"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom."
- Viktor E. Frankl, Austrian psychologist
Watching with curiosity our "secondguessing" playing out on our Chinese exposure supported by PBOC intervention in the process, it reminded us, of course, of our October 2014 note "Pascal's Wager", as the only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose the belief that our central bankers are indeed "Gods".
When it comes to choosing this week's title analogy, we remembered the herb Ephedra sinica used in traditional Chinese medicine, which contains ephedrine and pseudoephedrine as its principal active constituents. Ephedrine in its natural form was known as má huáng (麻黄) in traditional Chinese medicine, and has been documented in China since the Han dynasty (206 BC-220 AD) as an antiasthmatic and stimulant. In traditional Chinese medicine, má huáng has been used as an attempted treatment for asthma and bronchitis for centuries, so no wonder when economies catch the proverbial cold, it can also be used as a powerful "stimulant". What we find of historical interest is that in 1885, the chemical synthesis of ephedrine was first accomplished by Japanese organic chemist Nagai Nagayoshi, based on his research on traditional Japanese and Chinese herbal medicines. In similar fashion, the Japanese chemist/central bankers at the Bank of Japan were the first to realise the chemical synthesis of ephedrine and its "stimulant" effect on "asset prices". Though, Ephedrine is a potentially dangerous natural compound, as it can sometimes lead to mania/hallucinations as well as delusions, but we ramble again...
What we find of interest with this week's analogy is many pundits musing around the probability of China launching a QE of its own to offset the debilitating effects of its past credit binge. Therefore, in this week's musing, we would like to focus our attention on China's potential approach in offsetting the effects of past excesses, given that while Europe is attempting to avoid demolition, China - as we pointed out in our February 2014 "Crosswind" conversation - is attempting to deflate these past excesses:
"Chinese crosswind is of two folds, on one hand China's deflating exercise is akin to a "controlled demolition" and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy.
As we wrote back in September 2011 in our conversation "Controlled demolition", as far as Europe and China are concerned, nothing has really changed in terms of the treatment of the on-going crisis:
"While Europe is busy with the demolition, we have China attempting deconstruction. In both case we have an attempt of controlled demolition, it is just a question of style." - Macronomics, 19th of September 2011."
- Source Macronomics
- China's debt pile and household debt
- Private debt matters, but so does private consumption
- The US and Europe reducing "equity" versus China increasing "equity"
- China and QE and the myth of the Opium plague
- Final note: Dr. Copper, the metal with the economics Ph.D, is still in a bear market
China's debt pile and household debt
China's Purchasing Managers' Index from HSBC/Markit slowed to 48.9 in April versus 49.6 last month. We saw a similar pattern in 2014. But when it comes to assessing the meteoric rise in China's debt, one need to take into account household debt relative to GDP, as indicated in Bank of America Merrill Lynch's Cause and Effect note from the 27th of April entitled "The great US-China convergence trade":
"Between 2011 and 2014, loans from financial institutions to Chinese households more than doubled; during the same period, the debt of US households was unchanged. As a result, Chinese household debt as a share of GDP has climbed to 36% while US household debt as a share of GDP has fallen to 77% (Chart 14).
By the way, the McKinsey Global Institute recently estimates that total debt to GDP ratio for China has reached 282%, versus 269% for the US." - source Bank of America Merrill Lynch
To quote Bastiat, when it comes to debt levels:
"That Which is Seen, and That Which is Not Seen"
- Frédéric Bastiat
From our macro perspective, low household debt levels versus GDP is an essential positive factor when it comes to the "deleveraging" exercise undertaken by China. Therefore, given the lower leverage of Chinese households, we think the bubble watchers will watch with interest the Chinese market continuing to surge in the near future. In fact, as indicated by Asia Times, and relating to our HSI exposure, April saw significant inflows into the Chinese stock market:
"April saw HK$20.5 billion ($2.6 billion) flow into the Hang Seng H-Share Index Fund (SEHK STOCK CODE 2828). It was the largest monthly inflow since 2010 and the third-most among equity ETFs globally, according to data compiled by Bloomberg.
The Hang Seng H-Share ETF holds the stocks of 40 of China's biggest state-owned companies. Financials make up 67% of the portfolio. The fund is valued at about 10 times forward earnings, compared with the 17 multiple on the Shanghai Composite Index, according to Bloomberg.
The ETF's shares rose 17% last month to HK$145.20, its third consecutive month of gains. Over the past four months, the ETF has received a total of HK$29 billion, its longest stretch since 2013. Total assets grew to HK$57.1 billion.
