US 1Q Stumble : A Bigger Hit to Profits

Observations and Conclusions
What is one to make of the state of US GDP growth after the stumble to 0.2% annualized of the advance estimate for 1Q?  The immediate causes for the slump are known and have been tracked here repeatedly for the past few months, including: the unexpected rise in the personal savings rate, the opening up of a supply/demand disequilibrium in the industrial sector, the deterioration in inventory ratios both for manufacturers and wholesalers and the stalling of capital goods spending.

Some of those are clearly transitory disruptions generated by a completely unexpected shift in relative prices, notably the fall in energy prices. And in at least two cases, the most recent monthly data suggests that there is some reversion to previously-experienced ‘normality’ is already underway. For example, it is likely that the fall in petroleum prices gave households an unexpected windfall which they initially banked rather than spent. This ratcheted the personal savings rate  from 3.9% in November to a peak of 5% by February, but this retreated to 4.6% in March. The dynamic may now be changing but even so, personal savings jumped 16.2% yoy in 1Q, whilst personal spending growth slowed to 3.5% in 1Q from 4.1% in 4Q14.  Secondly,  by February, the unexpected climb in manufacturers’ inventory/shipment ratio which had taken it from 1.3 in September to 1.36 in January seems already to have peaked, falling to 1.35 in February.

Whilst we can watch some of these transitory dynamics develop and begin to resolve themselves, the1Q stumble reveals deeper weaknesses which cannot be resolved so quickly.

Those weaknesses show up when we subject the US economy in 1Q to a Dupont-style breakdown in an attempt to identify factors affecting growth, return on capital and cashflow.

The core problem is that there is more to worry about than merely 1Q’s stagnant topline growth (nominal GDP was stagnant). In addition, the first quarter saw stagnation in the previously-improving terms of trade, and an unexpected and unwelcome return to deleveraging strategies.

The result is that even though household savings rates and tallies rose, the private sector savings surplus for the economy as a whole almost certainly sank into deficit in 1Q. This is an unexpected result which strongly indicates that corporate profits must have been hit hard during 1Q, with asset turns, margins and leverage all contributing to a fall in return on capital. And whilst one should certainly expect some topline relief in 2Q, there seems no good reason to expect either a further boost to terms of trade, or an early willingness to change leveraging/deleveraging behaviour.  The logical conclusion from that is that the current weakness in the capital goods cycle is unlikely to reverse sharply in the near future, and consequently that the business cycle is similarly unlikely to bounce in the near future. At present, consensus expects a rebound to 3.1%  annualized growth in 2Q: the risk to that consensus, I’m afraid, is probably on the downside.

Let us look at these components one by one.

ROC and Capital Stock. The 1Q stumble has, of course, hurt the ROC directional indicator (generated by expressing GDP as a flow of income generated by a stock of fixed capital, with that stock estimated by depreciating gross fixed capital formation over a 10yr period). That downturn has now lasted two quarters, which is the longest fall since the financial crisis. Despite this, the indicator remains at historically very high levels (better than anything achieved in the 1990s) and capital stock growth is still extremely muted at just 2.6% yoy.  The current deterioration is only a modest decline from a propitious starting point, so unlikely by itself to be sufficient to be itself the cause of further deterioration. 

This does not necessarily point to a new slowdown in the capex cycle since a) there is usually a lag between the downturn in the return on capital indicator and a clear downturn in investment spending and b) the ROC indicator remains at historically very high levels. However, this two-quarter fall in the ROC indicator is consistent with the uninterrupted decline decline in capital goods orders seen since August. 

For labour, the data makes easier reading: in yoy terms, the number of employees rose 2.3% yoy and real GDP rose 3% yoy, so output per worker rose 0.7% yoy in real terms. Perhaps surprisingly, this is the highest yoy rise since 4Q13. With capital per worker rising 0.4% yoy, output per worker adjusted for changes in capital per worker still showed a rise of 0.3% yoy. This is hardly inspiring, but is probably sufficiently positive to maintain positive momentum in labour markets.

The rise in output per worker has been running ahead of capital per worker now almost uninterruptedly since 2010. However, it is worth noting that even now capital per worker also rose 0.2% qoq and 0.4% yoy, which is the highest it has been since the Great Recession.  In the immediate future, this combination of rising output per worker (deflated by capital per worker) and (probably) still rising capital per worker is likely to sustain both labour markets.

