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.

Shocks and Surprises, Week Ending March 25th

• Europe: Intensifying gloom from output surveys; surging optimism from confidence indicators
• Asia: Japan benefits from trade resilience; three China output surveys suggest moderate and lingering weakness
• US: Housing data initially shocks on the downside, but closer inspection lightens the mood

Europe: Singing in the Rain

We continue to have a clear split between data recording what's happening to output, and data recording levels of optimism. This last week, the monthly collection of PMIs for the Eurozone delivered a flurry of body-blows, as PMIs for the Eurozone, but also separately for Germany and France all came in below the range of expectations. The numbers themselves tells not merely of a contraction which has pushed the Eurozone into technical recession during 1Q, but worse, a contraction which is still intensifying. The disappointments encompassed the Eurozone manufacturing PMI (47.7 in March vs 49 in Feb), Eurozone services PMI (48.7 vs 48.8), the Eurozone composite PMI (48.7 vs 49.3), German manufacturing PMI (48.1 vs 50.2), German services PMI (51.8 vs 52.8) and French manufacturing PMI (47.6 vs 50). Italy produced a shock of its own, with industrial orders falling 7.4% MoM in January, reflecting a 7.6% MoM collapse in domestic orders.

German manufacturers are the single brightest hope to shorten and moderate the Eurozone's current recession. But, it was the German manufacturing PMI which was the most shocking, because the details recorded a fall in employment for the first time in two years, whilst input inflation accelerated to its highest since June 11. German manufacturers thus found themselves facing rising costs they could not pass one to customers, and which also left them unable to stimulate sales by discounting.

So it seems perverse that the week also brought a surprise recovery in European consumer confidence, to the best reading since April 11. But it is evidently no flash in the pan.

In France, the Business Confidence Indicator recovered beyond expectations to the highest level since November, based on a jump in export orders sentiment. In addition, in the UK, the CBI's survey of trends found optimism about pricing is far above expectations, and the best since June 11. This was not the first week that European optimism has proved surprisingly strong: in the previous week we saw Germany's Zew survey of economic expectations for both Germany and the Eurozone recover far beyond the range of expectations. And these were joined in the UK by the best reading since September of the Lloyds Employment Confidence survey.

At this stage, one can only read these jumps in European optimism as a relief reflex as the Eurozone backs a few steps away from catastrophic financial crisis. Who wouldn't be more cheerful in these circumstances. The proof of the pudding, however, is in the eating: and in this case, what really matters is whether the immediate financial relief translates into improved credit conditions and monetary conditions. The data for that arrives on Wednesday this week.

Asia: Don't Blame World Trade

Meanwhile, Asia continues to benefit from the surprising resilience of the world's trade cycle, even though China continues to struggle inconclusively with its own cyclical and (more difficult) structural issues. The resilience of the trade cycle was exemplified this week by a surprisingly good set of trade numbers from Japan for February, in which exports fell only 2.7% YoY (vs 9.3% in Jan and an expectation of 6.5%), thanks to a 11.9% YoY rise in exports to the US (which offset falls of 10.7% YoY to the EU and 13.9% to China). This export strength allowed Japan to record a small trade surplus for the first time since September.

Finally China. This week delivered three private surveys attempting to track current business conditions: the HSBC Manufacturing PMI Flash; the MNI March Business Sentiment Survey Flash, and the Conference Board Leading Economic Index. Whilst none of these provided any reason for early optimism, only the HSBC Manufacturing PMI Flash fell outside the range of expectations, declining to 48.1 in March from 49.6 in February. Most worryingly, all of the six subindexes came in below 50 (ie, recorded a contraction), and this contraction is new for output, employment and stocks of finished goods indexes. Not just the size of the overall decline, but also the uniformity of the details means this was a genuine shock.

In that light, it was natural to extend the shock to the MNI Business Sentiment Survey (down to 56.7 from 58.9) and the slowdown in the Leading Economic Index (up 0.8% MoM, after rising 1.5% MoM the previous month). Natural but wrong: although there are no consensus surveys for these two indicators, both these two surveys came in exactly in line with recent trends, and should not significantly accelerate a consensus on China which should be mildly gloomy (but is probably intensely gloomy).