The U.S.-listed iShares China Large-Cap ETF (NYSEARCA:FXI) received $385 million last month, the biggest inflow in eight months. It jumped 16% in April, for a 51% return over the past 12 months.
One big reason for the rally is that Chinese companies trading in Hong Kong are priced at a significant discount to their dual-listed counterparts on the mainland. UBS said even though the Hang Seng China Enterprises Index leapt 17% in April, its largest jump since October 2011, Chinese A shares still trade at a 31% premium to Hong Kong stocks."
- Source: Asia Times
Given the discount and the lag in term of performance of the Hang Seng China Enterprises benchmark versus the Shanghai Composite Index's A shares (up 48% versus 119%), there is still some upside move to close the gap.
Private debt matters, but so does private consumption
While arguably, China has experienced a slowdown and is playing a complicated "rebalancing" act from investment towards domestic consumption, we agree with Jeffrey Towson and Jonathan Woetzel from the adapted book excerpt from their follow-up to their "The One Hour China Book", as displayed by McKinsey in their article "Why China's consumers will continue to surprise the world":
"China has an awesome consumer story. Yet lately you can't pick up a newspaper, go online, or watch television without hearing continual moaning about the country's slowing economic growth and the need for "rebalancing." The reality is that Chinese consumers are going to continue to increase in wealth and complexity. And if you're worried the country's economic importance is declining, you're probably looking at its performance the wrong way.
Don't worry about consumer spending as a percentage of GDP
As in most developing Asian economies, China's early growth was based on savings, investment, and exports. You get your population to save, move to the cities, work in factories, and make stuff. This is sold, and cash is brought back home for investment. Plus, you get some foreign investment as well. This process enabled China to develop its infrastructure largely with its own cash. That, by the way, is not the norm. Developing economies typically borrow from foreigners and then default-for example, American states such as Mississippi and Florida were chronic defaulters on foreign debt as they initially developed.
One of the downsides of this investment-first approach is that it makes consumption look small and often like it's shrinking. Chinese consumption decreased from approximately 51 percent of gross domestic product in 1985 to 43 percent in 1995, 38 percent in 2005, and 34 percent in 2013. By comparison, consumption is around 61 percent in Japan and about 68 percent in the United States. In fact, China's small and decreasing consumption percentage is one reason why people keep talking about "rebalancing"-the need for the economy to become driven more by consumer spending than investment and exports.
Our position? Don't worry about this stuff.
First, from 2000 to 2010, the size of the Chinese economy more than doubled
So consumption grew from around $650 billion to almost $1.4 trillion. Regardless of its relative percentage of GDP, China's consumption has been growing faster than just about any other country's in absolute terms. Second, just getting consumer spending back to 43 percent of GDP, the level in 1995, would have a huge impact on "rebalancing." It would also create the largest consumer market in the world. Third, most of these numbers are wildly inaccurate. Consumer spending is nearly impossible to measure in such a big, complicated economy. Combining a vague number with two other big vague numbers (investment and net exports) is very fuzzy math. Until economists start putting uncertainty estimates on their China calculations, relative percentages aren't worth paying much attention to.
Household income is what matters, and it's great
The number you really want to keep in mind is household income. You can't have consumption without income. And here's where it gets really awesome. China's household income is huge. It is now likely above $5 trillion a year. Plus, lots of income is unreported, so this is really the lower boundary for true household income. Developing economies-especially the BRIC nations of Brazil, Russia, India, and China-are frequently grouped together, but Chinese consumers dwarf all the others in terms of household income.
Rising discretionary spending is the exciting part
Discretionary spending is buying the stuff you like but don't need. Or you only sort of need. And, fortunately, people seem to have an endless appetite for everything from entertainment to skiing to cafe lattes. Chinese citizens are now moving beyond being able to only afford the basics of life, and their discretionary spending is taking off. Growth in spending on annual discretionary categories in China is forecast to exceed 7 percent between 2010 and 2020, and growth of 6 to 7 percent annually is expected in a second category of "seminecessities." Both of these categories are growing faster than spending on actual necessities, which are expected to grow around 5 percent a year, about the same as expected GDP growth.
Finally, an important related issue is the Chinese tradition of saving. If we compare spending and saving rates across the emerging markets, we see a spike in savings in China. That spike is fairly understandable. First, it's cultural. Second, they are precautionary savings-no social safety net means if you get sick, it's all on you. Third, Chinese savings are not unique. Japan, Korea, and Taiwan all hit 30-percent-plus savings rates in their early development. And fourth, without much of a consumer-finance system, it's tough to use debt to hit truly spectacular consumption levels. After all, a vacation home or car may cost the equivalent of a year's income.
