This article was originally published on October 20, 2011 in Societe Generale’s Global Strategy Weekly.
While investors have been focused on the eurozone crisis, attention has been diverted from China’s precarious economic situation. Many investors acknowledge that China is a credit bubble waiting to burst. Yet investors remain complacent in the ability of Chinese policy makers to soft-land the economy in this downturn. Have we learnt nothing from the US Great Moderation? Yuan devaluation is still the end-game for a China hard landing.
° The coming downturn will surely separate the investment sheep from the goats. For we have learnt little from the investment disaster of the last decade. There is one thing that has become apparent to me in my 25 years of challenging even the most persuasive investment stories. That is, confronted with a lengthy period of strong and stable growth (either economic or earnings), investors fall into two distinct camps. The first simply extrapolates the reduced volatility into the future, ascribing the lack of a recession to ‘successful’ macro-economic management and taking it as clear evidence that the cycle has been tamed and that higher levels of risk can be safely taken on.
° The second school of thought takes the view that the more stable the cycle, and the more recessions are ‘avoided’, merely means that they are saved up for a future economic crashing as resulting Minsky-like credit excesses sow the seeds for a bust. But the longer the bears are proved wrong, the quieter they become, partly due to embarrassment, partly due to they’re being physically removed from their jobs in an industry that thrives on bull markets. We say what we see after having witnessed the US debacle, it seems clear to me that faith in a China soft landing (while not impossible) is most likely to be blown asunder by events. Investors should prepare for both a hard-landing and a yuan devaluation.
° Apparently the latest China GDP data showed a continued deceleration. Did it really?
Regular readers will know that I have a reasonable track record with big calls over the years. All these calls had one thing in common. The markets got intoxicated with a good ‘growth’ story that, with all the benefits of rampant credit growth, became a full blown bubble.
And so it is with China. We listed recently the financial market historian, Edward Chancellor’s 10 key facets of a financial bubble (see GSW, 24 June). After the US credit debacle, I find it perplexing that Chancellor’s Rule 2 is so relevant for China — namely “A blind faith in the competence of the authorities”, in this case in their ability to soft-land the economy. For myself I cannot understand this confidence. A soft landing may indeed be the outcome, but it’s unlikely. China is undoubtedly a severely imbalanced economy, suffering from credit-fueled investment and housing excesses that could easily spin out of control and crash, just like all the other ‘highly regarded’ economic bubbles before it.
Recent inflation data is interesting. In contrast to CPI inflation which edged down 6.1% in September, the Q3 GDP deflator rose by over 10% yoy (see chart below).
Many believe recent changes in the structure of Chinese CPI mean that it understates inflation and the GDP deflator is more representative. But however it is measured, high Chinese inflation is clearly underpinning higher inflation in the West (see chart above).
The Chinese authorities have a major problem. The high and rising cost of living has the potential to cause major social unrest (see chart below). Lest we forget, the unrest in 1989 was preceded by run-away inflation, so often a catalyst for disorderly regime change.
Our China economist Wei Yao believes the authorities are targeting a decline in property prices of 5-10% to appease this discontent. And she notes that, in September, the implied deflator for national residential housing sales rose a meagre 0.5% yoy. Wei also notes that the City of Wenzhou seems to be acting as a leading indicator as property prices have already started to decline by 0.5% yoy (see chart above, incidentally I have been impressed with quality and clarity of Wei’s analysis on China and comments on data. If you want me to put you on her list, just drop me an e-mail).
And therein lies the rub. If the authorities are trying to deflate property prices, why won’t this cause the overall economy to crash, just as it did in the US? The answer is that it can and probably will. But I am sitting in my kitchen writing this with every single work surface covered in persuasive articles about why the economy will soft-land. Some economists are so reassuring. Even in 2006/7 when I was convinced disaster was around the corner I often found their calm siren stories disturbingly reassuring.