Terms of Trade.  Difficult this: the improvement in terms of trade which accompanied the fall in petroleum prices was sustained between July 2014 and January 2015, and lifted them by 5.5%.  Such an improvement should have resulted in improved trading and profit margins for companies, and for households, reduced energy bill. Both should have improved cashflows into the financial system.  If it did, what happened to that money? Also note that in 1Q15, that that improvement stalled, which will have removed that stimulus (if any).

Leverage and Money. When we look at banks’ loan/deposit ratio we can see precisely what happened: the extra cashflow was banked. A relatively modest rise in bank loan/deposit ratios which emerged in 2Q14, fractionally reversing a decline in the ratio virtually uninterrupted since the financial crisis. The LDR rose from a low of 74.8% in April 2014 to a peak of 76.2% in October 2014. But there it peaked, and retreated very modestly to 75.6% in March. In short, the trading gains from the rise in terms of trade were banked (as the rise in the personal savings rate suggested) and the timid releveraging of early 2014 was snuffed out. 

The same story materializes when we look at the relationship between money and the economy. Two things are evident. First, in 1Q the recovery in liquidity preference (M1/M2) which had been quite dramatic since 2008  flattened out in 1Q15, suggesting a reduced transaction and speculative demand for money - consistent with a reduced eagerness to spend money. Second, the decline in monetary velocity (GDP/M2) which had been arrested during 2014’s brief flirtation with re-leveraging, bit back again with a vengeance in 1Q.  In plain terms, when falling energy prices delivered a windfall from trading margins (companies) or budgets (households), those gains were banked in deposits not spent (hence souring trends in liquidity preference and monetary velocity), which in turn reduced 1Q GDP.

Private Sector Savings Surplus

But now we come to a conundrum: all this suggests cashflows should have been very positive, and that the private sector would have generated a rising savings surplus in 1Q. But unless there is a sharply more positive current account position reported than seems likely from Jan-Feb data, this simply didn’t happen. Rather, the currently available data for federal debt and likely current account balance point to a small deficit (US$20.6bn) in 1Q, sharply reversing the $186.8bn surplus achieved in 1Q14, and cutting the surplus to a meagre 0.3% of GDP for the 12m to 1Q15.

How could this possibly be consistent with the rest of what we think we know about the economy? There are two potential sources of savings surpluses: household savings and corporate profits. Since we know from the personal income and spending data that household savings rose sharply during 1Q, assuming the 1Q estimate of the PSSS is not badly awry, the numbers must point to a far sharper downturn in corporate profitability than the ROC directional indicator suggests. This is, of course, consistent with the sharp downturn in orders of capital goods, and the way export growth has stalled in recent months.  

There is a further implication: movements from private sector savings surpluses to deficits generally tend to put pressure on bond yields and fx rates. 

Likely Near-Term Trajectory of the Cycle

Two of the three factors affecting return on capital seem unlikely to be helpful in the near term. First, last year’s jump in the terms of trade is unlikely to be extended or repeated, and this is likely to compromise margins and cashflows. Second, it is difficult to find a good reason to expect the current deleveraging will be once again be reversed in the near term.  There is, however, a third factor which should improve: the energy price windfall isn’t getting any bigger for households, but conversely, spending/savings patterns are likely to revert to normal (which means more spending). The net impact is probably neutral to positive for on household spending. 

But if corporate profitability has already been hit more than is immediately obvious (which seems to be the lesson from the private sector savings deficit), then the removal of terms of trade gains and sustained deleveraging will put more pressure on the capital goods cycle. And that, of course, puts pressure on the dynamic of the business cycle, and consequently on the prospects for a 2Q rebound.

The Hong Kong Connection: Postscript

The role played by Hong Kong's banks in the outflow of capital from China over recent months has a further consequence which is worth pointing out clearly. Very regularly, when faced with unexpected surges in China's trade balance, analysts scrutinise trade flows between Hong Kong and China particularly closely, looking for (and often finding) evidence of over-or-underinvoicing for exports and imports. 

