The Risks and Rewards of Asian Real Estate

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Macro Letter – No 69 – 27-01-2017

The Risks and Rewards of Asian Real Estate

  • Shanghai house prices increased 26.5% in 2016
  • International investment in Asian Real Estate is forecast to grow 64% by 2020
  • Chinese and Indian Real Estate has underperformed US stocks since 2009
  • Economic and demographic growth is supportive Real Estate in several Asian countries

Donald Trump may have torn up the Trans-Pacific Partnership trade agreement, but the economic fortunes of Asia are unlikely to be severely dented. This week Blackstone Group – which at $102bln AUM is one of the largest Real Estate investors in the world – announced that they intend to raise $5bln for a second Asian Real Estate fund. Their first $5bln fund – Blackstone Real Estate Partners (BREP) Asia – which launched in 2014, is now 70% invested and generated a 17% return through September 2016. Blackstone’s new vehicle is expected to invest over the next 12 to 18 months across assets such as warehouses and shopping malls in China, India, South-East Asia and Australia.

Last year 22 Asia-focused property funds raised a total of $10.6bln. Recent research by Preqin estimates that $33bln of cash is currently waiting to be allocated by existing Real Estate managers.

Blackrock, which has $21bln in Real Estate assets, predicts the amount invested in Real Estate assets will grow by 75% in the five years to 2020. In their March 2016 Global Real Estate Review they estimated that Global REITs returned 10% over five years, 6% over 10 years and 11% over 15 years.

This year – following the lead of countries such as Australia, Japan and Singapore – India is due to introduce Real Estate Investment Trusts (REITs) they also plan to permit infrastructure investment trusts (InvITs). Other Asian markets have introduced REITs but not many have been successful in achieving adequate liquidity. India, however, has the seventh highest home ownership rate in the world (86.6%) which bodes well for potential REIT investment demand.

UK asset manager M&G, make an excellent case for Asian Real Estate, emphasis mine:-

Exposure to a diversified and maturing region which accounts for a third of the world’s economic output and offers a sustainable growth premium over the US and Europe.

Diversification benefits. An allocation to Asian real estate boosts risk-adjusted returns as part of a global property portfolio; plus there are diverse opportunities within Asia itself.

Defensive characteristics, with underlying occupier demand supported by robust economic fundamentals, as showcased by Asia’s resilience during the European and US downturns of the recent financial crisis.

What M&G omit to mention is that investing in Real Estate is unlike investing in stocks (Companies can change and evolve) or Bonds which exhibit significant homogeneity – Real Estate might be termed the ultimate Fixed AssetLocation is a critical part of any investment decision. Mark Twain may have said, “Buy land. They’re not making it anymore.” but unless the land has commercial utility it is technically worthless.

The most developed regions of Asia, such as Singapore, Hong Kong, Japan and Australia, offer similar transparency to North America and Europe. They will also benefit from the growth of emerging Asian economies together with the expansion of their own domestic middle-income population. However, some of these markets, such as China, have witnessed multi-year price increases. Where is the long-term value and how great is the risk of contagion, should the US and Europe suffer another economic crisis?

In 2013 the IMF estimated that the Asia-Pacific Region accounted for approximately 30% of global GDP, by this juncture the region’s Real Estate assets had reached $4.2trln, nearly one third of the global total. During the past decade the average GDP growth of the region has been 7.4% – more than twice the rate of the US or Europe.

The problem for investors in Asia-Pacific Real Estate is the heavy weighting, especially for REIT investors, to markets which are more highly correlated to global equity markets. The MSCI AC Asia Pacific Real Estate Index, for example, is a free float-adjusted market capitalization index that consists of large and mid-cap equity across five Developed Markets (Australia, Hong Kong, Japan, New Zealand and Singapore) and eight Emerging Markets (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand) however, the percentage weighting is heavily skewed to developed markets:-

Country Weight
Japan 32.94%
Hong Kong 26.40%
Australia 19.81%
China 9.62%
Singapore 6.30%
Other 4.93%

Source: MSCI

Here is how the Index performed relative to the boarder Asia-Pacific Equity Index and  ACWI, which is a close proxy for the MSCI World Index:-

msci_asian_real_estate_etf

Source: MSCI

 

The MSCI Real-Estate Index has outperformed since 2002 but it is more volatile and yet closely correlated to the Asia-Pacific Equity or the ACWI. The 2008-2009 decline was particularly brutal.

Under what conditions will Real Estate investments perform?