US: Housing Market Wobbles

Main detail of the week was an unexpected deterioration in housing market data. This disappointment arrived in three tranches: first the NAHB Housing Market index reading for March was no better than flat; then the monthly house price index for January also came in flat, and with an additional sharp revision downwards for December (to 0.1% from 0.7%). Finally, new home sales for February fell to the lowest point since October 2011.

Yet this was not the all the housing market information delivered for the week: building permits for February came in higher than expected, with single family homes up 4.9% MoM, and housing starts and existing home sales both came in as expected.

So it's perhaps useful to look at the shocks a little more closely – particularly because the that the housing market will eventually clear is a major part of the belief in a sustained cyclical upturn. And the signals were less grim than initially appears. First, although the NAHB Housing Market Index disappointed, it didn't fall, but rather held steady at the most optimistic reading since 2007. Moreover, the details disclosed an improvement in future conditions, and a sharp jump in the regional reading for the Northeast (cyclically the most depressed regional housing market). Second, the drop in new home sales isn't quite what it seems, either: sales dropped 1.3% MoM, but the median prices jumped 8.3% MoM to the highest level since July 2011. What the numbers reflect is a drop-off in sales of houses priced under US$150,000, not a generalized deterioration in the market.

World Trade: Still No Great Depression

Back in December, I pooh-poohed the IMF's warning that the world might be tipping back into a new 1930s-stye Great Depression by looking at what the global trade data was telling us (see Trade Data vs 'The New Great Depression'). I concluded that 'so far not only is the slowdown nothing like what happened at the end of 2008, but it's less dramatic even than the slowdown which accompanied the near-recession of 2000-2001.'

Three months later this is still the case. The hinge of world trade remains the extraordinarily close relationship between what the G3 imports (US, Eurozone, Japan), and what Northeast Asia exports (China, Japan, Korea, Taiwan). Usually, it's hard to slip a cigarette paper between their changes in momentum.  

We have data for G3 imports for January, which shows imports up 6.8% YoY in dollar terms (US up 10.1% YoY, Eurozone up 0.1%, Japan up 17.8%). We also have NE Asia's export data for January and almost all of it for February too (for Japan we are working from the first 20 days data). That shows exports up 12.1% YoY (China up 18.3% YoY, Japan down 1%, Korea up 20.6% and Taiwan up 10.3%). No doubt the February export data is flattered by the rebound from January's Chinese New Year, but the fact remains that the 6 months trendline for sequential momentum broke into positive territory in February for the first time since August. Moreover, February data from both Singapore and Taiwan suggests that the squeeze on electronics exports appears to have relaxed (see Shocks and Surprises, Week Ending March 18^th).

The chart below shows how the current situation differs both from 2008/09 (obviously) but also remains far better in both YoY terms and underlying sequential momentum than in 2000/01.  

One further note: whilst a better-than-expected trading environment will be welcomed by almost everyone, it does continue to shine a light on China's underlying problem – that increases in its market-share are now won increasingly expensively in terms of investment spending (see this piece). China continues to win market share, but only slowly now. Whilst my best forecast is that China can expect its export total to grow around 10% this year, this no longer matches the c19% growth in China's capital stock. In other words, even in these conditions export growth will no longer be sufficient to support asset turns, return on capital, and private sector cashflows.   

Shocks and Surprises, Week Ending March 18th

This was a week of incremental change only, in which the most consequential data-point was probably the European trade balance for January, in which the non-seasonally adjusted deficit of Eu7.6bn was more than double the Eu 3bn expected. The important point about this was the resilience of Europe's import demand: although imports rose only 3.6% YoY (vs 0.9% in December), this was generated by a sequential change which was 1.1SDs above seasonalized historic trends. In seasonally adjusted terms, imports rose 2.4% MoM. In other words, the expected collapse of European import demand isn't yet visible. Unless it surfaces over the coming couple of months, people will be revising up numbers for NE Asian exports and growth.