The point to make is this: even if this succeeds in inflating China's overall trade surplus, if at the same time it inflates Hong Kong's trade deficit, then that will erode the very private sector savings surplus upon which Hong Kong relies to fund (or even maintain) its net bank lending to China.  In this symbiosis, the trade money flows to China, but that generates a demand by Hong Kong's banking system to claw it back by cutting credit lines to China. 

It didn't always work this way: when Hong Kong had a regular major savings surplus, or when net lending to China wasn't virtually the whole of Hong Kong's net foreign lending, the relationship would have been contingent, mild and even effectively non-existent. But that's not the case anymore: if China swells Hong Kong's trade deficit, Hong Kong will (must) get the money back by cutting lending to China. That's the symbiosis.

China's Capital Outflow: The Hong Kong Connection

A squeeze on lending to Chinese banks by Hong Kong’s banking system has been a primary, and perhaps even dominant factor in the capital outflow which has eroded China’s foreign reserves over the last six months.  Net foreign currency lending to China by Hong Kong’s banks contracted by HK$555bn (US$71.5bn) in the four months to January 2015 - a fall of 21% over those four months. So far, though, there has been no reciprocal significant withdrawal of Chinese bank liquidity from the Hong Kong dollar market.

The core fact needing explanation are these:  between the end of August 2014 and the end of March 2015, China’s fx reserves dropped by US$238.8bn, despite having recorded a US$67.021 bn current account surplus in 4Q, and a US$123.8bn trade surplus in 1Q15.  In 4Q14 China recorded a capital and financial account deficit of US$30.5bn, and the deficit was certainly much larger than this in 1Q15.

How was Hong Kong involved in those outflows? Was it a beneficiary of deposits moving from China to Hong Kong, or was it a protagonist, clawing back credit previously extended to China? More, has the decrease in China’s foreign exchange reserves meant any alteration in the extent to Chinese banks’ involvement in Hong Kong’s money markets?

We can find the answers in the changes in the net external position of Hong Kong’s banking system, and specifically the net position with China, both in Hong Kong dollar markets and in foreign currency markets. Within this, it is the foreign currency position which matters most,since the Hong Kong dollar position accounts for only about 22% of Chinese entities deposits in Hong Kong’s financial system.

Looking at the foreign currency position (which includes the Rmb position),  liabilities to Chinese banks rose by HK$138.6bn and to non-banks by HK$36.5bn in the four months to September, whilst foreign currency claims on Chinese banks fell by HK$379bn, and by HK$2.5bn to non-banks.  Overall, this means that Hong Kong banks’ net claims on Chinese entities diminished by no less than HK$554.8bn (US$71.5bn) in the four months to January. That’s a fall of 21% in the net position in four months!

Crucially, HK$515.8bn of that withdrawal from Chinese positions was attributable to closing positions with Chinese banks, with loans to Chinese banks being withdrawn far faster than Chinese banks raised their deposits: foreign currency claims on Chinese banks fell by HK$379bn, whilst liabilities to those banks rose by HK$136.6bn.  What is more, it is plain that the withdrawal of net foreign currency loans by Hong Kong banks has (so far) been specific to Chinese banks: to net lending to foreign banks (including China) fell by HK$99bn only in those four months, whilst net loans to foreign non-banks rose by HK$44.3bn.

Why have Hong Kong’s bankers cut their China loans? There are at least two ways to look at this. Most obviously, Hong Kong’s banks may have cut their risk profile with Chinese banks in response to concerns about China’s economic slowdown and the deteriorating credit quality.  

(One interesting question is: do China’s banks themselves share this perception of increased risk, and if so, will (are?) Chinese bankers taking a similar view of their customers’ prospects?  Given the concerted efforts made by banks to improve their abilities to assess risk and price for it, one would expect so.

For example, this week the results of a survey of 200 bank branches in 12 cities by Rong360 found no banks were offering first-time buyers the 30% discount on mortgage rates recently allowed by the government, or were giving discounts on second home loans, despite policy relaxations by central bank.  Rather, a majority of the banks were charging rates above the benchmark rate.  There were a couple of bankers’ quotes accompanying the report which bear repeating: 'It's difficult because our margins are already squeezed, there isn't much differentiation in the market, so our focus is on how much our capital costs are.'  Another: 'Banks look for good investment return, so they'd rather invest in the stockmarket.')