  • There are several supply and demand factors which drive Real Estate returns, this list is not exhaustive:-
  • Population growth – this may be due to internal demographic trends, such as higher birth rates, a rising working age population, inward migration or urbanisation.
  • Geographic constraints – lack of space drives prices higher.
  • Planning restrictions – limitations on development and redevelopment drive prices higher.
  • Economic growth – this can be at the country level or on a per-capita basis.
  • Economic policy – fiscal stimulus, in the form of infrastructure development, drives economic opportunity which in turn drives demand.
  • Monetary policy – interest rates – especially real-interest rates – and credit controls, drive demand: although supply may follow.
  • Taxation policy – transaction taxes directly impact liquidity – a decline in liquidity is detrimental to prices. Annual duties based on assessable value, directly reduce returns.
  • Legal framework – uncertain security of tenure and risk of curtailment or confiscation, reduces demand and prices.

The markets and countries which will offer lasting diversification benefits are those which exhibit strong economic growth and have low existing international investment in their Real Estate markets. The UN predicts that 380mln people will migrate to cities around the world in the next five years – 95mln in China alone. It is these metropoles, in growing economies, which should be the focus of investment. Since 1990, an estimated 470 new cities have been established in Asia, of which 393 were in China and India.

In their January 2017 update, the IMF – World Economic Outlook growth forecasts for Asian economies have been revised downwards, except for China:-

Country/Region 2017 Change
ASEAN* 4.90% -0.20%
India 7.20% -0.40%
China 6.50% 0.40%

*Indonesia, Malaysia, Philippines, Thailand, Vietnam

Source: IMF

The moderation of the Indian forecast is related to the negative consumption shock, induced by cash shortages and payment disruptions, associated with the recent currency note withdrawal. I am indebted to Focus Economics for allowing me to share their consensus forecast for February 2017. It is slightly lower for China (6.4%) and slightly higher for India (7.4%) suggesting that Indian growth will be less curtailed.

China and India

Research by Knight Frank and Sumitomo Mitsui from early 2016, indicates that the Prime Yield on Real Estate in Bengaluru was 10.5%, in Mumbai, 10% and 9.5% in Delhi. With lower official interest rates in China, yields in Beijing and Shanghai were a less tempting 6.3%. These yields remain attractive when compared to London and New York at 4%, Tokyo at 3.7% and Hong Kong 2.9%. They are also well above the rental yields for the broader residential Real Estate market – India 3.10% and China 3.20%: it’s yet another case of Location, Location, Location.

This brings us to three other risk factors which are especially pertinent for the international Real Estate investor: currency movements, capital flows and the correlation to US stocks.

Since the Chinese currency became tradable in the 1990’s it has been closely pegged to the value of the US$. After 2006 the currency was permitted to rise from USDCNY 8.3 to reach USDCNY 6.04 in 2014. Since then the direction of the Chinese currency has reversed, declining by around 15%.

This recent currency depreciation may be connected to the reversal in capital flows since Q4, 2014. Between 2000 and 2014 China saw $3.6trln of inflows, around 60% of which was Foreign Direct Investment (FDI). Since 2014 these flows have reversed, but the rate of outflow has been modest; the trickle may become a spate, if the new US administration continues to shoot from the hip. A move back to USDCNY 8.3 is not inconceivable:-

usdcny-1994-2017

Source: Trading Economics

Chinese inflation has averaged 3.86% since 1994, but since the GFC it has moderated to an annualised 2.38%.

The Indian Rupee, which has been freely exchangeable since 1993, has been considerably more volatile: and more inclined to decline. The chart below covers the period since January 2007:-

usdinr-10-yr

Source: Trading Economics

Since 1993 Indian inflation has averaged 7.29%, but since 2008 it has picked up to 8.65%. The sharp currency depreciation in 2013 saw inflation spike to nearly 11% – last year it averaged 5.22% helped, by declining oil prices. Official rates, which hit 8% in 2014, are back to 6.25%, bond yields have fallen in their wake. Barring an external shock, Indian inflation should trend lower.

Capital flows have had a more dramatic impact on India than China, due to the absence of Indian exchange controls. A February 2016 working paper from the World Bank – Capital Flows and Central Banking – The Indian Experience concludes:-

Going forward, under the new inflation targeting framework, monetary policy will likely respond even more than before to meet the inflation target and adjust less than before to the capital flow cycles. One concern some people have with the move of a developing country such as India to inflation targeting is that it could result in greater exchange rate flexibility. Having liberalized the capital account progressively over the last two and a half decades, the scope to use capital flow measures countercyclically has perhaps diminished as well.

Thus in years ahead, reserve management and macroprudential measures are likely to play a more significant role in helping respond to capital flow cycles, just as the policy makers and the economy develop greater tolerance for exchange rate adjustments.

