China Sectoral Flow Investment Assessment

by: Alan Longbon

Chinese fortunes continue to wane with self imposed diminished fiscal and credit creation flows.

As a command economy with firm economic plans and unity of action, there is no need for such a slowdown.

It is as though Chicago School of Economics monetarism has gained the upper hand in the Politburo and is deploying Austrian-style austerity.

The purpose of this article is to look at the macro sectoral flows and assess whether China is a good place for investment.

I last looked at China in this article in July 2018.

China at present is going through what can only be described as a self-induced slowdown. The vital statistics for the currency, GDP and stock market are shown below.

Since July, the Yuan has gained a little more strength as one would expect when the money supply is restricted by national government fiscal and private credit creation cutbacks. It is more a counter-trend to the longer-term trend of depreciation that began in April 2018.

GDP continues to rise, but more slowly than before and reflects the overall drop in fiscal and credit money flows. Overall GDP growth has been decelerating since 2010.

The stock market has fallen since the beginning of 2018 and has not yet found a bottom. The recently appreciating currency would not be helping.

Sectoral Flow Analysis

In 1970, Professor Wynne Godley moved to Cambridge, where, with Francis Cripps, he founded the Cambridge Economic Policy Group (CEPG). In early 1974, Godley first apprehended the strategic importance of the accounting identity - which says that measured at current prices, the government's budget balance, less the current account balance, is by definition equal to the private sector balance.

GDP = Federal Spending + Non-federal Spending + Net Exports

Gross Domestic Product [GDP] = Gross Domestic Income [GDI]

By definition, the stronger the private sector balance is, the stronger the private domestic economy and markets within it.

The following formula can express a nation's balance of accounts:

Private Sector [P] = Government Sector [G] + External Sector [X]

The community, business, and the stock market are located in P. For P to expand, it needs the balance of inputs from G and X to be positive. A negative balance causes P to contract.

When one adds all three sectors together, it equals the GDP for that year. One sector's loss is the other's gain, and if they all go down, so does GDP.

The charts below show the key information required to calculate the sectoral balances:

Up to 2016, the chart showed a steady process of spending and taxing into and out of the economy with a bias to spending more than was taxed out. After 2016, activity suddenly stopped and flat-lined like a heart attack on an ECG.

The current account has been falling since 2014 and for the first time in over a decade, China has posted a deficit in 2018 and more lately a weak surplus.

One sees from the charts that the key income flows have both been falling and this has deflated investment markets.

One can calculate the private sector balance by adding the current account balance and the government budget and expressing it as a percentage of GDP. As an accounting identity, this must sum to zero overall as a percentage of GDP. The table below shows the result.

(Source: Trading Economics, FRED and author calculations based on the same)

* Estimate as actual numbers not yet officially released.

# Forecast based on existing flow rates and plans.

One sees the private sector balance has steadily decreased from 2008 to the present day. The decrease has come from both a declining current account surplus and declining national government expenditure. Government expenditure appears larger as a percent of GDP. This is a paradox and belies the truth. Government expenditure appears larger only because trade income is much less than it was.

Private Credit Creation

The private sector balance, and therefore asset markets, is also reinforced by private credit creation from private banks. One can say that aggregate demand in any period is GDP + Credit. The chart below was prepared for me by Mr. Robert P Balan and his PAM team.

Government expenditure has a lagged impact on markets eight quarters later. Social spending (credit creation) has a lagged impact on markets six quarters later. The covariance with these important income flows is obvious from the chart above. Macroeconomic conditions, the currency and asset markets generally will follow the financial flows lower well into 2020.

This is not a good investment background for anything other than short trades.

Conclusion, Summary, And Recommendation

China has a positive but declining private sector balance, and this allows assets in the private sector such as stocks, bonds, and real estate to rise in value but at a lower rate of change.

The central government may well be of the opinion that too much of the credit creation before 2016 went into speculation in paper assets and land, and not enough into real assets such as factories infrastructure and public services.

The slowdown in Chinese fiscal flows joins an unfortunate global trend illustrated in the chart above, also from Mr. Balan and updated from this recent article.

Similar to the first such chart, movements in economic growth and asset markets can be forecast using the lagged income effect of Central Bank expenditure flows. This information is trade-able and forms the basis of the PAM Seeking Alpha investment service and is the reason I joined.

This is one of many such flow models used to trade all manner of asset markets long and short with a high degree of precision and success.

The chart is telegraphing a general decline in economic growth and asset markets well into the middle of 2019.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.