and only eight shocks. And the shocks weren't even difficult to predict – four of them stemmed from the wholesale collapse of German investor confidence tracked by the ZEW Survey. Frankly, ZEW need hardly have bothered: I could have told you that for free. (Indeed, I do.)

More worrying, and much more worth tracking, was the deterioration beyond expectations of Eurozone monetary aggregates. M3 rose only 2.0% YoY, vs an expectation of 2.2% and a range of expectation of 2.1% to 2.3%. Twenty basis points below expectations may not seem a big deal, but the details underlying it are horrible (repos up 20.1% YoY, money market institutions down 12.7%, private sector credit up only 1.9%). Moreover, as I explained here, Eurozone monetary velocity is flat on its back, so if Eurozone financial institutions no longer have the capital to buy or create financial assets, that strain will quickly show up in nominal GDP.

The economist in me worries about this a lot – so much so I'd be adding my weight to those consensus forecasts which are currently still proving too pessimistic.

If it has been a data-heavy week in the West, it's been data-light in Asia. Moreover, as far as China and NE Asia is concerned, there were few surprises. Almost all growth-related forecasts were about right: China MNI Business Conditions Survey, China HSBC Flash Manufacturing PMI , Taiwan IP, Taiwan commercial sales, leading/coincident indicators, Korea consumer confidence – all came in about as expected. That's the good news, the bad news is that the consensus expected stability or a modest continuing deterioration in conditions, and that's what happened.

Within that context, however, Hong Kong's trade data for July was a moderately unpleasant shock: not only did export growth of 9.3% YoY and import growth of 10.2% YoY undershoot expectations of 14.2% and 14.9% respectively (and the range of estimates too), but for both exports and imports, a MoM slowdown in the China-trade was to blame.

Flow Essentials: Scaffolding for the Cycle

Today I publish my Flow Essentials booklet for 2Q for the US, the Eurozone, China and Japan. It tracks those fundamental ratios which are scaffolding for my view on the cyclical state of these economies, and their likely near-term future. The pdf file can be downloaded here.

The charts look at return on capital, labour productivity, banking system leverage trends, private sector savings surpluses/deficits, and terms of trade. They also look at the changing relationships people and their money (liquidity preference), and between money and the economy (monetary velocity).

I believe how these ratios and indicators change tell us a great deal about what's really happening in these economies, above and beyond the noise of the monthly data-tide. Moreover, they uncover cyclical potentialities and perils which would otherwise be largely hidden. Given the extreme financial risk-aversion we're currently suffering, and the underlying economic scepticism and/or fear they reflect, an examination of the roots of the world's leading economies' business cycles feels unusually timely.

Here's what they reveal:

In the US, the charts shed a light on the profound divorce between current cyclical indicators, and financial fears. If you look at what's happening to the factors of production, it's pretty clear that both ROCs and labour productivity growth are still very positive – having survived the 1H downturn with ease. But – and this I find astonishing, if only in retrospect – something profound happened in 2Q. For the first time in 12 quarters, the US private sector ran a savings deficit during 2Q. This deficit was equivalent to 0.9% of GDP, and compares to a surplus of 6.1% in 2Q10, and a 12m savings surplus of 4.3%.

In one sense, this is a shocking reversal of cashflows – for the first time since 2Q08, the US private sector has had to attract a cashflow from the financial system in order to maintain its current level of consumption and investment. And it's no illusion: precisely during the same period, the US banking system's net foreign liabilities increased for the first time since the end of 2008 – precisely what you'd expect if the banking system were having suddenly to find cash, rather than allocate it. Against this background, the weakness of the dollar is hardly surprising.

But in another sense, this is merely a restoration of normal seasonal patterns, after three years interruption-by-crisis. I calculate the PSSS using non-seasonalized data for the current account and the fiscal deficit, and it's those seasonalities which caused the 2Q plunge into deficit. We can be almost certain that a surplus (probably declining) will be resumed in 3Q and 4Q, and that the equilibrium between the US private sector and foreign savers will be effected on easier terms as the year wears on.

The other factor which is very striking is the way monetary velocity has collapsed back almost to levels seen during the worst stretches of 2009. I am inclined to believe that this represents the continuing substitution of deposits for 'riskier' financial assets – nonetheless, the less-efficient allocation of savings that implies must surely be a drag on growth. Looked at in a positive light, however, it seems unlikely that monetary velocity will fall much further – which in turn argues that nominal GDP growth is probably bottoming out just about now (at around 3.7% YoY).

