We suspect there is a sense in financial markets that China has escaped the banking crisis / credit crunch / balance of payments crisis / economic slowdown that the Cassandras have long been predicting. Moreover, we suspect that it is further assumed that this escape was facilitated through the use of direct controls, state planning and of course the heavy-handed imposition of capital controls. It is of course somewhat ironic that the notionally ‘free markets’ of the global financial system have found themselves applauding China’s decidedly state-controlled economy quite so enthusiastically but markets were ever-fickle…...
Certainly, something has changed within China of late. At this time last year, China’s nominal GDP (a circa $10 trillion amount) was expanding by only around $285 billion per annum, an extremely modest rate of growth despite the $280 billion increase in the budget deficit that had occurred over the preceding 12 months and the massive $3.5 trillion of new credit that had been advanced (one of the largest increases in credit relative to GDP that we have witnessed since Malaysia in the mid-1990s). In short, for every dollar that China’s GDP was increasing last year, the level of debt was increasing by more than $13, one of the worst incremental debt to output ratios that we have yet witnessed – anywhere – in almost 30 years.
This year, the situation notionally seems to have improved a little. Nominal GDP growth has accelerated to $444 billion per annum while the budget deficit is “only” $45 billion larger than it was last year and credit growth has slowed to around $2.2 trillion per annum. In an absolute sense, the fact that it is still taking $5 of new debt to produce an extra $1 of GDP is hardly productive and this ratio is not far off that witnessed at the peak of the US / OECD credit boom that preceded the GFC.
China: GDP Deflator %YoY
Moreover, according to China’s headline GDP data, the rate of real economic growth has been virtually unchanged this year in comparison to last year (in fact, it is officially only 0.2% higher) and this implies that virtually all of the increase in nominal GDP growth has been the result of a pick-up in the rate of inflation. At this point, we must note that this acceleration in nominal GDP growth cannot be the result of oil prices given that China imports its oil and therefore higher import prices detract from nominal GDP not add to it. Clearly, the message from the official data is unequivocal on the nature of the pick-up in nominal GDP growth: it has been based on higher inflation.
There are of course many other signs of inflation present within the economy: although the headline CPI data remains strangely benign (a not unusual situation in North Asia), the rate of inflation within the PPI data has been somewhat elevated, export prices have ceased deflating, and the corporate goods price index (usually the most reliable index) is suggesting that inflation is running in the mid-single digits. Finally, and we would argue most significantly of all, surveyed expectations of inflation have picked up significantly and the official diffusion index of expectations is now occupying levels that have not been witnessed since the ‘boom-times’ of the early 2010s.
China: Corporate Price Expectations Dissusion Index
In most economies, such rapid rates of credit growth, and of course the subsequent rise in inflation, would be taken as prima facie evidence of an overheated economy, particularly when one also notes that the trade surplus has declined by around a fifth over the last year or so on the back of a surge in imports. Indeed, we estimate that China’s demand for imported consumer goods is growing at around 14-15% YoY at present in volume terms, almost three times the rate of growth of domestic output growth. Almost in any other country, alarm bells would be ringing in the light of this data and it must be admitted that the PBoC has indeed reacted to the situation, albeit in a relatively modest way.
For economists at least, the China story would seem to be relatively simple: there is still a huge amount of credit and a continuing fiscal stimulus being ‘pumped’ into the economy (even if the absolute amounts are less than they were last year) and, although advertised rates of domestic growth have remained robust, the rates of inflation that are being experienced by the economy have seemingly leapt and the country is sucking in imports at an impressive rate (this has of course provided a supremely useful and very significant boost to the wider global economy). In short, China would seem to be overheating.
Of course, we also understand that the China story can be spun the ‘other way’. Most equity investors notionally ‘only’ care about the nominal growth rates being achieved by their companies and the faster rate of nominal GDP growth is therefore to be welcomed, at least until the authorities admit that inflation has become a problem. Moreover, the faster import growth is not only providing a boost to the global economy, it can also be taken as a sign that the domestic economy is rebalancing itself away from production and investment towards a more consumer-driven and lower saving form society – which of course is something that the rest of the world has been demanding for some time.