Two positive surprises out of Asia this week perhaps prefigured/echoed this:

• Singapore's non-oil domestic exports jumped 30.5% YoY in February, with electronics exports finally beginning to recover, up 23.3% YoY. One contributing factor to this was that exports to the EU were up 11.9% YoY (vs a fall of 14.5% YoY the previous month).
• Taiwan's noticeably strong Manpower survey for 2Q, which recovered to a net positive reading of 36%, which was 1.1 SDs above the series' long-term average, and a sequential reading 1.3SDs above the long term average sequential change. The data from Taiwan's electronics-intensive industrial economy has been in decline since the middle of last year, so this improvement in the labour market environment was genuinely unexpected.

A third indicator gets an honourable mention in this theme: the 20.1% MoM jump in export orders received by Japan's machinery industry in January (up from a rise of just 5.6% in December).

US

This was a week with no significant shocks or surprises in the US data: we are used to labour market data being marginally better than expected and industrial economy indicators stuttering but generally improving. Industrial production came in flat MoM, against an expected 0.4% MoM rise, but the shock-value of this disappointment was moderated by a revision upwards in the previous month's data by . . . 0.4%. In addition, the US$124.1bn current account deficit for 4Q11 was roughly US$9bn bigger than expected, but is largely explained by the way the strength of the dollar (up 1.7% QoQ vs the SDR) deflates net international income receipts.

Perhaps marginally more worrying was a modest but unexpected retreat in economic confidence captured both by the University of Michigan reading (74.3 in March vs an expected 76.0 and 75.3 in Feb) and also in the IBD/TIPP Economic Optimism Index (47.5 in March vs 49.4 in Feb and 50 expected). These two should perhaps be viewed as a warning shot across the bows of the upturn, with doubts emerging about the economic outlook. At the moment, this message is neither coherent, nor unchallenged (the Bloomberg Consumer Comfort index, for example, came in stronger than expected this week). But it is worth watching.

Europe

Apart from the surprising strength of imports, the main feature of the week was the cheery optimism of German investors, as recorded in the Zew survey's of economic expectations both of Germany and the Eurozone. Whilst current situation readings rose only fractionally, there were very sharp jumps in expectations of the future (from +5.4 to +22.3 for Germany, and from -8.1 to +11 for the Eurozone). This is no doubt a reaction to the successful delay/defusing of the Greek sovereign debt crisis – in which the Eurozone has successfully dawdled through the crisis whilst the banks have quietly passed about US$37bn of their May 2010 US$68bn holdings of Greek debt to the Eurozone taxpayer, and thus cut their possible losses by at least 45%.

Against that, we had news that Eurozone industrial output grew only 0.2% MoM in Jan, having contracted 1.1% MoM the previous month. And, of course, output growth is concentrated in Germany, up 1.5% MoM, whilst France rose only 0.4%, Italy fell 2.5% and Spain fell 0.2%.

Finally, although this was probably China's most dramatic week politically since 1989, with the fall of Bo Xilai coupled with more public agonising from Premier Wen Jiabao about the absolute necessity of political reform to accompany the next, crucial, wave of economic and financial reform, we can only record that the drama didn't extend to the economic data. Foreign direct investment was recorded as falling 0.9% YoY in February (vs an expected rise of 14.6% YoY), and the Manpower employment outlook survey showed no significant overall improvement. It is just possible, however, that the 70 cities survey of real estate prices released over the weekend began to sketch out a bottom in the market.   

One Day the EU Will Apply to Join Turkey

I've spent the last couple of months an investment bank in Bahrain which had (past tense) an ambition to ally the surplus capital of the Gulf region to the financing opportunities presented by the historic emergence of Turkey and its near neighbours. To my mind, that was (and is) a hugely inviting prospect. Istanbul is one of the few cities that can claim to be the centre of the world, and right now hosts an alliance of demographics and growth that I remember from the great Asian emerging markets of 20 years ago. The long and short of it is that Turkey is a country of 74+mn, with a median age of 28.5 years, a per capita income averaging around US$10,300. Over the last decade its real GDP growth rate has averaged 5.3%, but it's been a rough old journey, with a standard deviation of 4.4%.

Growth, opportunity and volatility – what's not to like for an emerging market investor?