The surge and sudden stop nature of international capital flows, to and from India, are likely to continue; the most recent episode (2013) is sobering – the Rupee declined by 28% against the US$ in just four months, between May and August. The Sensex Stock Index fell 10.3% over the same period. The stock Index subsequently rallied 72%, making a new all-time high in March 2015. Since March 2015 the Rupee has weakened by a further 10.3% versus the US$ and the stock market has declined by 7.7% – although the Sensex was considerably lower during the Emerging Market rout of Q1, 2016.

Stock market correlations are the next factor to investigate. The three year correlation between the S&P500 and China is 0.37 whilst for India it is 0.60. Since the Great Financial Crisis (GFC) however, the IMF has observed a marked increase in synchronicity between Asian markets and China. The IMF WP16/173 – China’s Growing Influence on Asian Financial Markets is insightful, the table below shows the rising correlation seen in Asian equity and bond markets:-

imf_china_correlation_rising_-_march_2016

Source: IMF

With so many variables, the best way to look at the relative merits, of China versus India and Real Estate versus Equities, is by translating their returns into US$. Since the GFC stock market low in March 2009, returns in US$ have been as follows. I have added the current dividend and residential rental yield:-

Index Performance – March 09 – December 16 Performance in US$ Current Yield
S&P500 207% 207% 2%
FHFA House Price Index (US) 9.70% 9.70% 2.20%
Shanghai Composite (China) 50% 49.20% 4.20%
Shanghai Second Hand House Price Index 74% 72.85% 3.20%
S&P BSE Sensex (India) 204% 135.25% 1.50%
National Housing Bank Index (India) 58%* 38.45% 3.10%
*Data to end Q1 2016

Source: Investing.com, FHFA, eHomeday, National Housing Bank, Global Property Guide

There are a number of weaknesses with this analysis. Firstly, it does not include reinvested income from dividends or rent – whilst the current yields are deceptively low. Data for the S&P500 suggests reinvested dividend income would have added a further 40% to the return over this period, however, I have been unable to obtain reliable data for the other markets. Secondly, the rental yield data is for residential property. You will note that Frank Knight estimate Prime Yields for Bengaluru at 10.5%, 10% for Mumbai and 9.5% for Delhi. Prime Yields in Beijing and Shanghai offer the investor 6.3% – Location, Location, Location.

The chart below shows the evolution of the Shanghai Second Hand House Price Index since 2003:-

china_-_ehomeday_-_shanghai_second_hand_house_pric

Source: eHomeday, Global Property Guide

For comparison here is the National Housing Bank Index since 2007:-

india_-_national_housing_bank_-_house_price_index

Source: National Housing Bank, Global Property Guide

Finally, for global comparison, this is the FHFA – House Price Index going back to 1991:-

us_-_federal_housing_finance_agency_-_house_price_

Source: FHFA, Global Property Guide

The Rest of Asia

In this Letter I have focused on China and India, but this article is about Asian Real Estate. The 2004-2014 annual return on Real Estate investment in Hong Kong was 14.4% – the market may have cooled but demand remains. Singapore has delivered 11.7% per annum over the same period. Cities such as Kuala Lumpur and Bangkok remain attractive. Vietnam, with a GDP forecast of 6.6% for 2017 and favourable demographics, offers significant potential – Hanoi and Ho Chi Minh are the cities on which to focus. Indonesia and the Philippines also offer economic and demographic potential, Jakarta and Manilla having obvious appeal. The table below, sorted by the Mortgage to Income ratio, compares the valuation for residential property and economic growth across the region:-

Country Price/Income Ratio Rental Yield City Price/Rent Ratio City Mortgage As % of Income GDP f/c 2017
Malaysia 9.53 4.07 24.6 72.87 4%
Taiwan 12.87 1.54 64.91 78.76 1.80%
South Korea 12.38 2.04 49.1 85.47 2.40%
India 10.28 3.08 32.44 123.44 7.40%
Singapore 21.63 2.75 36.41 134.33 1.60%
Pakistan 12.09 4.08 24.51 156.97 5.10%
Philippines 16.91 3.75 26.69 162.87 6.60%
Bangladesh 12.89 3.25 30.81 181.3 6.80%
China 23.29 2.23 44.83 189.71 6.40%
Mongolia 15.77 9.78 10.22 203.47 1.80%
Thailand 24.43 3.8 26.29 212.03 3.30%
Hong Kong 36.15 2.25 44.35 224.85 1.80%
Sri Lanka 17.49 4.91 20.38 238.64 4.80%
Indonesia 21.03 4.67 21.41 247.68 5.10%
Vietnam 26.76 4.52 22.1 285.55 6.60%
Cambodia 24.32 7.44 13.44 292.43 7%

Source: Numbeo, Focus Economics, Trading Economics

There are opportunities and contradictions which make it difficult to draw investment conclusions from the table above: and this is just a country by country analysis.