As in the US, so in the Eurozone the cyclical growth factors were actually improving during 1H – ROC was rising gently albeit not yet to pre-crisis levels, and this was allowing a modest expansion of capital stock. There is much better news from labour productivity: real output per worker, adjusted for capital per worker, is now rising for the first time in recent Eurozone history, so labour markets are likely to be more resilient than might immediately be suspected. However, deleveraging is painfully slow, with bank private sector LDRs only dribbling down to around 105% (vs c82% fdor the US). Over 10% of gross foreign liabilities have quit the Eurozone banking system, with the result that even a reasonably large private sector savings surplus (about 5%) isn't delivering sufficient cash to allow much lending-growth. Added to which, monetary velocity has flatlined in Europe now since the end of 2008, with no sign of a pickup. As a result, with deposit growth slowing to under 4%, it seems unlikely Europe's nominal GDP growth will outpace that of the US any time in the near future.

For all the handringing and introspection, the story told by China's fundamental ratios is one of more of the same. Most ratios are disappointing, but not so much as to precipitate either a crisis or a major policy change. Thus, ROC is probably slightly worse in 2011 than 2010, whilst growth of capital stock is probably slightly higher in 2011 than in 2010. Monetary velocity is flatlining, as it has been for 18 months now. Terms of trade continue to decline, albeit gently.

Together the unaddressed inefficiencies are undermining China's cashflows – China's 12m PSSS probably declined to around 5.6% in 1H11 from 6.3% in 1H10 – but the pace of decline makes no dent at all in the financial sector's cashflows. In fact, by July, the banking system's LDR had fallen to 66%, which is actually down from 66.5% in July 2010. This underlying liquidity was, of course, sucked out of the system by PBOC's repeated raising of reserve requirements: once these were taken into account, the banking system's effective LDR was shunted up to just under 84%, it's highest rate since early 2004. The stress, though, is entirely policy-induced. China's real cyclical challenges are political, rather than financial or economic. (That probably makes them more real, more consequential, not less).

There's a challenge in interpreting the ratios for Japan. That challenge is first to separate out the impressive early recovery from the March 11 catastophe, from the real lasting damage done to Japan's economic infrastructure, and then secondly, to remember that even had March 11 not happened, Japan's economy would in any case be only in a mediocre position to prosper cyclically.

The disasters of March have taken a sharp toll on the factors of production: the rise in ROC was abruptly snuffed out, and previously sharp-gains in labour productivity were scaled back. Monetary velocity also collapsed. We can expect all these to bounce back to some extent during the rest of the year. But other problems cannot be attributed to March 11: for example, the unabated collapse of terms of trade – the effects of which are excacerbated by the rise in the Yen. This is also reflected in the slow decline of the private sector savings surplus, which started well before March 11, and has continued after it. The real problem is that this economy still looks fundamentally deflationary, and whilst monetary velocity will probably bounce back in 2H, there remains no reason to think it will or can return to pre-2008 levels. In which case, the long-term contraction of nominal GDP must be expected to continue in the medium to long term.

Finally, there's no real encouragement anywhere for operating margins: terms of trade have fallen sharply everywhere. In the Eurozone and Japan, they have fallen right back to the previous lows of 2008. Things aren't quite so bad in the US and China – but in both cases, comparisons are going to get tougher throughout the rest of this year.  

China Banks' Negative Cashflow - The Squeeze Intensifies

China's banking numbers,  released on Friday, were genuinely nasty, though not necessarily for the reasons mostly cited (a slight slowdown in monthly loan growth, which, on closer inspection still turned out to be  higher than you'd expect in July). Rather, the problem is deposits, which fell by 670b yuan, or 0.9% MoM, at a time when you'd normally expect deposits to rise about 0.6%. In fact, even before you take seasonal patterns into account, this was still the worst month for deposits since October 07. Probably part of  this retreat is simply a reaction to June's mad dash for deposits to satisfy quarterly and semi-annual inspections by CBRC centred on LDRs. Nonetheless, over the three months to July, the sequential growth of deposits was 1.3 standard deviations below historic trends. 