That's our rant on China's macro consumer situation. Basically, we believe it remains a great story. It may be volatile. It's also somewhat unpredictable. But you just don't get a consumer growth story this good anywhere else."
- Edited excerpt from The One Hour China Consumer Book: Five Short Stories That Explain the Brutal Fight for One Billion Chinese Consumers (Towson Group, 2015).
Compared with other latecomer countries, China has its own advantages.
First, with a total population of 1.3 billion people, the country contends with a huge domestic market that is rapidly growing.
Second, although China has faced shortage of rural labor force, the influx of 6-7 million college graduates into the job market every year will satisfy an increasing demand for high-skilled workers to fuel further growth.
China's manufacturing advantages are conducive to the industrialization of scientific and technological achievements. Over the past three decades, the country has achieved enormous economic growth, but its market economy system still has substantial room for improvement.
Manufacturing is going up the « added value » chain: high-speed rail, nuclear power, construction, biotechnology, to name a few.
Asia, for us, continues to be a good value play, given they are much more positively impacted by the fall in oil prices, but more importantly, by the fall in food prices, as displayed by Société Générale in a recent cross-asset note:
"Asia is the EM region where the share of food in the consumer price index is the highest on average."
- Source: Société Générale
With food prices falling for Chinese households, this is indeed an additional boost for discretionary spending, as displayed in McKinsey's projection of per-household annual consumption in China by category in percentage terms:
- Source: McKinsey
China's consumption strength is real, and the economic rebalancing is happening, with a growing role of the Services sector, as indicated in the CITI Asia Macro and Strategy Outlook 30th of March 2015:
"Services sector account for an average of 58% share of EM Asia's GDP (vs. 22% share in manufacturing), accounted for 43% of real GDP growth in EM Asia over the last decade (vs. 32% contribution from manufacturing sector), and employed 2.3x more people than manufacturing sector to account for the jobs of 35% of EM Asia's working population (manufacturing accounts for 16% of jobs)."
- Source: CITI Asia Macro and Strategy Outlook 30th of March 2015
Strong services demand is linked to rising per capita income, leading to stronger consumption. This has generated real sales growth, which has been trending up since July 2014.
US and Europe = reducing "equity" versus China increasing "equity"
The "controlled demolition" of their credit bubble has been sustained by the two recent interest rates cuts and the banks' reserve requirement ratios by the PBOC, in conjunction with the high level of savings of the Chinese household that can be "redirected" from housing towards an additional "equitization" of the Chinese market, as put it by Asia Times in its April 22nd article entitled "China's stealth deleveraging":
" Western analysts remain obsessed with the size of China's debt problem.
China is gradually deleveraging, though, through the following mechanisms:
1) Equity is slowly replacing debt as the soaring stock market cheapens the cost of equity capital, including at the small-and-medium enterprise level through the Shenzhen and Qianhai stock exchange;
2) Debt is shifting out of the usurious shadow banking market (where loan rates for small businesses can reach 20%) to banks, and to securitized debt markets (Alibaba (NYSE:BABA), China's e-commerce giant, has listed an asset-backed security based on small business loans on the Shenzhen stock change;
3) The commercial banks are recapitalizing (including $110 billion of preferred debt issuance in 2014);
4) The government is starting to swap high-yield and sometimes dodgy Local Government Financing Vehicles (LGTVs), the equivalent of US municipalities' economic development bonds, for provincial bonds backed by tax revenues-at much lower interest rates;
5) The overall level of interest rates is coming down from the highest in world (4% real short-term yields vs. negative yields in most of the industrial world."
- Source: Asia Times
We would also like to make the following point on the contrary: In the US and now Europe, debt has indeed been replacing equity thanks to debt issuance to fuel a buy-back binge as of late, meaning that leverage once more is trending up, which can be viewed as "credit negative" from a "ratings" perspective. For illustrative purposes, this trend of "releveraging" in Europe can be ascertained in Bank of America Merrill Lynch's graph below from its European Credit Strategy note from the 1st of May entitled "Who has done the deleveraging or not?":
- Source: Bank of America Merrill Lynch
On a side note, given the particular weaker tone for France's PMI and rising unemployment, as per our conversation "A Deficit Target Too Far" from the 18th of April, 2012, we continue to think the following: "We also believe France should be seen as the new barometer of Euro risk."