But there is a second reason: Hong Kong’s economy is no longer producing savings surpluses which need to be re-invested in foreign assets.  Historically, the massive build-up of net foreign assets of Hong Kong’s banking system have been a result of a massive sustained private sector savings surplus. Between 1990 and 1994 this averaged 6.6% of GDP, but in the  pre-handover boom years before 1997 this deteriorated into a private sector savings deficit of around 5% of GDP. That deficit was swiftly and dramatically rectified: from 1999 to 2009 the savings surplus was back, averaging onwards 8.4% of GDP. 

However, over the last three years, there has been a further reversal, with minor savings deficits emerging: there were deficits of 1.1% of GDP in both 2012 and 2013, followed by a surplus of 0.8% in 2014 which has probably dipped back into a deficit of around 1.4% in the 12m to 1Q2105. (Caveat - the 1Q15 result in the chart below is an estimate only.)

A sufficiently sophisticated financial system will, of course, find ways to finesse these underlying cashflow dynamics in the short to medium term. However, the erosion and disappearance of Hong Kong’s private sector savings surplus has capped the overall amount of net foreign assets Hong Kong’s banking system carries. The current US$288bn in net foreign assets is, for example, lower than the amount carried in 2007. 

Moreover, the dramatic concentration into China assets which mushroomed so dramatically after 2010 means that if cashflow concerns dictate that asset holdings have to be cut, then unavoidably it will be Chinese assets which are offloaded.

So far, Chinese banks have not really responded to the withdrawal of foreign currency lines from Hong Kong’s financial system by scaling back their own position in Hong Kong.  Indeed, so far this has had made almost no impact on Hong Kong’s HK$ banking liquidity, to which China is a major supplier. Taking the position in Hong Kong dollars,  between Sept 2014 and Jan 2015, HK$ liabilities to mainland banks fell by HK$9.3bn to HK$112.7bn, whilst HK$ liabilities to Chinese non-banks rose by HK$10.5bn to HK$205.4bn. However, HK$ claims on Chinese banks rose by HK$768bn and Chinese non-banks they rose by HK$9.32bn.  On a net basis, the total net HK$ exposure of Hong Kong banks to the mainland went from a net liability (deposit) of HK$73.1bn in Sept 2014 to HK$64.1bn in January 2015.  In the scheme of things this is a relatively minor change drop in China’s provision of HK$ liquidity to the system. 

Background to China's Cut in Banks' Reserve Ratios

(This commentary was written for the Shocks & Surprises Global Weekly Summary before the announcement of Monday's cut in reserve ratios. It has not been altered, because it gives what I believe is useful background to that decision.)

If Chinese monetary policy is to be continued consistently in the practice of the last few years, an early policy relaxation achieved by cutting banks’ reserve requirement ratio is to be expected, with each 1 percentage point cut gifting banks approximately Rmb 1.25tr in deposits available for lending, but probably also draining money from government bond markets in similar amounts.
Just as reserve ratios were raised to limit the monetary consequences of the huge inflow of capital during the last eight years, so now as capital exits China (despite a frenzied stockmarket boom), banks’ liquidity needs boosting.

The week’s economic data leaves no room for doubt that the economy continues to weaken: early in the week it was revealed that March’s exports fell 15% yoy, cutting the month’s trade surplus to just US$3.1bn.  Later came the news that M1 growth had slowed to 2.9% yoy and M2 growth to 11.6% in March, and that aggregate new financing was weaker than expected at Rmb1.18tr. Still later, there were disappointments for industrial production (up just 5.6% yoy), for retail sales (up just 10.2% yoy) and for urban investment (up just 13.5% yoy ytd).  Taken together they reveal that the underlying loss of momentum intensified, perhaps dangerously, in the industrial sector, in domestic demand, and in monetary conditions.

The fact that 1Q GDP growth was reported to have slowed only very modestly, to 7% yoy, was undercut by the fact that nominal GDP growth had slowed to just 5.8% yoy. Worse, when one excludes the positive impact of a 1Q trade surplus equivalent to 5.4% of GDP, the resulting nominal domestic demand growth slumped to just  0.9% yoy (or 5.3% on a 12ma).

