The reform legacy - Part II

Since the last post there have been a couple of articles which highlight quite well the importance of the reform debate and the main themes.  As the PBOC launched further stimulus (including via a new tool called "Pledged Supplementary Lending" involving 1 trillion yuan for new lending), James MacKintosh, Investment Editor of the Financial Times filmed an interesting presentation giving some context to the resulting rise in share prices. While ordinarily share prices would be indicative of higher confidence and expectations for growth, MacKintosh noted that the sectors which had shown the greatest share price increases (and saw the best response to stimulus measures) were companies in the banking, property and industrial sectors - all sectors which the Chinese authorities wanted to steer investment away from (and into other sectors) as part of the reform and rebalancing process.  Or as James put it:

 "a return to pre-crisis business as usual...a pause in reform means less risk in property and banking as well as the old line state-owned enterprises".

"China Property Gamble" (c) Financial Times

Of course what James didn't dwell on (but certainly implied) is that there would be more risk overall and in the medium to long term (hence the need for reform to reduce the risk, sadly not carried through).  Over at FTAlphaville, the suppression of risk was covered well in an article by David Keohane who noted falling bond yields, the bailing out of one trust which had been set to default and a pessimistic analysis from reputed analyst Diana Choyleva of Lombard Street Research who noted:

 ...But the more sinister explanation [of failure of domestic demand to drive economic growth] is that the authorities are unable to provide a significant boost to growth even if they want to. They may be trying to boost credit to SMEs, but demand for loans has come off again. China needs to clean up after its debt binge, not stoke it further. The current level of debt may just about mean that Beijing has a chance to reform successfully even if that will involve a few years of meagre growth and financial distress. But the ongoing rapid rate of increase in debt suggests that policymakers do not have too long to postpone much-needed defaults...

Zerohedge meanwhile has taken a much more vigorous editorial line and especially with the Qingdao commodity financing scandal (including discussion of a note from Goldman Sachs as to the impact from an unwinding of metal-based rehypothecation).  On the new stimulus measures and their indication of the slowdown in reforms, contributorTyler Durden is blunt:
 

So whatever way you look at it, the PBOC thinks China needs more credit (through one channel or another) to keep the ponzi alive. Anyone still harboring any belief in reform, rotation to consumerism is sadly mistaken. One day of illiquidity appears to have been enough to prove that they need to keep the pipes wide open. The question is where that hot money flows as they clamp down (or not) on external funding channels.

And also:

Simply put - you can kiss goodbye any hopes of China ceasing its exuberant credit creation... (especially now that the CCFD ponzi scheme has been exposed via Qingdao -and drastically reduced that channel). Reforms are all talk and the bubble will just grow bigger with fewer and fewer attractive outlets for that hot money (now that the US real estate transmission channel has been identified and likely closed)... cue real inflation.

From those Zerohedge articles are two charts of note, the first showing the total amount of credit (bank assets) in the Chinese economy and its rapid growth:

and the second the rise in rates which preceded the recent PBOC stimulus (after it apparently stopped conducting repo operations), which corresponds nicely with the increase in share prices mentioned before (imagine the effect on share prices if repo rates continue to rise and there is no new liquidity from the PBOC?!):

 

Finally, while it will still remain for the next post to discuss some summer reading about the history of reform in China, it can be added one extra piece of reading on exactly this point - a 2013 IMF Working Paper:  "China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency" (here), which " proposes a possible framework for identifying excessive investment".

China's adventures

Intrigues and dramas
This week saw news from China dominating broadcasts as political and economic affairs escalated.  The cracks in Party unity were exposed following the arrest of Gu Kailai for the murder of Neil Heywood, a British businessman who had assisted her and her husband, Bo Xilai, the former mayor of Chongqing and popular politician who was dismissed from the Central Committee and the Politburo of the Chinese Communist Party (following his dismissal from the position of mayor of Chongqing).

News services struggled to delve into the political circumstances underlying Bo's dismissal, subsequent reports have looked at allegations of corruption involving Bo and his associates, long term rivalries with other factions in the ruling elite and the significant business dealings of his wife as well as the circumstances of Mr Heywood's death.  Needless to say there was as much intrigue and mystery as a feudal saga.

