China: Recovery ahead
We expect the Chinese economy to rebound in the second half of the year following a series of measures taken by the Chinese government, including a phase one deal and deleveraging of non-financial corporates. Significant shocks are still fading through the economy till then. An eventual rebound in activity should benefit Asia Pacific, Latin America, Germany and, for that matter, US growth stocks. Rising foreign reserves should pressure EUR/USD higher by year end.
A structural slowdown
The Chinese economy is going through a structural slowdown as a result of its progress toward becoming an advanced economy. Other contributors are its ageing population, competition with advanced economies in the tech sector, scarce commodity reserves, accumulation of an easy inventory of infrastructure and real estate and an environment that favors national winners.
1. As an economy moves from agriculture to manufacturing and then services, the value-added chain, namely the physical, financial and intellectual capital, increases and with it the number of humans involved. This process becomes ever less efficient causing the economy to slow. Currently, China is following a trajectory reminiscent of Japan and South Korea, rising sharply as a percentage of world trade before slowing down. This trajectory has lasted longer, fed by aggressive currency interventions which have superheated China’s economy for a long time.
Source: Nordea Investment Funds S.A.
2. China’s population is ageing as a result of its previous one-child policy. This is exacerbated significantly by the shift of the population away from rural areas, where the cost of raising a child is lower, to urban centers. China is a place of traditionally extended families and clans. These have come under pressure as families migrate to the cities, where the cost of a raising a child is much higher. The second significant problem is that real estate has become so unaffordable that it delays the creation of households and their desire to have children. Indeed, many Chinese people save for long periods of time to buy an apartment, leaving few resources to raise a family. On top of these stresses, poor air quality can contribute to illness and breathing difficulties. In an economic slowdown, older and sicker workers become less certain of their income streams.
China, National Bureau of Statistics of China, Birth & Death, Nationwide Birth rate, percent of Total
We can look at other countries with low birth rates, such as Japan, Finland and Germany, to gain some perspective. In these countries, this is the result of personal choice (Germany), lack of access to affordable childcare (Germany), and society’s failure to adapt quickly enough to parenthood by making it easier to work and have children (Japan). While some of these factors may be at play in China, they do not seem to be acute.
3. One key problem for China as it moves up the value-added chain is that it takes more capital, both human and financial, to achieve the same technological breakthrough as in advanced economies. Furthermore, there are very few Jack Ma’s—highly entrepreneurial people who are able to achieve breakthroughs. China’s production of patents is an impressive achievement to behold, but which part is incremental versus structural? A testament to this is the fact that Skunk Works (official pseudonym for Lockheed Martin’s Advanced Development Programs) is American, not Chinese. China has built up the pyramid of knowledge but has not been able to lead in the way it did in past decades. As we move into a new decade, China’s governmental system as a “guided society” could offer advantages and disadvantages. While heavy controls severely hamper progress, it also can provide an easy pathway for new technologies, particularly those with national champions. Additionally, an advantage of being a late comer to the technological race is the ability to jump generations of technologies.
4. One key issue for China’s growth management is the absence of large commodities such as oil (though it does have rare earth). Such tax revenue and manufacturing help an economy to grow, manage downturns and invest in the future. These industries offer a degree of economic certainty lacking in China today and provide access to a revenue stream that is important in the early stages of development when domestic savings do not flow well throughout the economy.
5. As China grew its first-tier cities, it eventually moved to second tier and behind building infrastructure and sometimes over doing it. As these easy gains accumulate like a stock, the path ahead becomes more limited. China decided to swing its resources towards the less developed West likely with inferior returns.
6.China favors national champions and industries through directed policies. By definition, this leads to a misallocation of capital and excess capacity which then impinge on the ability of banks to lend more. This is often the case for smaller regional banks.
A slowdown led by cycles and balance sheets
Excess capacity, e.g. steel and real estate bubbles, means that bank balance sheets are under pressure. This is presumed to be particularly acute in regional banks. Looking at forward earnings of Chinese banks, one is struck by how low they are— though some larger banks are clearly very strong from a Tier1 point of view, while regional banks are weaker. A side effect of China’s less developed financial market is that it is hard to find credit default swap (CDS) pricing for banks. Counterparties would typically reduce their exposure this way allowing greater leverage in the system; money would then theoretically move faster.
A recent development is that some bankruptcies have been allowed to hit regional banks more than large national banks, which are believed to be focused on Sovereign Operated Entities and large companies like Alibaba. For example, the Wall Street Journal reports that Blackstone, Bain Capital, Lone Star and Oak Tree are piling into soured loans (21/1/2019). There is CNY 2.37bn in Non-Performing Loans(NPLs) (1.81% on IMF data BNPLNPCN Index) and CNY 3.8bn in Special Mention (problematic or at high risk of default). Nonetheless, foreigners are small players in this market and NPLs remain officially very low relative to the side of the bank balance sheets. The reality is potentially more complex otherwise the government would not have been so aggressive in containing and reforming the shadow banking system nor would it have moved aggressively to deleverage non-financial corporates.