Consequently, policy-loosening is needed, and soon. What form should it take? When in early February PBOC cut reserve ratios, it it claimed the cut was to offset capital outflow, rather than open the gate for monetary easing. As the chart shows, this was China’s consistently applied policy between 2007 and the middle of 2013: as China’s reserve rose from US$1.1tr in January 2007 to US$3.55tr by July 2013, so the reserve ratios required of banks rose from 9.5% of deposits to 20% of deposits. During periods when the reserves build-up slowed or faltered in 2H2008 and again in 2011-2012, PBOC responded by cutting RRRs.

So far, however, it has not responded significantly to the far sharper falls in reserves seen during the last six months. In 3Q14 reserves fell by US$106bn, in 4Q14 they fell by a further US$45bn, and in the first three months of 2015 they fell by a further US$113bn.  1Q’s fall is the most worrying, since it indicates a heavy flow of capital out of the country. During 1Q, we know that China recorded a trade surplus of US$123.8bn, and that it attracted US$38.4bn in FDI whilst overseas direct investment out of China came to US$25.8bn - these flows add up to a net inflow of US$136.4bn. However, we know that foreign reserves fell by US$113bn, which means that the combination of the balance of services and net capital movements produced a deficit of US$249.4bn.  This is an extraordinary development, given the background of surging domestic stockmarkets, which one would normally expect to attract capital into China.

One explanation has it that the capital has merely migrated to Hong Kong in order to capture the profits from arbitraging between the different stockmarket prices of A-shares in China and Hong Kong. No-one doubts that this arbitrage has been enthusiastically pursued, but since Hong Kong’s foreign reserves rose only US$3.7bn during 1Q, such investment cannot be more than a footnote in the larger story of capital flight from China.

Now let us look at the impact these capital outflows have made on the cashflows of China’s banking system, counted as the change in deposits minus the change in loans. In this analysis, we also have to include one other policy initiative - the widening of the definition of deposits made in January 2015 which added approximately Rmb8.3tr to January’s deposit total. For the purposes of the chart below, these are excluded.

The chart shows how successful this flexible movement of reserve ratios has been in muting the financial repercussions of China’s foreign exchange build-up - typically during the heavy inflow years it halved banks’ net cash inflow, whilst in 2011 it engineered a genuine liquidity tightening.  However, it also shows that the huge capital outflows from China during the last year has completely changed banks’ cashflow situation: before changes in reserve ratios, the picture changed from a net cash inflow of Rmb2.02tr in the 12m to March 2014, to a net outflow of Rmb3.52bn in the 12m to March 2015. 

With PBOC having cut RRRs so far by only 50bps, the situation is hardly improved: the net cashflow moves from a Rmb214bn shortfall in the 12m to March 2014, to a Rmb4.395bn shortfall in the 12m to March 2015. Still, at this point, every percentage point cut in RRRs would free up approximately Rmb 1.25tr, potentially available for lending. 

It is in this context that the widening of the definition of deposits, which resulted in a book entry inflow of an estimated Rmb8.3bn deposits in January, and a positive cashflow for that month of Rmb 6.53bn, becomes so crucial. Looked at in the light of the pressure capital outflow is putting on China’s bank liquidity, this re-definition looks like a useful holding tactic of a central bank hoping to avoid significant cuts in RRRs (perhaps because of the negative impact cuts would make on government bond markets?).  If capital outflows continue to pressure banks’ cashflows - and it's difficult to believe it won’t, given the deterioration in China’s economic data - more and deeper cuts to reserve requirements will be expected and needed.

China 1Q GDP: The Cost of Financial Efficiency

China’s 1Q GDP growth of 7% is exactly as predicted/stipulated, and by itself tells us nothing interesting, except that it provides no cover for a much-needed relaxation of current policies.

More interesting is what happened to nominal GDP growth, which slowed to just 5.8% yoy. Although we do not have a quarterly breakdown by expenditure, I estimate that in nominal terms, China’s capital stock was growing by around 13.3% yoy in 2014 (based on depreciating gross fixed capital investment over 10yrs). If so, nominal growth of 5.8% means asset turns, and therefore returns on capital, must certainly be plummeting far faster than that 7% ‘real GDP’ suggests. 

