China's Great Wall Of Worry

Includes: FXI, PGJ
by: Tom Guttenberger

Last Friday, China released their Q2 GDP print and sparked a rally in world markets. Economist Marc Faber appearing here on CNBC, casts doubts over the headline 7.6% YOY growth figure, and even goes as far as to say that the rally was due to how weak the report was, and the expectation of further monetary stimulus. He goes on to mention that his view of GDP in China is much lower based on trade data of Asian partners who are very reliant on exports to China. Are his views corroborated with the data? What else could he be looking at that would lend itself to this skeptical view?

To explore these questions I examined data from the World Trade Organization (WTO). It sounds like his central thesis is that the exports figures from some of China's major trade partners have been weak. As he alludes to, China is a major export destination for many Asian countries and using their export figures should provide a reliable proxy for overall personal consumption in China. Because if less international goods are being consumed, it is probable that less domestic goods are consumed as well - the main assumption being that the product mix has not changed. Shown below are YOY change rates for several countries' merchandise exports.

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You will notice from this chart that trade is slowing globally almost uniformly. Some notable YOY export growth rates: China (10.5%), U.S. (4.6%), Japan (4.6%), EU-external (-1.7%) South Korea (-1.5%), and Taipei (-5.4%). Analyzing these export figures in conjunction with China's WTO trade profile highlights Faber's point. Export data from Taipei (28% destined for China) and South Korea (25% destined for China) suggest weakness in Chinese imports, so inferentially, personal consumption. On the other hand, Japanese (20% destined to China) and American export growth could be a result of increased Chinese consumption. Still, it is hard to reconcile how exactly China managed to increased imports by 6.4% in Q2 on an annual basis as reported, especially with falling commodity prices. Shown below are a time series of select international imports, China's WTO profile, and a chart of commodity prices over the past year.

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Faber's point is certainly interesting, and it is definitely strange that China managed to increase imports while many of their vendor-nations saw exports decline. It just is not definitive proof. Exact product distributions are unknown, and it is possible that the higher-than-expected number could be an indication of increased domestic consumer-end product mix, even if it is thought to be unlikely.

There are other interesting observations in this trade data when discussing China. Could Faber also think that China is over-stating their export figures?

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Based on the import data from their 5 largest trading partners we are able to ground an estimate for Chinese exports. This estimate is nothing more than a weighted average of YOY import growth from these top 5 destinations scaled to their total portion of Chinese exports. If China's exports to the EU, USA, South Korea, Japan, and Hong Kong (who together make up 64% of Chinese exports) were equally competitive to imports from other nations, China's exports would be accurate to this estimate. If China reports that their export figure is above the prediction (like they consistently have), then it gained 'market share' relative to other exporting countries during that time period. The chart above illustrates that China has been gaining export market share aggregated across their top 5 export destinations. While everyone in the west was screaming, "property bubble", "fraud", "inflation", "deflation", etc., China was consistently gaining market share in terms of global exports.

Crucial to the competitiveness of exports is the valuation of the domestic currency. If a currency is undervalued it follows that relative labor and the cost to produce goods should be lower, thus helping the competitiveness of that country's exports. So persistent yuan undervaluation buoys exports and has helped them consistently gain market share of world exports from 2007-present.

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Q2 2012 also displayed an interesting divergence in the reported export figure vs. the import destination prediction. Notice that the largest trade residuals tend to come on the tail of pegged or stagnant yuan appreciation periods. To me, rather than fudging the numbers, this most recent divergence plainly suggests that the current 2.5% YOY yuan appreciation rate has been far too low and is not keeping up with improvements in the real Chinese export economy. From a trade standpoint, the yuan looks as strong as ever.

Monetary Policy, Banking, and Inflation

Recently the PBoC has gently been lowering the baseline interest rate and reverse requirements. These actions have resulted in prices for the yuan actually falling over the past couple months against the USD. Rather than deliberately weakening the yuan, my interpretation is that the PBoC is simply trying to invigorate lending to counteract the population of credit-worthy, 50%-down home buyers having outpaced banks' earnings at current reserve rates. Consider the logic:

  1. Banks' capital base growth is a function of their earnings which are a function of their lending margins.
  2. To add incremental loans without a change in the reserve rate requirement would require banks' profits to grow faster than the pool of customers (Assuming already full utilization).
  3. They have not been able to add many incremental loans without lowering the reserve rate requirements.
  4. Therefore, lending earnings are being outpaced by credit-worthy customer growth (Assuming the PBoC is acting on good intentions).

Sounds like a banking 'problem' I would like to have. The fact that their capital base is not growing fast enough could be a cause to concern for some. I disagree, because systemically, rate-gouging will always add to future risk. If the capital base was growing at a fantastic rate, this would indicate generally expensive loan terms to the populous, thus heighten systemic risk. This does not appear to be the case and M1 money supply is still growing at a slowing, but steady pace YOY. This all without mentioning the relationship - Wage Inflation>GDP Deflator>CPI>PPI - has been intact for a while, and represents the ideal inflation measure hierarchy.

To gain access to yuan appreciation, I would consider Chinese equities. Even considering the inconsistencies Faber pointed out, you have a ~200% buffer (7.5,+/-5% difference) before nominal GDP growth is near parity to the domestic market. FXI currently trades at a P/E multiple of ~7.5, a ~65% discount to the S&P500. Those are some deep discounts. If there is a "Wall of Worry" in American investments, the "Great Wall" still calls China its home.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.