We might of course quibble that the 20% plus annual rates of consumer borrowing growth that are helping to drive the savings rate lower are unlikely to be sustainable over the longer term (not least because the resulting increase in demand is implicitly being funneled into third-tier cities by the property market controls, with massively inflationary consequences within these localized areas) but what most concerns us about China’s consumer boom is the nature of its origin and the primary reason for the decline in the savings rate.
In theory, the demand for money within any economy should fluctuate inversely with expectations of inflation. Therefore, and in a rare case of other things indeed being equal (i.e. real GDP growth and nominal interest rates), we could surmise that the demand for money in China should be growing at a much slower rate this year than it was last year as a result of the higher inflation. Crucially, the official data would appear to confirm that this is occurring. Moreover, we can all too easily observe that China’s population is showing an obvious demand for alternative stores of value including a variety of crypto currencies, many if not all of which are beginning to lose their scarcity value despite the computing power – and demand for electricity – that their ‘mining’ requires. This stampede into ‘alternative currencies’ would seem to confirm that the demand for money (i.e. bank deposits) is indeed weakening or perhaps even falling.
Unfortunately, for many people who now don’t wish to hold yet more deposits within their stock of wealth (and China’s savers already possessed one of the highest weightings to deposits in the World), there simply are not any viable alternative savings vehicles available that they can access. In reality, the local equity market is too small and volatile, the local bond markets are inaccessible, much of the property market is closed off to investors and the access to overseas assets has been curtailed. As a result, we suspect that many of those people that are currently satiated with deposits have simply decided to stop saving, or at least reduce to their savings rates. Hence, we have a consumer boom in full swing despite suggestions that real wage growth at present is quite modest.
We would argue, however, that this is not the type of restructuring or even consumer boom that many people would ‘want’ to see. If households were faced with a free choice of whether to save or not, and a choice of instruments in which they could save if they so wished, then we would argue that their recent decision to save less was most likely ‘efficient’ and sustainable. However, the reality of the situation is that as China has increased its level of financial repression through capital controls, property market controls, and even the manipulation of the equity market (particularly in early 2015), the ability to save ‘optimally’ has in effect become rationed and hence the attractiveness of saving has declined. Hence, people are spending more of their incomes but we would defy anyone to suggest that this is an optimal or even sustainable situation.
Moreover, given that China is clearly an ‘over monetized economy’ (otherwise people would not be eschewing further saving in deposits), such a situation could easily become highly inflationary, as indeed broadly similar situations became within the Eastern European economies in the late 1970s and early 1980s. Ultimately, the high rates of inflation led to economic collapse and ultimately regime change but we can be assured that China’s government will wish to avoid such an outcome at all costs.
Therefore, if President Xi is indeed successful in consolidating and enhancing the position of his supporters in relation to the more liberal factions of the Party over the next few months, as seems likely, then we can assume that economic policy in the fourth quarter will most likely switch from using the available policy levers to support growth to combating inflation.
Initially, given Xi’s revealed penchant for using direct non-market mechanisms to control things of which he disapproves, we can assume that there will be more property market and even direct consumer price controls enacted but ultimately (i.e. as 2018 progresses) we can assume that the authorities may have to further reduce their growth targets in order to combat the inflationary pressures that have recently entered the economy. We therefore doubt that the PBoC is currently even ‘close’ to easing its policy stance. Implicit in this process will be the fact that, by acting against inflation, the authorities will of course be admitting to the world and to markets that the faster rate of inflation, that has boosted nominal GDP growth, is indeed a ‘problem’ that must be tackled and this of course is the point at which (global) equity markets traditionally start to take more notice of the negative side of the China inflation story…..
In summary, we would maintain that over recent months, financial markets have largely failed to look the Chinese ‘Gift Horse’ in the mouth but if Xi is successful in consolidating his power base over the next few weeks, markets may find that they will be obliged to look again at the true state of the PRC economy and the processes that have provided it with the appearance of growth this year. Unfortunately, we suspect that if they do this, they will lose some of their faith in the infallibility of the economy and more particularly in the sustainability of its recent growth. Consequently, while we would tilt portfolios in the near term to the China / global inflation story, as 2017 Q4 continues, we would begin to look for a slowdown in the PRC economy and, most importantly, its demand for imports..