But there is a second calculation to be made. Nominal growth slowed to 5.8% yoy even though the 1Q trade surplus of US$123.8bn is a multiple of the US$16.6bn surplus recorded in 1Q14. The trade surplus was equivalent to 5.4% of GDP in 1Q15 rather than the 0.8% of 1Q14, and that must make a major contribution to the overall nominal GDP growth. When one subtracts the trade balance from nominal GDP to estimate nominal domestic demand one finds China’s domestic economy already at a standstill - it rose only 0.9% yoy in 1Q15.

(Incidentally, I am  not straining for this result - I do these calculations every time).

We can also use the nominal GDP data to explore how money and finance are affecting China's economy. The relationship between money and the economy, and the Chinese population and money, has not yet stabilized, but neither is it deteriorating any more rapidly than usual. Monetary velocity (GDP/M2) continues to deteriorate, although given how badly asset turns must be falling, the deterioration is actually surprisingly modest.   Liquidity preference also continued to fall to new lows, but as with monetary velocity, the continuing fall is no worse than one would expect, extrapolating from historic seasonal trends. 

And finally, I am interested in the efficiency of Chinese finance, expressed as how much additional GDP growth is associated with an extra yuan of finance.  Recovering this efficiency of finance is, after all, an indispensable aim of any reform which hopes to rebalance the economy. For bank lending, over the last 12 months an extra 1 yuan of lending has been associated with only 0.44 yuan of extra GDP. This has not quite stabilized the fall seen between 2011 and 2014, but the rate of decline has clearly moderated.  What’s more, the last year (and in particular the last two quarters) have been marked by the government’s successful attempt to shut down several ‘shadow banking’ lines of finance and squeeze that financing back into straightforward ‘bank lending’.  In the year to March 2015, bank lending accounted for 67.5% of aggregate new financing, up from 54.6% in the same period last year.  Naturally, this shift in the form of financing will tend to produce a decline in the measured efficiency of bank finance. 

So the wider measure - the GDP gain associated with an increase in total new aggregate financing (including bank lending) - becomes the one to watch. And the news is good: the efficiency of finance is improving, albeit only marginally. In the 12m to March 2015, one yuan of extra total financing was associated with 0.302 yuan of extra GDP, up from 0.295 yuan in the 12m Dec 14, and 0.251 yuan in the 12m to Sept 14. In fact, the 12m to March 2015 was the highest reading since 4Q2013 - although it is still less than half the 0.77  yuan achieved during pre-crisis 2006-2009. 

The problem is that these small gains have been bought at an economic cost which is too great to sustain. We have previously laid out how China’s trade data, and its monetary conditions are deteriorating too rapidly for comfort. If in addition, we accept the extraordinary possibility that 1Q nominal domestic demand slumped to only 0.9% yoy, it seems inevitable and indeed unavoidable that some rather extensive belt-loosening will be needed and accomplished in the near future. At which point, we can expect the hard-won gains in financial efficiency to be lost once again.  

Can China's Bad Monetary Data Really Be Good News?

There’s a usually-lucrative understanding that bad economic news can be good news because of the positive policy response it provokes. This works so often one can forget that the belief assumes that the news is not so bad that it is telling you events are spinning out of control, and/or that there’s nothing going on that an early policy easing won’t fix. But if these don’t hold, bad news can be just that - bad news.

And so to China’s March’s monetary and credit data. As bad news goes, this was nearer to the real thing than is comfortable.

Purely in measurement terms, China’s March M2 and M1 data was the weakest I’ve seen, (excluding obvious holiday-related anomalies). M1 growth slowed to 2.9% yoy on a monthly movements a full SD below historic seasonal trends, and the weakest since 1996 at least (with the exception of Jan 2014 - a holiday anomaly).  M2 growth was worse, slowing to 11.6% yoy on a monthly movement which was 1.4SDs below trend, and the slowest growth in more than 20 years (holiday anomalies excepted). Bank deposits growth slowed to 10.1% yoy, and again, the monthly movement was 1.5SDs below trend.

But the weakness of the monetary and credit data isn’t the only thing weighing on Chinese monetary conditions. In addition, the Rmb has tracked the dollar higher, actually rising 0.1% yoy against the dollar in March,  whilst the dollar was up 13.6% yoy against the SDR.  And with 10yr government bond yields of 3.5%% and CPI inflation of only 1.4%, the 2.1% real yield is 0.6SDs above historic seasonal trends. It is this combination of factors which means that, from an empirical point of view, the current deterioration in monetary conditions is unprecedented for China. 