By itself, that would be a worry. But the funding squeeze on China's banks is far worse than merely that,  because there have been six hikes in reserve ratio requirements this year, with big banks now having to hand over 21.5% of their deposit base. Once you factor in those RR hikes, you'll find that whilst deposits are growing at 15.4% YoY, growth of deposits potentially available for lending or purchase of other assets has now fallen to 8.5% YoY. And this is the slowest rate since - well, my database starts in 1998, and it can show me no similar slowdowns. 

But yuan loans are still growing at a rate of 15.0%, and even though the loan/deposit ratio of China's banking system prints at 66%, that's still means China's banks are now giving out loans far faster than they are taking in deposits available to be lent. 

Over the 12 months to July China's banks took in 10.4 trillion yuan in new deposits, and made 6.76 trillion in new yuan loans - a positive cashflow of 3.64 trillion yuan. However, at the same time, the state commandeered 5.614 trillion yuan of those new deposits. So when you subtract those, the banks' net cashflow situation looks very different - after reserve ratios, the banks made just under 2 trillion yuan more new loans than they took in new and available deposits. In other words to keep lending at this rate, banks need to sell other assets, or take on new liabilities (such as foreign equity or bonds).  They need to do that simply to recreate a cashflow which has been confiscated by the state.

PBOC used this tactic of -  shall we call it redacting the inflow of deposits? - back in 2003/04 and again in 2007/08. But what's happened since September 2010 has been bigger, and sharper, than has ever been seen before in China. 

In 2003/04, the cashflow squeeze peaked in May 04, and for six months after that sequential loan-growth collapsed to 2 SDs below seasonalized trends, with the result that by May 05, loan growth had slowed to single digits (9.2%). 

In 2007/08, the cashflow sqeeze had a double nadir in Oct 07 and Jan 08. Although the subsequent slowdown in loan-growth was not as dramatic as in 2003/04 the subsequent collapse of the domestic economy is a matter of record.  

So even in July 2011 proves to be the absolute nadir of the squeeze, unless we see a concerted relaxation of regulatory and policy pressure, the 16% loan growth target is likely to be missed by a long way this year. My best guess at the moment? Unless something changes. . . . 11%. 

Will China Implode? Not Just Now

So to recap, the world economy was swinging along nicely, despite the collapse in confidence, when it ran across  three potential catastrophes:

1. The possibility that the US recovery is stalling (a complex nexus of causes and effects which includes the impact of a profoundly divided political establishment on economic and financial confidence); 
2. The existential crisis of the Eurozone;
3. The possibility of a hard land for China. 

Today I'm going to look at the third - China.

(But first, note that the debt crises in the US and Europe are actually historic reflections of each other. The US Treasury market was a war-child - between 1861 and the end of the Civil War in 1865 government debt  mushroomed from US$65 million to US$2.756 billion. Out of desperate need to finance a war to finally settle the historic States/Federal political question, was born a single dominant Federal debt market. We watch now as that debt market becomes hostage to precisely the same question of State/Federal rights and powers (which is what, ultimately, the Tea Partiers are on about). Meanwhile, over in Europe, the attempt to try and retain a full fiscal panoply of State Powers whilst sharing a single currency has delivered bankruptcy to at least one State, and probably more. The result, more likely than not, will be the construction of a single dominant Federal debt market.)

I remain sanguine about China's immediate future.  This is not, I hope,  because I don't recognize China's problems, or the threat they pose. But for the most part they are not new. Take, for example, the worry about the debts of local government financing platforms. Now, there is no doubt that they are far bigger than they have been, and far bigger than they should be - whether you accept the National Auditor's lowball figure of around 9.5 trillian yuan, or the higher estimates, which range up to around 14.5 trillion yuan.  But in the end, these debts represent the accumulated fiscal deficit of provincial and lower levels of government. Since in China taxes flow upwards to Beijing, but responsibilities flow downwards to the regional authorities, how to finance these layers of government has been a perennial problem for China for as long as I can remember. Indeed, I'd say that how to finance lower-tiers of government has been the problem for China, possibly exceeded only by problems of water and agriculture (to which, of course, it is linked).  Monetising this problem away was the underlying reason why China used to be inflation-prone , and which ultimately brought Zhu Rongji to power in the 1990s.  About his first act was to re-set the split of China's tax-take between national and provincial governments. Anyway, here's the big bad secret which China's (not) been hiding all these years - if you're fiscally squeamish look away now. . .