One way to navigate the landscape in China (c) Chooseco LLC

An interesting economic statistic
Meanwhile there was much talk about the lower than expected first quarter GDP figure of 8.1% released on Friday for which there wasn't a consensus.  The range of views on the GDP figure included:


i) the Chinese economy is re-accelerating: DBS Bank of Singapore seem to be the strongest proponent of this view, mostly relying on GDP and inflation growth.  Definitely too bullish - Zerohedge, the economics website, tweeted that DBS overestimated the GDP number at 9% in an advance research note (and labelled DBS a "3rd tier research firm").  DBS may have a point regarding inflation (see below).

ii) the Chinese economy is growing, but at a slower pace:  Richard Jerrum, economist at the Bank of Singapore painted a favourable picture of the Chinese economy based on low inflation, sufficient capital investment and decent property growth (with means to stimulate) in an interview with Reuters.  The World Bank echoed this in its favourable report on Thursday which cut its growth forecast to 8.2 per cent for 2012 emphasising the success so far in cooling the property sector and remaining available tools for the central bank to inject liquidity.  This would be the case for a "soft landing" which the World Bank predicted as highly likely.  And Standard Chartered's Stephen Green also favoured a soft landing, expecting continued capacity for growth across the economy, a strong labour market and broad scope of tools available to the central bank.

The problem with the soft landing view its critics say, is that the underlying assumptions are simply not true, i.e. inflation is high, the property market is in a slump and the central bank does not have as many tools at its disposal (or as much scope to use them).

iii) the Chinese economy is contracting or not growing:  One key point for the hard-landing proponents is that there is simply too big a credibility gap to take statistics of the Chinese economy at face value.  The FT Alphaville blog published a short but interesting article (inspired by the above book on China) detailing a number of recent statistics which showed significant variation depending on their source or were significantly inconsistent with related statistics. The notable example was the Purchasing Manager's Index (a measure of manufacturing activity) - the official Chinese figure showed expansion while HSBC's figure showed contraction.

There was equal scepticism from some towards the inflation figures (via the Consumer Price Index which was recorded at 3.6% for March (announced at the start of the week). Not only was this number higher than expected, but Patrick Chovanec commented in an interview with Bloomberg prior to the release that a figure of such magnitude seemed vastly understated and as evidence he noted the 33% increase in the cost of his milk supply (although on Twitter he added that he thought it was due to increased delivery charges rather than the milk itself!).  More seriously he noted that in all his recent discussions with business people across China he did not come across an outlook of low inflation and higher growth consistent with a soft landing.

Meanwhile although Stephen Green's team have done some updating research which showed a recent pick up in construction activity and improvements in sentiments of developers this was tempered by research suggesting that activity is being driven in a large part through financing from less regulated shadow banking, including loans from investment trusts, which may not be a sustainable source of finance. And as mentioned in the FT Alphaville note, this week saw what could be the first bankruptcy of a property developer in China.

And a couple of articles in Reuters pointed out that tools of the central bank to stimulate demand had already been brought into use since 2011 (through cuts to the amounts of capital the banks hold, the required reserve ratio, in 2011) with resulting significant amounts of new lending likely to complicate the central bank's monetary operations in the future.  Jeremy Stevens, an economist for Standard Bank in Beijing summed up the mood:

Overall conditions seem to have stabilized, but it wouldn't take much to push sentiment in the wrong direction...

In any case due to factors like the excessive extent of local government debts and the shadow banking sector it was argued by James Kynge in the Financial Times last year that the powers of the central monetary authorities to control the supply  and price of credit are "tenuous".  A couple of others were more upfront - Satyajit Das wrote a follow-up piece to his last effort in the Australian media where he referred to recent Chinese growth as an "illusion", while economist Jim Walker in an interview with Reuters stated "economies don't have soft landings".

iv) the Chinese economy has reached the bottom and is rising again (though not necessarily fast): This view was put forward by a number of people who considered the possibility of a hard landing but had felt optimistic with recent figures. Some examples included Karine Hern of East Capital (from the property perspective) and Zhiwei Zhang of Nomura who revised his bearish estimate on GDP growth this week on a view of increased economic output and lending.  As the Beyond Brics post noted (and was noted elsewhere) the significant growth element of consumption included government spending which may have distorted the measure showing stimulus rather than genuine growth.

The verdict from the markets was negative - stockmarkets worldwide slumped on the expectation of lower growth going forwards, especially as the GDP figure was the lowest comparatively in a number of years.  Noel Roubini's report picked up on this and in a tweet he commented that the GDP figure may in fact have been 6.9%.

Unlike in the adventure books where the reader can flick through to see what outcome will occur following his choice, we will have to wait and see.