As one would expect, such monetary constriction is hurting the rest of the economy (regardless of what tomorrow’s 1Q GDP result might show). 

The data suggests that monetary conditions have deteriorated beyond the point in 2008 when it was deemed necessary to rescue the economy. The wider data (particularly March’s trade data, with its collapsing exports and collapsing trade surplus) is also consistent with the worry that negative feedbacks from the real economy to the financial economy are beginning to re-inforce the monetary constriction. Whilst we are (probably) not yet in the maelstrom, I’d say it is visible from the deck. 

So the first requirement of bad news being good news is plainly present: the data of the last couple of days is surely bad enough to provoke an early and more vigorous policy response. 

The question then becomes: can the policy tools available easily fix the problem? And here I have two combined worries. The first is simply political and strategic: an effective policy response would almost certainly involve at least a partial repudiation of the reform strategy to which Xi Jingping has dedicated his presidency. Clearly, it will be he rather than the PBOC who will determine policy, but how can he square the major reliquefication the economy needs without setting back the process of improving capital allocation, upon which the necessary strategic change in China’s growth model rests? From this strategic point of view, a reprise of the 2009 credit splurge is almost unthinkable. (Isn’t it?)

The second problem is that at this stage we simply do not really know what sort of damage is growing inside the banking system, or how the rapid diversification and elaboration of China’s financial systems will affect how the system as a whole works. But we do know there are multiple potential sources of bad loans in the system: real estate loans; local authority financing vehicle loans; commodity finance loans (both domestic and international). And, of course, on top of that there’s straightforward commercial and consumer lending that’s going bad. 

Although we can’t know the details, we can see plenty of signs that concern is mounting. At the highest strategic level, February’s decision to re-define China Development Bank as an official policy bank is at least consistent with the possibility of problems in its domestic real estate and international commodities-project loans. Similarly, the central government’s decision to allow local authorities to replace expensive financing vehicle bad debt with centrally-backed bonds is also a plain acknowledgement of their financing problems.  But on a more mundane basis, we have Dagong Rating’s warning of problems in the internet-based P2P lending market, with their report raising the prospect that losses to creditors (mostly small investors) could reach Rmb 100bn. And we have the suspension/near collapse of Hebei Financing, which is carrying approximately Rmb 50bn loan guarantees.

The third problem complicates the situation further: because China’s debt problems are no longer merely domestic, any monetary rescue package which significantly undermines the international value of the Rmb is problematic by itself. We touched on this yesterday. 

And it is in this context that we should consider China’s other piece of ‘bad news’: China is losing its fx reserves even faster than we had thought. In 4Q, we saw that despite a US$67bn current account surplus, China’s foreign exchange reserves fell US$44.7bn, implying a capital outflow of  US$112bn during the last three months of 2014. Now figures for 1Q show foreign exchange reserves falling by a further US$113bn in the first three months of 2015, despite writing a trade surplus of US$123.8bn during that period! Bear in mind that this massive net capital outflow happened at a time when China’s stockmarket was on the sort of tear which normally attracts capital inflows.  It raises the question: what level of reserves is China already devoting to maintain the value of the Rmb? 

All of this leaves us in a less comfortable position than normal. Generally speaking, my default bias in China is one of comfort verging on complacency. The system has an extraordinary level of resources, both financial and political, that it can deploy if necessary. And this has been bolstered by a belief that provided China's domestic cashflows remain strongly positive (as they have been historically), then ways can and will be found to finesse balance sheet problems, even if it takes some time for the political fix to be found. I also think that China's leading bureaucrats are exquisitely alert to the potential problems of their economy and financial system - I genuinely think there is a level of senior administrators who spend huge amounts of time and mental energy obsessing about these problems. Similarly, I have little doubt that China's banks are better run than at any time in the relevant past. But conversely, experience tells us that PBOC can be dangerously slow to recognize when its policies are inflicting real damage - remember, it was still raising rates in summer 2008!

The problem now is two-fold: PBOCs responses have already been dangerously slow, and, worse, capital outflow has, at least for now, denuded the financial system of the positive cashflow which the rest of the economy is being forced to generate, and which is needed to cover any spike in non-performing assets. So at this stage, I fear that what we're seeing is just what it seems to be: bad news.

