There's been a lot of over-hyped talk of China tightening and deleveraging over the past few weeks. Sure, inter-bank rates and corporate bond yields have significantly increased over the past year. But if you include things such as central bank injections into the inter-bank market and unsterilised foreign exchange purchases - where the central bank buys foreign currency to maintain the partial dollar peg - it's clear there's been no net tightening at all.
As for deleveraging, figures released on China lending over the weekend should be enough to put that to bed. January lending was the highest in four years. More worryingly, total societal financing - a broad measure of credit including shadow financing - increased 17% to 2.58 trillion yuan, smashing analyst estimates of 1.9 trillion yuan. China remains addicted to credit despite the ratcheting up of rates.
The fact is that China's President, Xi Jinping, hasn't done nearly enough to deflate the country's credit bubble. He needs to do three things, and fast: 1) allow defaults of wealth management products so risk can be properly priced 2) accelerate structural reforms laid out late last year 3) lower Beijing's bottom line for GDP growth from 7% to a more realistic 6%. Without these initiatives, Xi risks a much larger economic blow-up in the not-too-distant future.
For investors, the question isn't whether China's economy will slow down from here, but to what degree. And more importantly, how much of it is priced into markets. In Asia Confidential's view, China's stock market, down two-thirds from the 2007 peak, is already reflecting a lot of (not all) of the bad news. But key China proxies, including the Hong Kong and Australian stock markets as well as large iron ore miners, aren't and remain most at risk from the coming China downturn.
No deleveraging here
The Telegraph columnist Ambrose Evans-Pritchard wrote a recent piece on China which garnered much attention. Headlined, "World asleep while China tightens deflationary vice", he stated:
"China's Xi Jinping has cast the die. After weighing up the unappetising choice before him for a year, he has picked the lesser of two poisons.
The balance of evidence is that the most powerful Chinese leader since Mao Zedong aims to prick China's $24 trillion credit bubble early in his 10-year term, rather than putting off the day of reckoning for yet another cycle."
Great prose but the evidence that Evans-Pritchard provides to support his case is thin, at best. He acknowledges that China blinked in January when it stepped in to cover liabilities of $500 million for the trust fund, "China Equals Gold No. 1" (an unfortunate name, to say the least). But Evans-Pritchard goes on to suggest that the evidence for Xi getting serious about deflating China's credit bubble can be found with the tightening of rates. He cites the central bank lifting of the 7-day repo rate, a gauge of inter-bank liquidity, by 200 basis points to 5.21% (since then, it's dropped to 4.4%).
The columnist also cites the jump in corporate bond yields. Thus, the yield of corporate AA 1-year bonds has increased 272 basis points to 7.15% since June. Evans-Pritchard then quotes several stock brokers about how China intends to raise interest rates right across the spectrum and this means that Xi is intent on popping the credit bubble.
In our view, the thesis is vastly overstated. Yes, repo rates and corporate bond yields have risen markedly. But both are coming off abnormally low bases and have only just began to normalise. Also, if you count net repo injections - central bank injections into the inter-bank market in order to provide liquidity - and unsterilised foreign exchange purchases, there is no net tightening in the system. China is still pumping money into the economy in an unsustainable manner.
Evans-Pritchard is on firmer ground when he talks about how the world is asleep to the potential fall-out from a China slowdown. Foreign loans to Chinese companies now total $1.1 trillion, posing a large risk to banking systems with exposure, particularly those in the U.K., Hong Kong and Australia. We won't go into the details here but it's worth a read.
During the week, The Financial Times took Evans-Prtichard's lead and ran with it in an article called "Chinese-style tapering eclipses US tapering in scale". The article suggests the unwinding of monetary stimulus in China is greater in numerical terms than that of the U.S. So, total societal financing in China fell to 7.1 trillion yuan in the second half of last year, from 10.2 trillion yuan in the first half. In other words, a net reduction of just over 3 trillion yuan.
The article then cites an analyst who suggests that China may now be entering a period of deleveraging. Well, no. While the reduction in Chinese credit growth may be tapering, it certainly doesn't fit the definition of deleveraging. The latter means reducing debt, particularly versus GDP. And as the figures over the weekend on lending show, Chinese credit is still growing strongly, well above nominal GDP growth rates. In other words, debt to GDP is still rapidly increasing, not decreasing.
Thus, the January figures show Chinese banks lent 1.32 trillion yuan, beating a 1.1 trillion yuan forecast and more than 3x December's level. It isn't unusual for January lending to spike but this was the strongest month in four years. More concerning was the total societal financing number. This figure increased 17% to 2.58 trillion, way above analyst estimates of 1.9 trillion. Yes, the growth was the lowest in 18 months but it's still about double nominal GDP growth.
In sum, there's no net tightening in China nor deleveraging at present, despite claims to the contrary. It doesn't mean that there won't be tightening or deleveraging in the future, but that's pure speculation at this stage.
What Xi needs to do
What the weight of evidence indicates instead is that China's President Xi Jinping has tinkered with policies to reduce the country's credit dependency, but hasn't done enough to make substantial inroads. Let's be clear: Xi inherited a credit bubble of gargantuan proportions. Chinese credit grew some $12 trillion, or 2x total GDP, in the four years prior to him coming to power. To put that into perspective, U.S. bank credit grew around $1.5 trillion over the same period.
Given what he inherited, Xi had no good choices. He could choose to deflate the credit bubble and endure short-term pain. Or delay deflating until later and risk an even larger bubble developing and larger subsequent pop. It's not yet clear whether he's chosen the former option but if he has, he certainly hasn't acted decisively enough. And without hard choices, Xi risks a bigger economic fall-out later on.