China is a ‘freak’ economy. To my knowledge no other economy in history has experienced such high investment/GDP ratios and seen so many sequential years of strong investment growth (see chart below). If you came down from Mars and saw an economy with investment/GDP ratio of 50% you would conclude it would be among the most volatile in the world, not the most stable!
Wei notes that typically when M1 grows more slowly than M2, as it is now, the economy is still in deceleration mode. The slowdown in money growth has been driven in the main by repeated rises in the reserve requirement ratio and credit directives. Indeed, M2 should slow even faster as new directives have just been announced to restrict banks use of wealth-management products (WMPs). Similar to structured notes offered by banks in the US, the Chinese regulators have been concerned that these loans have been going to the very sectors the authorities are trying to restrain, like real estate (see chart above). Indeed the size and growth of the shadow banking system is now a key policy concern. Wei estimates it to be around CNY15 trillion, or just under one-third of formal lending in the economy.
Dylan flagged up to me an interesting article about the problems shadow banking defaults are causing in the City of Wenzhou — especially in underground banking (lending to family members of people in the same community). These loans have surged in the wake of the PBoC lending curbs. As the economy slows and these loans default, reports of mass bankruptcies and suicides in Wenzhou are disturbing. Wei believes that Wenzhou is the most extreme case, but it might be the canary in the coal mine for the economy as a whole (see ‘China’s shadow banking needs a rescue,’ 5 October – link).
There is one additional phase to the China credit crunch which recently arrived at the party (or wake). Foreign exchange reserves have stopped rising. They grew by a paltry $4bn in Q3 compared to an average monthly rise of $58bn in the first half (see chart below).
We have previously highlighted the key role of rapid FX reserves growth in boosting inflation. This is evident even in a moribund deflationary economy such as Japan (see chart above). China, by tying itself to the US dollar, has effectively engaged in its own QE for years, printing whatever quantity of yuan is necessary to buy US dollars. FX intervention of this order of magnitude cannot be ‘sterilised’ and inevitably boosts domestic asset prices, activity and inflation. So, trying to slow property and CPI inflation using mainly quantitative credit restrictions while still keeping the printing press going is a bit like stoppin gthe pressure cooker lid from blowing off by holding it down rather than switching off the gas.
But why did China FX reserves growth stall in Q3? Many suggest capital flight may have occurred recently, but also recent buoyancy of the dollar would have played a role, as less FX intervention by the PBoC will be needed to peg the exchange rate. We have been strong in our belief that growth in global foreign exchange reserves has been closely associated with buoyant EM equity and commodity markets. We have shown previously that the dollar’s rally in mid-2008 and the collapse in the growth of China’s FX reserves preceded the collapse in commodity prices and EM equities in 2008 H2.
The dollar’s recent rally seems to have changed the attitude of the Chinese authorities towards their exchange rate management. In a recent statement Premier Wen Jiabao said that China will keep the exchange rate basically stable to avoid hurting beleaguered exporters feeling the pain from three directions: slowing global demand, rapid domestic wage inflation in response to cost of living pressures, and the lagged effects of previous yuan appreciation.
The week of the PBoC allowed the yuan to decline against the dollar with many seeing this as a clear change in policy. Many in China are angry with the US in the wake of the US Senate having approved a bill to penalise China for its currency policy and this could be interpreted as a defiant response to the Senate’s action. But the US is angry that the bilateral trade imbalance reached a record $29bn in August. To be sure some of this surge is seasonal, but even seasonally adjusted, the deficit is close to its seasonally adjusted record (chart below).
Amid the growing risk of a trade war, one thing is clear: Chinese authorities are trying to soft-land a credit-fueled property/investment bubble. They may succeed at their own bit of cankicking, but history is not on their side. The sudden cessation of FX reserve growth (China’s very own form of QE – see chart below) may well be the last straw to break the panda’s back. And if China is hard landing, I agree with the bulls on one thing: expect the authorities to become aggressively stimulative. And if as is highly likely, aggressive conventional monetary and fiscal stimuli fail to prevent a hard landing (as indeed was the case in the US in 2008) — ‘other’ measures will surely include yuan devaluation.