If we focus on the steel industry, where overcapacity is widely reported and indeed investigated by the central government (Reuters 27/9/2019), what can be verified is a price. Reduction of excess capacity and improved demand have helped to stabilize steel prices. Hence, what once was an acute crisis has to some extent faded away.
Estimating the precise size of the NPL sector is difficult, but it is unlikely to cause a crisis, unless we get a large correction in the real estate market. The government is likely keen on pointing out that it has cleaned up some significant excess capacity and, as importantly, that it has been deleveraging the non-financial corporate sector.
The deleveraging of the non-financial sector
China has maintained a relatively tight monetary policy amidst weaker growth (officially 6% for 2020) most likely because the real estate sector is still buoying the economy and some risk-taking has been excessive. Funding with lower rates sectors that are in excess capacity does not help much, though targeted Required Reserve Ratios achieve part of this objective. In China, money lent is not always fungible, it is directed and encouraged for the greater good in a social game played by most parties. In recent report, Wai Yao and Michelle Lam allude to the inefficiency of State-Owned Enterprises being protected from credit risk and heavily financed by large banks. This seems to be the gist of the problem—it is not a case of credit risk, but rather of low productivity.
Two large hits to growth
The Chinese economy is being buffeted by two large shocks: 1. A trade war with the United States and 2. A SARS- like disease spreading through China and forcing the closure of three cities.
We learned from SARS that the economic impact of a widespread virus can impact roughly 1 – 2% of growth. Assuming that the central government is far better prepared this time around, we are still left with a plausible 1-1.5% hit. The shock from the trade war was likely extremely acute, with many reports of factories sitting idle, and must have moved like a ricochet throughout the economy. The sequence was a series of tariffs starting in January, March, May, June and September 2019. This means that some of the shock is still travelling through the economy. The fact that this is barely perceptible in the data is surprising. Since then, the US has signed a very one-sided deal with China, and we expect China to start reneging on some of it as the economy recovers in the second half of the year.
There are, however, a series of positive shock travelling through the economy:
1. Past easing, particularly the powerful Required Reserve Ratio, has been prudent but should do the job in 12 – 24 months (Fernald, Spiegel, Swanson, Fed Working Paper 2014-07). The monetary mechanisms are actually different in China as quantity can be redirected where the central government desires, while the price of money reacts to the business cycle and the consequence of this directed activity. It is oft said that large companies have a direct line to the government, which means that the economy can react much faster in China than it does in Western countries.
2. Inflation should start to fade as the pork health crisis eventually fades away. Meanwhile, other sub-indices have shown muted inflationary pressure. Direct and indirect evidence of consumption suggests that it is holding well in the mid- to higher-tier segment. The performance of the MSCI Consumer Discretionary sector shows a lack of ability to markup, but has been rebounding encouragingly since October, before plunging with the Wuhan virus outbreak.
3. Phase one of the US-China trade deal is fairly horrible from a Chinese point of view and will likely have a limited shelf-life, but we expect this to be positive in terms of some roll-backs of tariffs and a reduction in the degree of economic uncertainty. Nonetheless, some of the damage is permanent. US companies have learned to partially outsource out of China. The consequence of this has been some cost cutting, as is evident in the Producer Price Index series. This is likely to continue feeding into consumer inflation.
4. The Chinese government said it would improve the effectiveness of its fiscal policy and there will be suggestions of expansion ahead.
5. Finally, the effort of deleveraging should not be underestimated. As the two economic shocks fade away, this should free up the balance sheets of financials.
A recovery in the second half of 2020
We expect that this series of policy decisions will eventually lead to a significant rebound in economic activity in the second half of 2020. The obvious question is whether it is the usual habit of economists to believe that things will normalize. The sad reality is that sometimes things are simply broken, as is oft the case in Emerging Markets.
What is broken is a “boundary condition” that has been reached. Said more plainly, there is a credit issue either at the level of government, non-financial corporates, financials or consumers, which translates into a position of owing money to the rest of the world as measured by a negative current account. There are, or were, problems in non-financials and financials that are being dealt with. The question is where the Wuhan virus and trade war shocks will have them most extreme impact. The trade war shock is reverting and, if we had a guess, Chinese financials are a mix of what would be core Europe, semi-core and the defunct periphery. Hence, there are broken bits, but they are far less broken than they used to be and in a directed economy it matters far less than it does in advanced economies.
 Wai Yao and Michelle Lam, China debt restructuring: the beginning of the end, Societe Generale