No Rest for the Chinese Stock Market

There is still no respite for the Chinese stock market (or, for that matter, of any of the other global stock markets).  On Thursday the SSE composite fell more or less in a straight line, losing 72 points, or 3.3%, rising a single point on Friday to close at 2079.  We are now less than 4% away from 2000, yet another barrier that may not prove to be much of a barrier. 

There is no lack of bad news on the economy to drive the stock market down.  Thursday saw the release by the PBoC and the National Bureau of Statistics of another big batch of data, and it seems pretty clear that the economy is slowing, and perhaps very rapidly.  

Industrial output grew by 12.8% year on year in August, versus 14.7% in July, and 17.5% last August.  There was weakness in almost every sector, with iron and automobile production actually contracting versus one year ago.   Clearly the industrial sector is slowing, and this puts all the more pressure on rising consumer demand to keep the economy strong.  

At first glance consumers seemed to be doing their job.  Retail sales, the main measure of Chinese consumer spending, grew by 23.2% year on year in August, slightly less than July’s 23.3% but substantially better than last August’s 17.1%.  This growth, however, may have more to do with Olympics spending than with long-term trends, and we will probably need to see September and October numbers to get a real sense of how consumers are responding, although I suspect these will be excessively low because at least part of July and August’s robust growth in consumption probably consisted of anticipated spending for the Olympics. 

Loan and M2 growth were also slightly weaker than expected.  Given the existence of the large informal lending market I am not sure what that means for total loans in the system, and given the complications imposed by a rapidly changing society and a very inefficient financial system, I am not sure how valuable M2 or any of the other monetary aggregates are in explaining money supply.  Sill, I would argue that the continued rapid growth of foreign currency reserves at the PBoC is probably being countered by the sharp fall in real estate and stock prices to represent money growth below what we would have expected (and I wonder if we will soon begin to see hot money outflows).  The fact that loans in the banking system – much cheaper than loans available in the informal sector – grew by less than they could have under the loan caps, suggests that either companies are reluctant to borrow and invest because of concerns about the slowing economy, or that banks are reluctant to lend because of credit fears.  

Neither of these explanations is very comforting.  Morgan Stanly just released a report saying the real estate sector is on the point of an imminent collapse, which suggests even that perhaps both explanations might be true.  Needless to say a collapse in the real estate sector is one of the biggest risks in China.  Not only would it cause havoc in the banks’ loan portfolios, causing a sharp rise in NPLs, but it would contract one of the main pillars of Chinese growth, real estate development.  The one piece of good news is that I have heard anecdotal evidence that developers that reduce prices have seen very strong subsequent demand for apartments and offices, so perhaps the problem is as much one of high prices (which can be fairly easily fixed) as of oversupply (which cannot). 

One of the questions I have been getting a lot from my investor meetings in New York concerns the sharp split between rising PPI inflation and declining CPI inflation.  What does this indicate about inflation and financial conditions in China? 

I have already indicated my puzzlement in my entry of two days ago that CPI inflation has come down so quickly, and I worry that we may not be capturing all the inflation correctly.  But aside from that, if you assume that PPI inflation is a proxy for rising input prices among corporations, and CPI inflation is a proxy for rising output prices, the tremendous gap between them suggests that corporate profits are going to be killed.  This already seems to be happening, with corporate profits down and most analysts expecting them to decline further. 

How do corporations react? I think there are two ways they can react.  First, if they are able, they will raise prices, and so PPI inflation will then cause a subsequent surge in CPI inflation to bring the two back into line.  This is what I always thought would happen, but now I confess I am not so sure.  If the economy is slowing, capacity rising, and demand falling off (although we have not yet seen the third condition), companies will have great difficulty in raising prices.  In that case we may see a sharp drop in profitability and even a rise in bankruptcies, to the extent that the banking system is forced to contract. 

One way or the other the system has to adjust to the tremendous monetary expansion of previous years, and there are two ways it can do so.  We can see high inflation, which brings nominal demand and nominal supply back into balance by adjusting prices.  Or we can see an equivalent contraction in the money supply because of a contraction in banking.  

Neither of these is a good outcome, but excess money expansion – as we are seeing, by the way, in the US – must eventually cause something to adjust, and the adjustment is rarely benign.  Historically it almost always consists either of rising prices inflating away the growth in money supply or of a sharply contracting banking system reversing the earlier money contraction through debt deflation.  The key determinant of which path this takes, I think, is the fragility of the banking system and the response of the central banks. 

I can’t really predict which outcome we will see in China.  On the one hand I have been notoriously bearish on the quality of the banking system for so long – and, I suspect, to the annoyance of many of my colleagues in the market – that it seems to me very reasonable to me to expect real problems in the banks that lead to loan contractions and the hoarding of liquidity.  By the way, reducing minimum reserve requirements will have little effect on lending if banks don’t want to lend, borrowers don’t want to borrow, or if informal banks have acted to undermine the impact of lending constraints, which I believe has happened in China.  

