By Paul Harding for China Brain
Another month, another set of disappointing data. This month’s releases from the People’s Bank of China (PBOC), the National Bureau of Statistics (NBS) and other government departments continued to paint a worrying picture about the state of China’s economy. The much touted third quarter recovery failed to materialize.
With July Consumer Price Index (CPI) inflation down to 1.8%YonY and the producer price index hitting -2.9%YonY, an impressive array of headlines in financial newspapers stressed that these stats leave room for “further easing”, seen now as all the more necessary given slowing FAI, IP, Export and Import growth and below consensus new lending (at 540bn RMB). There was even some expectation that the PBOC would cut the Required Reserve Ratio (RRR) over the weekend, effectively freeing up hundreds of billions of RMB of the commercial banks’ cash. This failed to materialize.
Despite a lot of optimism primarily amongst sell side analysts and foreign media about the government riding to the rescue, the data continues to show that what little efforts have been made (two interest cuts, an RRR decrease, talk) are not yielding the expected results. The narrative has been disrupted. Hints at further action from the State Council continue to offer hope, but the interest rate cuts failed to stoke up a significant increase in lending for July.
There are several reasons why the government hasn’t stepped harder on the accelerator. They can be roughly divided into three categories: Inflation, Property, and Systemic Risk.
Inflation
The PBOC remains worried about re-emerging inflation. PPI and CPI are not presently a problem, but the dramatic US drought combined with unusually hot weather in Russia, Ukraine and Kazakhstan are poised to cause a dramatic rise in wheat, corn and soya bean prices. Futures contracts have already spiked and the prospect of another food crisis is very real. China is in danger as corn prices feed literally into pork prices, making hog rearing unprofitable and decreasing supply as producers shift from the market. There is also the risk of food oil prices rising.
Food makes up roughly 30% of China’s CPI basket, and is a key issue to many of the country’s poor. The government has no choice but to remain sensitive to any upward food prices pressure and there are already local signs of food prices picking up.
Property Prices
The very slight recovery in the property sector has also caused the government to reiterate its determination to keep controls in place. The State Council has dispatched teams to study how measures are working and government announcements / pieces in official papers suggest that there is no intention to ease off the property market. A major easing could automatically bring further significant upward pressure onto property prices.
Serious overinvestment in property has seen a growing number of “ghost towns”, famously in Ordos but also in many other locations around the country. Overly bubbly property prices increases risk of a meltdown and stoke fears of social unrest. The government remains sensitive to both issues. The market is aware of the risk.
Stock markets on 20th Aug hit their lowest levels since early 2009 on news that home prices have risen in the majority of large cities monitored. Market players are obviously taking the government very seriously.
Systemic Limits
The third issue, the main focus of this piece, is the systemic problems which are simultaneously discouraging the government from easing whilst also creating drags on growth. Property is one manifestation of these systemic problems, but is being treated separately here due to the government stress on house prices.
Diagram 1 is a (very simplified) model seeking to incorporate the main policy dilemmas facing the Chinese government – particularly in the post 2008 period. The starting point should be growth, seen as paramount to creating employment and thus limiting public unrest - and also being necessary to maintain China’s rise back to its perceived position of global dominance. Growth must come from net exports (i.e. a trade surplus), investment (here divided into stimulus infrastructure projects and investment generally) or consumption.
Investment after a certain limit (which China with its near 50% investment share GDP has certainly passed) requires ever more liquidity and lending, even as it faces diminishing returns and increasing waste. The resulting non-performing loans (NPLs) and decreasing returns should automatically “correct” this. However, in China this reckoning has been delayed through the suppressed financial system, by which savings, trapped in a closed capital system (both household, corporate and government), earn unnaturally low or even negative real rates of interest. This allows borrowers (mostly corporate and especially State Owned Enterprises (SOEs), and Local Government Financing Platforms (LGVPs)) to obtain subsidized financing and capital. This financial repression “tax” falls disproportionately on households and limits consumption, whilst inflation further subsidizes borrowers and punishes depositors. The subsidised borrowing predisposes companies to rely more on capital than they otherwise would; meaning more investment. The result is repressed consumption, but also the ability of the financial system to carry on functioning.
Meanwhile the trade surplus also relies on the RMB peg, which distorts monetary policy and again punishes the majority of Chinese who are not exporters. China is a net energy importer whose import bills are now unnaturally high. Again consumption suffers.
Low household incomes are also a product of the toothless trade unions, which are legally prevented from being independent and functioning as trade unions normally do. Despite some headline making local wage growth over the last 2 years, these wages are starting from a very low base. Workers work at low wages, and companies again reap the benefits through lower labor costs.
This model has resulted in consumption shrinking as a share of GDP. As the economy relies ever more heavily on investment and exports, the efforts required to reverse the model increase, and the pain that must be experienced to do so increases correspondingly. Chinese consumption is at an almost record low share of GDP for any major economy.