As you can see, between 1995 and 2009, Guangdong and the Yangtze Delta can lay claim to fiscal respectability.   But most of the rest of China can't. The capital region (Beijing-Bohai) has finances which, were it not the capital, would be among the most disastrous in the nation - but we can perhaps give it a pass on account of its unique position in China. But the Industrial Northeast, which ran a fiscal deficit of over 12% of provincial GDP in 2009, has a distinctly rust-belt fiscal legacy. And in the Central Provinces - China's heartlands - the deficit was running at near 8% of GDP in 2009. In short, the fiscal position of China's provincial governments is a mess, and has pretty much always been a mess.

So although the situation is now news, it's not exactly new. Nor are the ways in which it has been solved. First, the central government rebates the vast majority of taxes back to lower levels of government. And secondly, local governments supplement their budgets by land sales and by using near-deniable near-provincial-sovereign financing platforms.  When times are tough, or when provincial countercyclical spending has been particularly ferocious,  there will be an extended tussle about who, ultimately, gets to pick up the tab.

With a bit of luck we will not be witness to the grisly infighting which will eventually produce a settlement.  But we can be pretty sure that it's a question of 'who's going to pay', rather than 'where on earth are we going to get the money from', because we can track the underlying cashflows of the whole China economy via the private sector savings surplus. And here is my estimate of it, up to June this year:

The key point of this chart is that although the private sector savings surplus is in decline, it's still massive at around 5.6% of GDP, or 2.4 trillion yuan a year. And that surplus is effectively the net cashflow into China's financial system after the banks have done all the lending they can do to the private sector (which for these purposes includes the local government financial vehicles). There's nothing for this money to go on except either central government debt, or foreign assets. This persistent deluge of cash into the banking system is the reason why China's banking system has a collective loan/deposit ratio of only 66%. It's the reason why bank lending can growth at mid-teen levels persistently even though the government has commandeered and disabled 20%+ of the deposit base as reserves.  And, of course, it's also the reason why China isn't going to run out of financial or fiscal options any time soon.

China's April Data - The Short Conclusion

Excluding the social housing campaign, you can sum up April's data like this: contrary to popular belief, China’s economy is  being rescued by the upturn in the global economy – not the other way round.  

China's Transition - Installing Complexity

I'm off to China at the end of the week, and I've no doubt everyone will still be telling me that China's transition is underway. Certainly if you look at the Street's forecasts for China, you'll see everyone is dutifully sketching in the transition from investment & export led growth, to consumption-led growth, whilst the underlying growth rate and savings/investment balance barely skips a beat.

Let's hope so.

But I can't help noticing that in dealing with the challenges posed by China's current economic situation, the recourse to administrative measures in every way favours those parts of the economy which are most susceptible to state direction, which systematically making life difficult for China's freebooters and SMEs. Consider, for example, the choice to curb money supply growth by applying credit controls either directly (by raising reserve requirements, patrolling bank loan/deposit ratios, and directly discouraging lending into certain sectors), rather than by simply raising interest rates. What happens? Well, since the banking system isn't able or encouraged to price for risk, it'll simply lend to its 'safest' customers - the SOEs. The rest - that's the SMEs and the private sector - will soon learn not to bother applying for loans.  And so today the Chinese press tells us that kerb market rates in Guangdong, Zhejiang and Jiangsu are running at 10% a month.  When one part of the economy continues to misallocate, the other part gets squeezed hard.

It's not just money either - it's also electricity. China's got brownouts now, partly because of longstanding coal/electricity mispricing, but also partly owing to the powering-up of those energy-intensive industries which were shut down temporarily at the end of last year in order to meet environmental targets. And in Zhejiang, guess what?  When electricity is allocated, SOEs survive but private enterprises and SMEs are correspondingly  badly hit: enterprises using less than 2,000 kW per day have been shut down every other day since last year.

Now these sorts of policy choices and actions can in the short term mean targets (growth, inflation) will be hit. But by reinforcing an allocation of resources to that part of the economy which knows above all else how to invest big time now and worry about the end-market later,  the choices are surely not bringing forward the day when China's economy is driven by consumer demand, rather than the capex plans of the SOEs. Nor are they  likely to reverse the underlying downward trajectory of China's ROC and cashflows (see here).