Right now, it looks as if 2012 will be another rocky year, with investors needing to take a view on how far Turkey overheated last year, how quickly it is rebalancing its economy between domestic demand and exports, and how much appetite world markets have to keep financing Turkey's investment spending. My sort of questions, in other words. (Incidentally, I expect the usual suspects will markedly underestimate the capital appetite for Turkish risk at this point: the key datapoint being the 110% jump in FDI – the world's stickiest money – last year).

My starting point is, as usual, to run the Flow Essentials charts to get to the underlying ratios Turkey's economic growth and financing depends on. Start with estimated growth of capital stock and the direction of ROC. My assumption is that when you've got a rapidly expanding banking system (loan growth of 42.3% last year) you must have significant misallocation of resources, disguised temporarily by inflation (up 6.5% on average in 2011, and rising sharply, to 10.6% YoY in January). But even using deflated numbers, on my count capital stock is growing around 8.6% pa (or 16.5% nominal), but ROC was no worse than flat last year.

And this was borne out by the monetary velocity reading, which again was no worse than flat.

This was a genuine surprise: the expected misallocation should have shown up far more starkly on these charts.

Still, leverage must have been rising sharply, and banking data tells us that banks' loan/deposit ratio rose from around 80% at the beginning of the year to 89% by the end of the year, and that this had been financed at least in part by an increase in foreign liabilities from a net US$16.74bn at the beginning of the year to around US$20.4bn by the end of the year. But once again, one would have expected the rise in leverage of the banking system, and is escalating exposure to the jitters of its foreign liabilities to be more extreme. Run the numbers, and it turns out that only 9% of the rise in the loan book was funded by the net increase in foreign liabilities – slightly less than the 11.2% that was funded by banks' running down their holdings of domestic securities.

But in the end, we cannot escape the fact that even if Turkey's rapid 2011 growth has been driven by rather less inefficient resource allocation than we had expected, and even if the financing of the growth was rather less reckless than it might have been, Turkey's growth was still powered by a major private sector savings deficit. In fact, I estimate that that deficit came to 8.7% of GDP in 2011.

And here is the rub: judging how far and how fast that savings deficit is being corrected this year is surely the key to potentially one of the most exciting turnaround stories of the year.

Yesterday Turkey reported that it ran a current account deficit of US$5,998mn in January, slightly down from US$6,565 mn in December, and US$6,022mn in January 2011. Nonetheless, this was taken as a slight disappointment (consensus had expected a deficit of only US$5,500mn for the month), because the monthly improvement was only approximately half the improvement of the trade balance. The surplus on 'invisibles' amounted to only just over US$1bn, which was 24.1% less than in January 2011. Part of the reason for this, no doubt, was the stalling of the tourism trade: tourist arrivals rose only 0.6% YoY in January – no doubt reflecting Europe's straitened economic circumstances.

So far so gloomy. However, what matters for Turkish financial markets right now is the extent to which, and the pace at which, it winds back the private sector savings deficit which ballooned to around 9% of GDP last year. Movements in the current account are a crucial part of this calculation, and here the news is distinctly better.

In nominal terms, the 3m private sector savings deficit hit bottom in May 2011 at Tkl 33.99bn, and has since moderated. That progress was continued during January. In the three months to end-Jan, the PSSD improved to Tkl 26.57bn – only Tkl 2.38bn above where the balance was the same period last year.

Private sector savings surpluses and deficits usually have a distinctive seasonal pattern (as do current account balances, and government fiscal balances) so we can also assess how current changes in private sector savings flows compare to 'normal' conditions. And, as the second chart shows, when judged on this basis, Turkey's private sector savings cashflow position continues to improve, with the pace of improvement having picked up noticeably in the three months to both December and January.

Shocks and Surprises, Week Ending March 11th

There is a difficulty, because the biggest shock of the week was China's February trade data, but the  explanation for US$31.5 bn February trade deficit is quite different from that we're picking up from the way in which exports and imports deviated from consensus.

For the record, China's export growth of 18.4% YoY was far below the consensus forecast of 31.1%, whilst import growth of 39.6% YoY was within the range of consensus expectation (which ran from 20.4% to 42.2%). Judging from that consensus, the explanation for the trade deficit is simple: exports are weak, mainly thanks to a slowdown in European markets.