With the collapse in external demand caused by the unravelling of credit fuelled consumption in the US and the pursuant EURO crisis, China has been ever more reliant on investment to fuel growth. It was investment that made up the bulk of the massive 2008/9 stimulus – further unbalancing the China’s GDP. The flip side to most investment is debt, as subsidised borrowing make this much more attractive to financial managers than it should be. The following chart (reference Alsosprach analyst) shows just how much increasing lending has been necessary to maintain China’s growth. The difference between pre and post 2008 is particularly stark, and reflects the loss of exports as a major growth driver. Meanwhile not shown on the chart, the amount of non-official lending in the economy has dramatically grown, including shadow banking, underground lending, private lending etc.
Investment often experiences diminishing returns, as the “low hanging fruit” opportunities are taken up first, investments become ever more risky, and increasingly unlikely to realise real economic benefits (this is not the same as social benefits). As total GDP increases, the amount of new lending (debt) required to support investment heavy GDP growth increases exponentially (10% growth on a $50billion economy means $5billion of new output is required, whilst 10% growth on a $5billion economy requires only $500million of new output.). China has already been experiencing diminishing returns and a rapidly expanding credit/GDP ratio (60%+ trough to peak by some counts). Repressed consumption is still lagging investment, and will continue to do so until household incomes grow at rates higher than GDP (and investment) over many years. Absent that, there is nothing to take over the growth mantle and we are left with MORE investment and debt – just as investment returns are diminishing. It is not hard to see how debt can increase so dramatically under such circumstances.
The IMF has recently estimated that Chinese capacity usage has fallen to just 60%, which for many manufacturers and producers suggests that more investment cannot be profitable. Infrastructure projects may produce social and perhaps economic benefits in the future, but again the likelihood of making real economic returns is decreasing when cash flow is appropriately discounted.
The decreasing returns on an increasing pile of lending are producing more and more non-performing debt. This is occurring just as the economy slows (a pro-cyclical problem). Whether or not the debt is recognized as such, much is not performing in terms of generating real economic benefits. Banks require continued financial repression to be able to keep forgiving / rolling over / restructuring / writing down the NPLs, and this limits consumption.
It is clear from many recent central government statements that the government is entirely aware of the danger these imbalances are creating. They are reluctant to push more investment for the reasons given above; more investment is going to make the rebalancing even more painful. In this environment, there are few alternatives to slowing growth.
It is slowing growth that we are now experiencing, and the central government have been disappointing those who are not listening to / believing their announcements about policy. The plethora of local government stimulus project announcements generated a lot of optimism, but there are serious concerns about how cities such as Changsha can finance such vast stimulus plans as land sale and corporation tax revenues fall. Due to China’s system of transferring local government officials to new locations / posts every few years, local governments face different dynamics – small picture and shorter term. However they still rely on Beijing for project approval and to make credit available.
To return to the diagram, we should remember that growth is not a goal for its own sake. It is employment generation that stood behind the “magic” 8% growth figure (now 7.5%). As of now, employment seems resilient. We have not heard the stories of mass layoffs that came in early 2009. Employment levels going forward are more important to central policy makers than simply maintaining growth for the leadership transition or for headline making stats. The official unemployment figure is generally considered to be nonsense, so a true employment picture depends on reports of layoffs, factory closures, applicant/job ratios, and wage increase demands / deals.
Given the systemic problems in China, as well as the fears over property prices and general inflation, We should not be focusing on how lower CPI is giving the government room to ease more (as has been the fashion in the FT, WSJ, Bloomberg, SCMP, Reuters, Caixin, and various investment bank research divisions). Rather, it would be better to see the situation thus: The resilient employment situation is giving the government room NOT to ease. If employment starts to collapse, the central government must react.
The lower growth target suggests that lower growth is acceptable from the employment perspective. The fact that (so far) we have not heard of mass firings or layoffs despite the lower growth rates validates this belief. Before the current slowdown, reports were of structural / demographic tightness beginning to hit labour markets in key regions. This tightness is providing a cushion of sorts. This is by no means guaranteed to continue, it just hasn’t become an issue so far.
Hence we are left with a near future of “half” measures. Investment can be propped up somewhat, whilst not being allowed to increase too dramatically. Property curbs can be strengthened ahead of any further easing that may be necessary – to limit the bubble’s return. NPLs can be gradually dealt with on the sly, whilst financial system reforms creep forward. SOEs and their value destroying models can be slowly reformed (especially once Li Keqiang arrives as Premier) whilst continuing their role of providing “social welfare” by employing people for no economic reason – even at consumption reducing suppressed salaries. Future strategic industries can be given a boost, etc. Absent a dramatic deterioration in the picture, these can produce a moderate and temporary stabilization or pick up by year end, but will only be enough to buy time until the external environment improves…perhaps too long a wait given current overseas dynamics.
Anything other than these limited measures in 2H 2012 will strongly suggest that things are getting much worse. This could be due to an employment crisis, a serious financial meltdown in a locale which threatens systemic contagion, or a further deterioration in the Balance of Payments situation – which complicates liquidity operations. External factors are another key area. If the Eurozone fails to improve, China’s rebalancing situation becomes much more painful, and the growth environment toughens.