As I've already observed, making the transition from exogenous growth models to endogenous growth models is damned hard, if only because the wild success of the financial repression/investment intensive and export-the-surplus model constantly reinforces precisely those lessons which ultimately need to be unlearned and discarded.

If the transition is to be made, all of us, investors, observers and policymakers, had better resign ourselves to a far greater complexity, and probably a far greater volatility, in the Chinese economy than we currently observe.  For, as the great Kevin Kelly says:

You can't install complexity. Networks are biased against large-scale drastic change. The only way to implement a large new system is to grow it. You can't install it. After the collapse of the Soviet Union, Russia tried to install capitalism, but this complex system couldn't be installed; it had to be grown. The network economy favors assembling large organizations from many smaller ones that keep their autonomy within the large. Networks, too, need to be grown, rather than installed. They need to accumulate over time. To grow a large network, one needs to start with a small network that works, then add more sophisticated nodes and levels to it. Every successful large system was once a successful small system.

About Economic Transitions

You've read all about it, I've read all about it. I've talked to the economists and think-tanks in Beijing who wrote the message in the first place, and felt the sincerity and conviction with which they deliver it. I've gone through their numbers, and tried to understand what they actually mean. So yes, everyone is agreed that China is embarking on a change of economic model which will shift the dynamic of growth from investment and exports, to domestic consumption.

But there are three obvious problems. The first is that these transitions are incredibly hard to achieve:  the economic and political history of the last 100 years is littered with examples of economies which tried and failed. The second is that, as they say, 'you wouldn't want to start from here' - the transition China intends is probably the most extreme ever envisaged and even with the best policy-settings and initiatives, would take not years but decades of sustained effort to accomplish. The third is that the immediate and compelling responses to China's current economic challenges can only entrench the existing model deeper than ever.

Let's take these three separately. The pattern of economic history has been repeated several times now. I wasn't around at the time, but the history books tell me unequivocally that in the early 1950s the Soviet Union  had achieved economic miracles and looked economically invincible. People looked at the extraordinary  mobilization of resources, and wondered what the US could offer in response. Richard Nixon's 1959 answer - way-cooler kitchenware  -  hardly seemed plausible, but turned out to be right.  Japan has attempted it at least twice - once in the aftermath of the first oil shock, the second with the implosion of the bubble economy. (Three times actually, if you include the Taisho democracy of the 1920s.)  How's it going?  Well, Japan is determined, organized and deploys an astonishing accumulation of social capital, but its nominal GDP last year was just about what it was in 1992.  South Korea talks a good game about making the transition, but  devalues the Won at the whiff of economic grapeshot.

The reason that these transitions are so rarely achieved is bound-up in the very foundations of economic success. For simplicity's sake, let's say that the transition being attempted is one from an 'exogenous growth model' to an 'endogenous growth model.'  Exogenous growth models are in essence rather simple and can be quite wildly successful. The recipe is this: muster savings ruthlessly and pile them into industry. You'll produce far more than you can consume, but don't worry, because you can always export the surplus (that's the 'exogenous demand' bit of the 'exogenous growth model').  On the assumption that exogenous demand is inexhaustible, you'll be able to do this right up to the point at which adding up-to-date capital, technology and management techniques stop raising productivity levels. Or savings run out.

If you are a political leader, you'll pick up above all on two aspects of this model. First, it justifies enduring financial repression, in which consumption is discouraged, savings encouraged, and the financial system heavily monitored/regulated.  You'll  like that, not least because it'll pay your bills.  Second, in the short, medium and even long term, it can be wildly, unbelievably successful in terms of growth and employment. And everyone'll like that.

So why bother to change? Good question - and one which the Japanese still haven't managed to answer. But we  know that when a country approaches the technological frontier, the going gets a lot tougher. By which I mean, returns on capital fall, cashflows begin to dry, the failures of resource allocation become more noticeable and costly, and finally investment opportunities dry up, and growth with it. (Probably around the time your people are beginning to want that way-cooler kitchenware.)  

But here's the rub. The very success of the exogenous growth model over decades will have taught the political leadership that beyond any shadow of doubt they know how to make things work. Save harder. Invest more.  Keep your currency competitive. Not only does your experience tell you this, so does every businessman and financier who comes through your office door.  To do anything other than double-down goes against every instinct in the body politic.