From a credit perspective, not only French "corporates" have been releveraging, but in terms of EBITDA, Germany's growth, once again, is making outsized gains thanks to its "mercantilism" approach with its low wages/strong export model helped even more by a weaker Euro as displayed as well in Bank of America Merrill Lynch's European Credit Strategist note:
- Source: Bank of America Merrill Lynch
And when it comes to France's unemployment woes, we have yet to see a rise in CAPEX in the country, clearly showing that French president Hollande's economic policy is based more on hope than reality, as again indicated in the below Bank of America Merrill Lynch graph from the same report:
- Source: Bank of America Merrill Lynch
But being French ourselves, we ramble again and get sidetracked in the process. Let's move back to our traditional Chinese medicine, má huáng (麻黄).
China, QE and the Myth of the Opium Plague
While musing around QE and its similarities with narcotics, given our chosen title, we reflected on the history of drugs in China and the myth of the "Opium Plague", as there is indeed a case for the myth of the "QE" plague when it comes to perceiving PBOC actions.
Many pundits believe that, China will eventually resort to QE and face a similar demise due to imperialist Britain's most desirable trade commodity, namely opium.
From a historical perspective, we would like to point towards Frank Dikotter, Lars Laamann and Zhou Xun's 2004 book entitled "A history of drugs in China", published by the University of Chicago:
"To this day, the perception persists that China was a civilization defeated by imperialist Britain's most desirable trade commodity, opium-a drug that turned the Chinese into cadaverous addicts in the iron grip of dependence. Britain, in an effort to reverse the damage caused by opium addiction, launched its own version of the "war on drugs," which lasted roughly sixty years, from 1880 to World War II and the beginning of Chinese communism. But, as Narcotic Culture brilliantly shows, the real scandal in Chinese history was not the expansion of the drug trade by Britain in the early nineteenth century, but rather the failure of the British to grasp the consequences of prohibition.
In a stunning historical reversal, Frank Dikötter, Lars Laamann, and Zhou Xun tell this different story of the relationship between opium and the Chinese. They reveal that opium actually had few harmful effects on either health or longevity; in fact, it was prepared and appreciated in highly complex rituals with inbuilt constraints preventing excessive use. Opium was even used as a medicinal panacea in China before the availability of aspirin and penicillin. But as a result of the British effort to eradicate opium, the Chinese turned from the relatively benign use of that drug to heroin, morphine, cocaine, and countless other psychoactive substances. Narcotic Culture provides abundant evidence that the transition from a tolerated opium culture to a system of prohibition produced a "cure" that was far worse than the disease.
Delving into a history of drugs and their abuses, Narcotic Culture is part revisionist history of imperial and twentieth-century Britain and part sobering portrait of the dangers of prohibition."
- Source: The University of Chicago Press Books
In similar fashion we think regarding the "war on the savers", thanks to ZIRP and QE, that in the future, historians will paint a sobering portrait of the dangers of meddling with markets and interest rates - but we are ranting again.
When it comes to "easing", the POBC will be launching soon its own credit easing, but in no way a QE sort of program, as interestingly described in Asia Times on the 28th of April in its article "PBOC goes back to drawing board on bond/loan swaps":
"After going back to the drawing board, the People's Bank of China now plans to launch its own version of the credit-easing programs seen in the U.S. and Europe, reported the Wall Street Journal on Tuesday.
The central bank will allow Chinese banks to swap local-government bailout bonds for loans as a way to bolster liquidity and boost lending, said the Journal.
The big problem is that in an effort to stimulate the economy regional governments have borrowed huge amounts of cash to fund infrastructure projects, said the Financial Times. Now the Chinese economy is slowing down and many citizens are pulling huge amounts of capital out of the country and investing it overseas. But as the property and manufacturing industry suffer, policy makers want to cushion the economic slowdown into a soft landing with more infrastructure spending.
Amid all this many of these loans are coming due. So the central bank wants to help the local governments by converting short-term high interest loans into low-interest long-term bonds.
Strictly speaking it's not quantitative easing. The central bank just wants more people to buy the debt of the cash-strapped local governments. And one way it hopes to accomplish this is by letting institutions use the debt as collateral for loans to commercial lenders. China's Finance Ministry said it would do this by allowing heavily indebted local governments to sell new bonds with explicit government guarantees to replace their existing debt - mostly bank loans," said the Journal"
- Source: Asia Times
Hence our title, this PBOC monetary policy amounts to "Ephedrine" or "Opium", not the highly addictive "heroin", QE, as embraced by central bankers of the BOE, FED, BOJ and ECB.
We agree with Asia Times. This does not amount to QE.
