One of the few consensus ideas that I took away from the Strategic Investment Conference is that China has the potential to become a real problem. It seemed to me that almost everyone who addressed the topic was either seriously alarmed at the extent of China’s troubles or merely very worried. No one was sanguine. If you recall, a few weeks back I introduced my young colleague and protégé Worth Wray to you; and his inaugural Thoughts from the Frontline focused on China, a topic on which he is well-versed, having lived and studied there. Worth is once again visiting China in this week’s letter. Here are the key points from his report.
While China watchers tend to trade reactively around official and unofficial manufacturing PMI releases as monthly proxies for the broader economy, very few investors realize that “not only is manufacturing no longer the bellwether of the Chinese economy, more often than not it now performs counter-cyclically.”
Although China is the world’s largest producer of value-added manufactured goods, it has not been an export-led economy for a very long time. China’s growth has largely relied on extraordinarily high levels of fixed investment, supported by even higher levels of domestic savings and an unsustainable rise in private-sector credit.
Even so, industry experts often fall into the trap of extrapolating flash manufacturing readings into forecasts for the broader economy.
China has seen its total debt-to-income ratio jump by more than 100 percentage points (another full turn of GDP) in the last five years… more debt growth than any other major economy on the planet, including Japan.
According to the first quarter China Beige Book (CBB) report, the pace of Chinese economic expansion has painfully slowed. Revenue, sales, profit, and wage growth are all weaker than a year ago. The slowdown is particularly steep in the North and Northeast and also pronounced in Beijing and Central China.
The worst performer, both on-quarter and on-year, is real estate and construction.
Growth in new domestic orders was solid, and domestic orders and export orders were both stronger in powerhouse Guangdong.
Shadow finance may be revving up for a comeback. CBB numbers show a recovery in the sales of wealth management products (WMPs), likely due to competition from online banking. This is cash leaving the traditional banking sector and, while non-bank lending did not pick up in the first quarter, the groundwork is being laid for it to do so.
Online lenders are typically viewed as a force for liberalization, as well as a potentially healthier alternative to unregulated shadow finance. Yet their proliferation would impart significant costs as well.
What appears to be happening is the higher returns available in online banking are forcing banks to move more transactions off-balance sheet, in order to avoid the interest rate cap. While this may accommodate policy goals in the short term, an uptick in off-balance sheet funding portends more shadow bank lending down the line.
Bank loan rates and bond yields eased slightly this quarter, but the cost of capital increased again for those borrowing from non-bank lenders. While the shifts were not dramatic, the spread between bank and non-bank loan rates nationwide is now the largest since Q1 2013. This highlights the still more challenging road for those firms, principally domestic private entities that are pushed outside formal lending channels.
Great data often has that effect – it’s like shining a light into the shadows (including China’s shadow banks). We can see the nuanced regional contrast in economic activity, the modest (but still insufficient) rebalancing between sectors, and pressure points in the credit markets that suggest last summer’s interbank volatility may return in 2014.
The overall pace of Chinese economic growth is clearly slowing but not collapsing. The credit transmission mechanism is obviously broken, as you can see in the accompanying chart (with government and government-sponsored borrowers in zombie industries consuming the majority of the country’s credit… in turn forcing households to borrow through shadow banks at massive risk premiums); but so far, the credit bubble is not imploding.
The writer is a best-selling author and publisher of the Thoughts from the Frontline investment newsletter.
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