Short Thoughts on China's March Trade Disaster

China’s March trade data looks nothing short of disastrous.  In particular, the 15% yoy fall in exports is a dreadful shock, with the US$144.57bn in exports the lowest nominal total since February 2014’;s holiday-afflicted tally. Worse, March is usually a strong month for exporters, with the history of the last five years showing an average rise of 40.1% mom: this year, exports fell 14.6% mom. In terms of standard deviations from the pattern, February;’s total was 1.6SDs above trend, but March’s was 6.7SDs below trend.

Such a collapse can’t really be described as a ‘deviation against the trend’, but rather a result which smashes the historic trend entirely - China has entered new and dangerous waters.  As such, it has implications both for China and its trading partners.

Before we consider that, however, there is another possibility - that the very smashing of normal seasonal patterns points to some sort of seasonal anomaly which we don’t yet understand and which is afflicting only exports. If so, we should ignore this monthly collapse in preference to the slightly longer-term picture.  Doing so allows one to see that during 1Q exports rose 4.6% yoy, which, although not great, is roughly in line with the 6% yoy growth recorded in calendar 2014.

And there is a second lifeline to this less-pessimistic approach: although March’s imports fell 12.9% yoy, the monthly move (a 30.3% mom rise) conformed almost exactly to historic seasonal patterns, after 1SD+ falls in both January and February. Although with the exception of petroleum and refined products, there is no sign of a recovery in China’s appetite for industrial commodities,  volumes of commodity imports have generally stabilised.

Hang onto that hope, because, having acknowledged those qualifications, March’s collapse of exports, and the consequent collapse of the trade surplus (to just US$3.1bn in March from Eu60.62bn in February), are the last thing China needs. There are two interlinked problems. First, China needs a hefty trade surplus to counter enormous underlying cash outflows which are undermining the liquidity of its financial system. Let’s do the maths: during 4Q14 China had a current account surplus of US$67.021bn, but its foreign exchange reserves fell by US$44.68bn - so somehow there was a net capital outflow of US$111.7bn in 4Q alone.  Second, this capital outflow put pressure on the banking system’s net cashflow: the private sector generated a net savings surplus of Rmb1.925tr in 4Q, equivalent to 8.9% of GDP. These surplus savings should have piled into the banking system as a build-up of net deposits: in fact, what happened during 4Q14 was that banks gave out Rmb 900bn more loans than they received in deposits.

That is the background to January’s expansion of the definition of ‘deposits’ counting towards regulatory loan/deposit ratios, the cuts in banks’ deposit reserve requirements announced in February, and, of course, the cuts in interest rates.

But there is a third problem: if the collapse in March’s export earnings and trade surplus are taken at face value, they also suggest that the loss of competitiveness may put the Rmb under pressure.  That is something I expect PBOC will be reluctant to entertain, simply because of the level of international debt China is now carrying. How much debt?  Last week fx regulator SAFE said those debt were ‘broadly under control’ at US$895.5bn at end-2014, of which US$621.1bn was short-term debt, and US$274.4bn was medium and long-term debt.  But it could be much more: according to BIS, at end-September 2014 (latest data available), their banks had extended US$1.3tr in debts to China, and in 4Q, BIS also reported private international debt securities outstanding to China to total US$91bn. If you are carrying that sort of debt-load, there’s plenty to lose from a currency devaluation. 

This is where things begin to matter, a lot, for China’s trading partners. Right now, most of Asia is living in a world in which although liquidity flows from the West to the East have lessened as the dollar has strengthened, thus discouraging growth-by-leverage, most companies have found compensation in a rise in the terms of trade.  So although in March, export prices were down 11.6% yoy in dollar terms for Japan, down 10.2% for S Korea and down 7.7% for Taiwan, in each case, import prices were down much further, so terms of trade were up 12.2% yoy for Japan, 9.7% yoy for S Korea and 9.6% yoy for Taiwan. The upshot is that the deflationary impact of a sharply rising dollar on profits and margins have been more than offset by falling import prices. 

Such a reasonably satisfactory outcome  for the rest of Asia would probably not survive a trading environment in which China was compelled to devalue sharply to recover export market share gains.