So, what does Xi have to do to properly address the issue? There are three key things:
- He needs to allow defaults of wealth management products. Remember, these products are private loan management vehicles, which will often promise 12% returns or higher on assets. People have bought these products because they think the government stands behind these instruments. Xi needs to send a clear message that the government won't stand behind these products. Only in this way can risk again be properly priced.
- He needs to speed up implementation of last year's proposed reforms. There's much talk that there are fiscal reforms coming soon. And deposit interest rate liberalisation will also happen quicker than expected. Bring them on. Reform is needed to re-balance China's economy and propel the next phase of growth.
- It's widely known that Beijing sees 7% GDP growth as the bottom line for growth, without risking social stability. We believe this needs to change to 6%. And in my view, if GDP growth fell to that level, it wouldn't risk social stability. The key reasons are: i) China's tight labor market means unemployment won't be a major issue even at those lower levels ii) Xi has consolidated power and has a strong mandate for change. The government is paranoid about social stability but 7% GDP growth ain't going to effect change; 6% will.
These ideas will undoubtedly receive some push back. For instance, allowing defaults of trust fund products and the like may risk widespread defaults. My retort to this is that this is a possibility, but further government bail-outs will just delay and inflate the problem.
Structural reforms also have the potential to be a sharp drag on economic growth. Particularly if implemented at the same time as deflating credit. This is true. You could choose to deflate credit first, then roll out reforms. Doing both at once though makes some sense as it will take some time for reforms to filter through to real economy.
Lastly, some will see 6% GDP growth as a disaster scenario for China. Many government officials will see it as such. I'd suggest it isn't though and it's a realistic appraisal of the short-term pain needed to decrease China's credit dependency and to put the economy on a more sustainable footing. And it's not even close to a worst case scenario, where the credit bubble is inflated for a further year to two and then bursts. Under that scenario, 6% growth would be wildly optimistic.
What it means for investors
For investors, the key message is this: a China downturn is coming, one way or another. And the more that Xi Jinping tinkers with policy and fails to make hard decisions, the greater the probabilities of a sharp economic downturn. Let's assess the potential fall-out for China first. French bank, Societe Generale, says an economic hard landing would entail GDP growth troughing at 2%, with two quarters of contraction. That would result in a decline in China stocks of 30%. Let's face it, Soc Gen's scenario is guesswork. No-one really knows what a GDP trough would be in the event of a hard landing, or the ultimate impact on Chinese equities.
It's important to recognise that China's stock market is already down two-thirds from the peaks reached in 2007. At 8x this year earnings, it's the second cheapest major market in Asia behind South Korea. A lot of the bad news is already priced into Chinese stocks. In my experience though, the Chinese stock market doesn't move on economic data or fundamentals, but policy change. This means that if the President gets serious in reducing credit, then the stock market should decline. Ironically, that would be a positive sign for the economy. Conversely, if Chinese equities were to rise from here, that would indicate that the President is choosing to further inflate the credit bubble. That would be a bad sign for the economy.
Put simply, you should expect further pain in Chinese stocks from already low levels. But it could soon turn into a fabulous buying opportunity for long-term investors. I'd focus on sectors which will benefit in the "new" consumption-driven China, including consumer discretionary and staples, telecommunications and internet companies. Cheap ways to play the future of China, in other words. I like retailer Giordano, telecoms giant China Mobile (NYSE:CHL), China Mengniu Dairy (OTCPK:CIADY) as well as internet play Tencent (OTCPK:TCEHY), though expect to pick them all up at cheaper prices.
While Chinese stocks may have partially priced in a sharp downturn, many markets and sectors outside of China certainly haven't. Take mining. There's no doubt commodities and commodity-producing countries have started to feel the pain from declining demand growth from China. But the impact is likely far from finished. Soc Gen suggests a China economic hard landing would lead to a 50% crash in copper prices. Again, that's guesswork. But it's undoubtedly right that China is the largest and most important consumer of most commodities.
In my view, iron ore is even more vulnerable than copper given the limited price correction thus far and the fact that China is the key driver, accounting for around 50% of global consumption. If correct, Australian iron ore miner, Fortescue Metals (OTCQX:FSUGY), is an easy short.
Australia's economy is particularly susceptible to a fall in metals. Mining is 9% of GDP, up from close to 1% in the late 1990s. If mining reverts back to below 3% of GDP over the next two years, that spells big trouble for Australia's economy. It isn't hard to foresee a deep recession starting next year. The Aussie dollar and Australian banks are both expensive and vulnerable to sharp corrections.
Lastly, banks with direct Chinese exposure may be vulnerable. Hong Kong banks would have to be near the top of the list. China accounts for close to 30% of Hong Kong bank loans. Moreover, bank assets are now an astonishing 7x the size of Hong Kong GDP. It's a scary number that equates to the size of Iceland's prior to its 2008 crisis. The circumstances are very different but Hong Kong banks are susceptible due to their exposure to China as well as a gigantic local property bubble (which the Chinese have helped inflate).
Incidentally, commentary on the fall-out from a China downturn to date has failed to make mention of the potential impact on global property markets. In Hong Kong, Australia, Canada and-- to a lesser extent-- Singapore, Chinese have been key investors over the past three years. It's difficult to get any hard numbers on the extent of Chinese investment in the residential property (and other property segments) of these countries. But it's substantial and any reduced Chinese investment would be keenly felt by residential developers and banks in these countries.
Disclosure: No positions