And so, you double down . . . . and lose. It's the hardest lesson in economics: it is only by ruthlessly repudiating the lessons learned in the decades of success that you can transcend the model's limitations.  More later. . . .

 

What The Street Isn't Telling You About China

The thing is this: more than at any time in the recent past, the economic signals coming out of China are  contradictory, incomplete, wildly and inexplicably volatile and ultimately incoherent.   I've been watching China's data for - oh god - decades now, and I don't honestly think it's ever been as weird as this.  I cannot confidently tell you what China's economy is going to look like in six or nine months time, let alone in two or three year's time. But I'll tentatively say this: that unless things change swiftly and radically, the much-heralded and desired shift to an endogenous growth model (consumption allied with innovation-inspired productivity gains) and away from the exogenous growth model (massive investment, financial repression and US-devil-take-the-surplus) isn't going to happen. Indeed, if you have to straightjacket the current mess of data into a coherent pattern, it's one in which the investment & exports model is back big-time, mandated and reinforced by the choice of monetary policy instruments. (I'll explain how monetary policy choices are forcing this in a later post.)

Let's talk first of the gaps in the data. Here are just a few of the things we don't know about the 1Q. We don't know whether the government was running a surplus or a deficit - that's right, we really don't know the fiscal position. We also don't really know anything about retail consumption apart from the national total (up 16.3% in 1Q) because we have no by-province breakdown.  We think we know what's happening now to  property prices and sales, but we've no good way to interpret them because all the indexes have been abandoned or rebased.  We don't really know what's happening to liquidity, because PBOC has (wisely) started tracking a broader measure of credit, but (unfortunately) without also giving us some historic perspective. And, of course, we don't really know what's happening to inventory.

We do know what's happening to investment spending, because at least we have both national and provincial data. But of all the data, the fixed asset investment data is the ropiest in China because, like local authorities in the UK, it's wildly seasonal in order to satisfy various budget mandates.  What we do know, however, is that  the seemingly smoothly-growing national investment spend conceals unprecedentedly wild geographical swings. I regularly break down China's economy into seven different regions, and when you do that, you'll find that investment spending in the NW in March was 5.75 standard deviations above its historic seasonalized trends; spending in the Industrial NE was 4.5 standard deviations above; in the Yangtze Delta it was 3.9 standard deviations above.

Really?

But then March's data generally - particularly the industrial sector data - doesn't look right. Yes, January to March is the Dark Side of the Lunar New Year as far as data is concerned. But this year shouldn't have been too anomalous, since the holidays began on 3 Feb this year, compared to 14 Feb last year. But in fact, the seasonal anomalies were the most extreme in recent history:  exports fell 35.8% MoM in February and jumped 57.3% MoM in March - whereas normally (including adjusting for CNY) you'd expect a contraction of around 12.9% in Feb, followed by a 27.5% jump in March.  The anomaly was a full 2 standard deviations above where one would expect it.  Does anyone know why? I don't.

I also can't explain where the export growth came from.  In Guangdong, the pattern conformed pretty much to seasonal type, with March's exports up just 0.6 SDs from seasonalised trends. But in the Yangtze Delta . . . good lord, exports were 2.8 SDs higher than you'd expect them in March; in the Industrial NE they were 2.6 SDs above seasonalized trends, and in the Central Provinces they were 2.7 SDs.

How come Guangdong missed out on the fun?

Now I know what you're thinking: it must be the labour shortage. But I have news for you: I can track national employment totals monthly for 39 industries - it comes to about 80 million employees. And when I do that I find that in  February employment 1.6% lower YoY - ie,  these industries have shed about 1.3 million employees over the last year, mainly right at the end of last year. The figures tell me this: you can forget about the 'labour shortage' in the textiles, garments, paper, chemicals, plastic products, metal products, machinery  and nonmetal minerals industries, because they're all shedding workers fast.  Lucky the auto sector is still hiring (but what's this, auto sales up only 2.6% in Feb, whilst sector employment is up 5.2%?

Must be seasonal . . . touch wood.

And so on. We have tangled wreckage where we'd like to have data. Yet the question of whether China is overheating or heading for a hard landing has to be addressed. And, presumably, responded to by fiscal and monetary policies.  And that's what we'll look at next. As a sneak preview, though, I feel it fair to warn you that the likely outcomes of current policy settings are rather different from the ones you have been encouraged to contemplate and invest in.