On the other hand it is always easy to inflate your way out of trouble, and this tends to be the politicians’ preferred response to a banking contraction, especially in systems with limited central bank independence.  I suspect that in China we may see concerns about unemployment in the short term trump concerns about inflation in the long term.  The point is that if I am right in having argued for so long that we have seen out-of-control money growth in the past few years, we will inevitably have to see an adjustment that is as likely to be a sharp rise in inflation or a sudden debt deflation.  As Robert Frost might put it: 

Some say the world will end in fire

Some say in ice 

I hate to sound so apocalyptical, but this week in New York everyone around me seems to have been filled with dread, and I – no stranger to worried pessimism, as all my blog readers surely know – am also being infected by the mood.

Comments

[globalHOBBIT:]

I own both FXI and CAF in a 1:2 ratio and have watched both go from the upper $70's [FXI split adjusted] to their current levels of $37 and $27 respectively over the last year. I've owned both since their inception, FXI in 2004 and CAF in 2007 and I'm still up..... barely. One thing that always must be remembered by all who invest in China. China = Communist Dictatorship. The President, the Chairman of the Politburo, the Premier and all our industrious comrades must invest in 'A' shares and the more equal among the equals can own B and H shares also. I don't know when the Chinese markets will turn bullish I do know eventually will and step aside when they do because it'll be like a rocket.

2008 Sep 14 09:05 PM

[James Lewis:]

globalHOBBIT lets just hope it won't be like the Chinese Satellite Rockets.

I think the only question remains:

Is the fact that everyone is so bearish actually a reason to start becoming bullish.

or...

Is everyone bearish because we all sense that a mutli-year depression is coming.

2008 Sep 15 04:17 AM

[David Oliver_:]

How do corporations react (to profits being squeezed)? Maybe by adding melamine to their infant milk powder products ...

2008 Sep 15 11:12 AM

[Urbane Gori...:]

I think the best explanation for the more recent decline in the China market was that many small investors were pulling out of the market in response to the large decline after having basically bet big that it would pull up. A nice image of the small Chinese investor can be found in 'Be Your Own China Guru', which describes grandmothers and taxi drivers stopping their work to watch their ticker and it's associated MACD.

jegan ;-)

2008 Sep 15 12:44 PM

[portable al...:]

excuse me Michael, apart from collecting and displaying all kinds of economics figures just to try your best to interpret them in the most negative way possible, you didn't put down anything more significant or valuable in your article. I can everything in daily news releases, so it is time for you to have a rest.

The industrial output is slightly lower than same time last year, but take into account that the US and euro zone and the rest of Asia are already close to or in a contraction, it is not that bad as you have described for China. Oh Retail Sales figures, which grew slightly less than July's, is because of the Olympic? What about July's good figure? What has contributed to it? So if the Aug retail sales is good, it is because of the Olympic, and if it is bad, well it is supposed to be bad. Thanks for your pointless analysis!

2008 Sep 15 03:47 PM

[portable al...:]

Another couple of points here: as for the Loan and Ms money supply figure, I am sure you are the only teaching professor in China who is actually trying to assess those figures. So better stop telling people to stop reading it. And then you have to explain to me what you mean here ‘I would argue that the continued rapid growth of foreign currency reserves at the PBoC is probably being countered by the sharp fall in real estate and stock prices to represent money growth below what we would have expected’. What is the inner relationship between PBoC’s FX reserve and the sharp fall in real estate and stock prices in China? How do they counter each other? You are actually saying that if the real estate and stock prices keep falling, it will mitigate or mitigate the effect of FX accumulation……by what means?

Furthermore, according to what you said here ‘Morgan Stanly just released a report saying the real estate sector is on the point of an imminent collapse. which suggests even that perhaps both explanations might be true. Needless to say a collapse in the real estate sector is one of the biggest risks in China’, my question is if you actually live in China. The clamp-down on housing prices is actually expected to benefit the average household, and for that you could simply ask any walk-by on the street. This illustrate that sometimes economists are not commenting on the actual life but what is in their imagination.

Sorry I am running out of time so cannot carry on anymore……cheers

2008 Sep 15 04:12 PM

[HeF:]

PAF, given current markets I am a little surprised that you think things are going so well. At any rate I am not a Chinese nespaper. It is not my goal to try to cheer people up. It is my goal to try to understand risks in the financial system, and you would have to be pretty foolish to argue for the bright side of collapsing real estate prices. The fact that collapsing real estate prices might help future buyers may very well be true, but it hardly is good news for existing investors, and it is always terrible news for banks. I would have thought that was sort of obvious.

By the way your IP numbers obviously haven't been deflated by PPI or you would have had a different view. As for consumer demand, I have always said July and August growth was high but this may because of the Olypmpics. We must wait and see. I suggest, again, that we wait and see.

2008 Sep 19 07:43 AM