The purpose of this report is to update macro-fiscal flows in China with the new private credit creation data and see what impact his has on investment markets.
This report was produced using a balance of national accounts assessment of China
One can summarize the national accounts in the following formula:
GDP = Private Sector Spending [P] + Government Sector Spending [G] + External Sector Spending [X]
See the methodology section below for more detail on these formulae.
Each sector will be examined in turn starting with the private sector.
The private sector is where the stock market is and we as investors want the stock market to go up. The stock market can only go up if the flows into it are positive. The private sector derives income from three sources:
Credit creation from banks - More loans created than repaid.
Externally from overseas commerce - More exported than imported.
Government spending - more spent than taxed out.
In an ideal scenario, the private sector would receive large, and growing income flows from all three sources, and at the very least, the overall impact should be a positive flow overall even if one or two of the three flows are negative. The stock market in the private sector, as well as all other private financial assets, should rise if the overall income flow into the private sector is positive.
Certainly, the stock market would be unlikely to rise if the income flows were negative. Even in a shrinking economy, some sectors can grow while the rest of the pie shrinks. One has the best chance of earning a positive return in a private sector that is growing rather than shrinking, and this should be a macro investing consideration for any investor.
The chart below shows the level of private credit creation entering the private sector through commercial and State banks.
In China, loans to the private sector refer to total social financing. Social financing is the volume of financing provided by the financial system to the real economy (domestic non-financial enterprises and households) during a period. This credit is presumably not used for financial speculation and asset price inflation and leads to the creation of new goods and services. Whereas the chart above it is total loans to banks, which like in the West, are used for purchasing existing assets rather than financing the creation of new ones. Sadly the latter is one-tenth of the former.
The chart shows that credit creation is both large and trending upwards and the sums involved enormous. Added together both forms of credit creation added 16.9% of GDP to the private sector in 2017, that is over US$1.8T
This is what the loan growth of an emerging superpower looks like.
The flow of private credit adds to the stock of private debt in the economy and this stock is shown in the chart below.
(Source: Professor Steve Keen)
The stock of debt is 200% of GDP. The impact of the debt service on this stock of debt can be modeled over a range of interest rates as shown in the table below.
The central bank rate is 4.35% and so some $US895B is spent on debt service each year or over 8% of GDP.
Professor Steve Keen has found that a private debt level of 150% of GDP tends to be a natural barrier and that economies that reach this level tend not to become more indebted.
China is a special case in that a lot of the debt belongs to state-controlled enterprises, and so is sovereign debt that our western accounting standards have trouble disaggregating from credit money debt. Sovereign debt is guaranteed by the monetary currency sovereign that can only go broke by choice but not by functional necessity. It creates money as it spends and can pay any bill in its unit of account that it created by passing laws in its parliament.
Household private debt is less than 45% of GDP which is a more reassuring level and shows a capacity to fuel a credit money fuelled bull run.
The external sector captures trade and commerce with other countries and is shown in the current account. The current account is exports less imports, and also includes capital flows in and out of the country from financial transactions and investments. A positive overall result is best.
The chart below shows the current account balance. The chart shows the surplus has been trending down. The result for 2017 is less than for 2016 as the chart trend shows. 2017 will be a surplus of only 0.17% of GDP or US$19B. The Chinese almost have a balanced current account despite their reputation as massive exporters of cheaply made goods. Just not balanced with the U.S.A.
The government budget is in the chart below.
The result for 2017 is at hand and is 3.5% of GDP and does not tally at all with the first chart above for China Government Budget Value.
Sectoral Analysis Methodology
Professor Wynne Godley developed the stock-flow consistent sector flow framework of analysis.
Each nation state is composed of three essential components:
The private sector
The government sector
The external sector
The private sector comprises the people, business and community, and most importantly, the stock market. For the stock market to move upwards, this sector needs to be growing. This sector by itself is an engine for growth and innovation; however, it needs income from one or both of the other two sectors to grow.
The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained. For a sovereign government with a freely floating exchange rate, any financial constraint such matching bond issuance with deficits is a self-imposed restriction. A debt ceiling is also a self-imposed restriction as is a fiscal brake.
The external sector is trade and commerce with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.
For the stock market in the private sector to prosper and keep moving upwards, income is required to be put into the flow. Otherwise, the sector can only circulate existing funds or is being drained of funds and is in decline.
The ideal situation is that the private sector has a net inflow of funds and is always growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.
The following formula can express this relationship:
GDP = Private Sector + Government Sector + External Sector
These are accounting entities and correct by definition.
For the best investing outcome, one looks for countries with stock markets located in private sectors that are receiving positive income flows overall. Top marks come where private credit creation, the government sector, and external sector are both in plus and trending upwards.
Conclusion, Recommendation, and Summary
When we take our inputs and place them in our formula, we can calculate the following sectoral flow result based as a percentage of GDP.
Private Sector Credit Creation
(Source: Trading Economics and Author calculations based on same)
*Estimate until actual figures are reported.
#Forecast based on present trends and plans.
One can see that private credit creation is doing the heavy lifting and that the overall fiscal flows are large but decelerating. A large part of the private credit creation could be classed as government spending given that many recipients are State enterprises receiving loans from State banks. But that is not how the data is presented. What it does mean is that the debt is not fragile given that a state bank stands behind it and the state is a monetary currency sovereign that can only default by choice.
If you want a free lunch from this macro-fiscal flow extravaganza you can do so using the following China ETFs:
- iShares China Large-Cap ETF (FXI)
- iShares MSCI China ETF (MCHI)
- SPDR S&P China ETF (GXC)
- Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR)
- PowerShares Golden Dragon China Portfolio (PGJP)
- Direxion Daily FTSE China Bull 3x Shares ETF (YINN)
- VanEck Vectors ChinaAMC CSI 300 ETF (PEK)
- iShares MSCI China A ETF (CNYA)
- CSOP MSCI China A International Hedged ETF (CSOP)
- Deutsche X-trackers MSCI All China Equity ETF (CN)
- Direxion Daily CSI 300 China A Share Bull 2x Shares ETF (CHAU)
- Deutsche X-trackers CSI 300 China A-Shares Hedged Equity ETF (ASHX)
- CSOP FTSE China A50 ETF (AFTY)
The chart below shows how FXI has traded over the last year.
There appears to have been a blow-off top and a return to the growth pattern prior to January 2018 and could represent a good entry point. I am going to wait for a confirmatory "V" to appear before buying a position.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FXI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.