Nomura also shared the same views on the 28th of April in their Asia Insights note entitled "China QE on the way? No!":
"Is the PBoC's liquidity injection equivalent to a Chinese version of QE? No. QE, in essence, is a monetary policy regime change with an accelerated expansion of a central bank's balance sheet while policy rates are close to zero. Given China's monetary background, QE would mean a more aggressive expansion of the PBoC's balance sheet, but this is not what is happening. As explained above, the recent liquidity injections have mainly been to offset shrinking FX purchases in the maintenance of the normal expansion of the central bank's balance sheet. The bottom line is that there is no extra liquidity growth in terms of the monetary base or broad money (M2) from the PBoC's liquidity injections.
Will the PBoC inject liquidity by buying local government bonds? Unlikely, and not in any QE way. First, the PBoC is forbidden by law to buy government bonds directly; second, the primary aim of injected liquidity is to provide the monetary base rather than bailing out local governments. The PBoC already has enough tools to create the monetary base, so has no need to buy government bonds in the secondary market. That said, we suspect that the PBoC may participate in local government bonds in some way in future. According to a recent Xinhua article, local governments have had difficulty in issuing bonds as banks are reluctant to buy them at such low yields.1 To encourage the banks to replace current high yield local government debt - mainly in form of loans and LGFV bonds - with low yield local government bonds, the PBoC may need to provide banks with some compensation via RRR cuts or low interest rate re-loans, or some other creative arrangement. In particular, as the policy banks - such as the China Development Bank (CDB) - hold lots of local government debt, there could be some special arrangement between the PBoC and CDB in future to deal with a debt swap.
To sum up, we believe the PBoC will continue to ease monetary policy through RRR cuts, rate cuts and liquidity injections. But QE is not the correct term to describe the PBoC's framework of monetary easing - because its balance sheet has never stopped expanding and will not suddenly jump due to asset buying like that of the Fed, ECB and the BOJ."
- Source: Nomura
Indeed, as depicted by Professor Frank Dikotter in an inaugural lecture given in 2003 and entitled "Patient Zero": China and the Myth of the "Opium Plague", there is growing "demonisation" of central banks' intervention when it comes to assessing the "QE" factor, such as the PBOC:
"Another problem which needs to be addressed is the demonisation of 'opium' into a single and uniform substance. The paste varied immensely in strength and quality, while many consumers were connoisseurs who could distinguish between a large variety of products, ranging from expensive red Persian opium to qualitatively poor local produce. Opium is an extremely complex compound containing sugars, gums, acids and proteins as well as dozens of alkaloids which varied in proportion and content. General statements about the purported effects of 'opium' are thus as vague as blanket condemnations of 'alcohol': a world of difference existed between weak homebrewed beers in medieval Europe and strong spirits in Victorian England, and both were used in radically different social contexts. Most of the imported paste from India and the locally cultivated opium in China had a very low morphine content, on average 3 or 4 per cent. On the other hand, the opium imported every year into England from Turkey in tens of thousands of tonnes was very rich in morphine, ranging from 10 to 15 per cent. Moreover, smoking was generally acknowledged to be more wasteful than ingestion, although the morphine content reached the bloodstream more quickly and caused a rush: 80-90 per cent of the active compound was lost from fumes which either escaped from the pipe or were exhaled unabsorbed by the smoker."
- Source: Professor Frank Dikotter.
In similar fashion, China's current's monetary easing stance has a very low morphine content, whereas the BOE, the FED, the BOJ and the ECB's QE have become highly addictive and are more akin to heroin than opium, we think. As pointed out by Professor Frank Dikotter's lecture, opium was a medical panacea for many working people before modern synthetic medications became available in similar fashion "Ephedrine" is used a stimulant for the "ailing" Chinese economy by the PBOC.
Final note: Dr. Copper, the metal with the economics Ph.D, is still in a bear market
While Dr. Copper, the metal with the economics Ph.D, has seen a recent rally; as a final note, this was merely driven by short covering, as indicated by Bank of America Merrill Lynch's Global Metals Weekly note from the 1st of May entitled "Do you believe in the copper rally":
"Near-term strength, followed by weakness
We believe the immense weakness of copper prices in the first quarter was driven partially by flows, so was not entirely justified. As such, we kept an average 2Q15 forecast of $6,150/t ($2.79/lb). Considering more policy support by Chinese authorities and keeping in mind that demand usually strengthens seasonally after winter, prices may rally further through 2Q, a point we made in various notes. Yet, that rebound does not change our view that copper fundamentals are structurally challenged, with prices likely coming under renewed pressure in 2H15 and 2016 at the latest" - source Bank of America Merrill Lynch
Of course we agree, as we are not "believers" in the copper rally.
"Religion is the opium of the masses."
- Karl Marx