The problem with that conclusion is that it is wrong. I cannot explain why the consensus forecast for export growth in February was so high: simply adhering to seasonal patterns would have suggested growth of 13.6% YoY. In fact, exports did slightly better than normal seasonal patterns despite problems in the EU. True, exports to the EU rose only 2.2% YoY (vs a fall of 3.3% in January), but exports to the US were up 22.6% YoY (5.4% in January), to HK were up 22.5% (down 16.4%), and to Asean were up 34.1% (5.6%).

Is my reading of February's relative export strength merely a trick of the Chinese New Year calendar? No: February's sequential export growth was 0.33 SDs above seasonalized trends; combined Jan-Feb export were 0.11 SDs above trends, and Dec-Feb exports were 0.04SDs below trends.

The same sort of analysis for China's imports gives a very different result: China's 39.6% YoY jump in February represented a sequential jump of 19% MoM, which was 2.41 SDs above seasonalized trends. For Jan-Feb, the growth of imports was 0.77SDs above trends, and for Dec-Feb imports were 0.31SDs above trend.

In short, exports were resilient, but the import bill was a true blow-out. I have no idea how the majority of the 29 economists forecasting China's February export growth generated their forecasts.

Unfortunately, the obvious but incorrect storyline of the trade balance being undermined by weak exports is easier to square with the rest of the shocks and surprises of China's February's data than the true story of powerful import demand breaking the trade surplus. For February's data also produced negative shocks on:

• industrial production (up 11.4% YtoY during Jan-Feb, vs consensus expectation of 12.5%);
• retail sales (up 14.7% YoY during Jan-Feb, vs a consensus of 17.4%);
• M1 monetary aggregate (up 4.3% YoY in February, vs consensus of 6.1%).

Other data (M2 up 13% YoY and new yuan loans up 710bn yuan in February, urban fixed asset investment up 21.5% YoY during Jan-Feb, CPI up 3.2% YoY and PPI flat) arrive in line with consensus. 

How, then, to explain coherently this spread of surprises and disappointments? I think two contradictory forces are revealed. First, the really sharp slowdown in M1 growth, coupled with a disappointment in retail sales and a suddenly serious trade deficit all tells us that the economy itself right now is not generating positive cashflow. This lack of cashflow (largely a function of the misallocation of investment since late 2008) is finally having an impact on spending patterns and consumer sentiment. Although measured consumer confidence picked up slightly in January from the record lows of late 2011, it remains at historically low levels (in January about 1.3SDs below the long-term series average.)

But the surge in imports tells a completely opposite story – one in which China's trading environment is expected to improve sharply in the near future, and is therefore re-inventorying sharply. Thus February's data disclosed sharply higher import volumes of crude oil, refined products, iron ore and copper. This expectation is backed by the unrecognizedly resilient export growth, and is bankrolled by new yuan lending which, at 1.45tr yuan during Jan-Feb, was fully 50% higher than the same period last year! And that new lending is also, of course, directly showing up in the sustained investment spending, and even in other regional data, such as the 20.1% MoM in export orders recorded in January by Japan's machinery industry.

If this is the balance of forces – negative cashflow generation offset by sustained new lending funding investment spending and reinventorying – then we should expect the latter force to prevail over the short to medium term.

Elsewhere in the world, the shocks and surprises of last week revealed little we didn't already know: in the US, non-farm payrolls surprised positively not only by adding 227k during February, but also because of major upward revisions made to the (already positive) data for January and December. US consumer credit totals also surprised positively for the third month in a row, with non-revolving credit rising US$20.7bn on the month. Economists have not yet figured out what is happening – but essentially it's the Federal Government which is doing all the new lending. Is it too cynical to observe that this is an election year?

Europe continues to produce exclusively negative shocks, with the tally this week including Italian industrial output (down 5% YoY), UK industrial output (down 3.8% YoY), German factory orders (down 4.9% YoY). In addition, we also saw the unexpected deterioration in France's fiscal position during January, as spending was up 24.8% YoY, whilst revenues were up only 14% YoY. Is it too cynical to observe that this is an election year?  

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.