Conclusions and Investment Opportunities

Real Estate, more so than any of the other major asset classes, is individual asset specific. Since we are looking for diversification we need to evaluate the two types of collective vehicle available to the investor.

Investing via REITs exposes you to the volatility of the stock market as well as the underlying asset. Investing directly via unlisted funds has been the preferred choice of pension fund managers in the UK for many years. There are pros and cons to this approach, but, for diversification, this is likely to be the less correlated strategy. Make sure, however, that you understand the liquidity constraints, not just of the fund, but also of the constituents of the portfolio. The GFC was, in particular, a crisis of liquidity: and property is not a liquid investment.

Unsurprisingly Norway’s $894bln Sovereign Wealth Fund – Norges Bank Investment Management – invests in Real Estate for the long run. This is how they describe their approach to the asset class, emphasis mine:-

The fund invests for future generations. It has no short term liabilities and is not subject to rules that could require costly adjustments at inopportune times.

…Our goal is to build a global, but concentrated, real estate portfolio…The strategy is to invest in a limited number of major cities in key markets.

According to Institutional Real Estate Inc. the largest investment managers in the Asia-Pacific Region at 31st December 2014 were. I’m sure they will be happy to take your call:-

Investment Manager Asian AUM $Blns Total AUM $Blns
UBS Global Asset Management 9.33 64.89
Global Logistic Properties 9.26 20.14
CBRE Global Investors 8.56 91.27
LaSalle Investment Management 8.05 55.75
Blackstone Group 7.58 121.88
Alpha Investment Partners 7.48 8.70
Blackrock 7.32 22.92
Pramerica Real Estate Investors 6.84 59.17
Gaw Capital Partners 6.64 9.16
Prologis 6.08 29.98

Source: Institutional Real Estate Inc.

In their August 2016 H2, 2016 Outlook, UBS Global Asset Management made the following observations:-

Although property yields across the APAC region are at, or close to, historical lows, demand for real estate exposure in a multi-asset context is set to remain healthy in the near-to-medium term. Capital inflows into the asset class will continue to be supported by broad structural shifts across the region related to demographics and demand for income producing assets on the one hand, and (ex-ante) excess supply of private (household and/or corporate) sector savings on the other. Part of this excess savings will continue to find its way into real estate, both in APAC and in other regions…

Real Estate investment in Asia offers opportunity in the long run, but for markets such as Shanghai (+26.5% in 2016) the next year may see a return from the ether. India, by contrast, has stronger growth, stronger demographics, higher interest rates and an already weak currency. The currency may not offer protection, inflation is still relatively high and the Rupee has been falling for decades – nonetheless, Indian cities offer a compelling growth story for Real Estate investors. Other developing Asian countries may perform better still but they are likely to be less liquid and less transparent. The developed countries of the region offer greater transparency and liquidity but their returns are likely to be lower. A specialist portfolio manager offers the best solution for most investors – that’s assuming you’re not a Sovereign Wealth Fund.

China – Coal, Steel, Water and Demographics – Which way now?

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Macro Letter – No 62 – 30-09-2016

China – Coal, Steel, Water and Demographics – Which way now?

  • The price of coking coal has risen 164% this year, doubling since July
  • The NDRC is still attempting to reduce both coal and steel production this year
  • The April stimulus package has boosted construction and infrastructure demand
  • The pace of Chinese growth has stabilised but at a much reduced level

This year several commodity markets saw significant price increases. I discussed this in Macro Letter – No 51 – 11-3-2016 – How do we square the decline in trade with the rebound in industrial commodities?

The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally.

Over the last six months the US economy has maintaining momentum, albeit at a disappointingly modest pace. Elsewhere the economic headwinds are blowing harder, with Europe and Japan still mired in a “slow-growth/no-growth” environment. Yet during the last few weeks the spot price of premium coking coal – one of the key inputs for steel production – has doubled to more than $200/tonne. Although this is from multi-year lows seen in 2015, coking coal is now the top performing commodity market year to date:-

steel-index-coking-coal

Source: Steel Index, Amcharts.com

According to CME data, the futures curve for Australian Coking Coal is in steep backwardation out to December 2017 delivery. This suggests a short-term supply shortage rather than a generalised increase in demand.  Mining.com – Stunning coking coal rally wreaks havoc in steel, iron ore explains what has been happening:-

The rise in the price of coking is upending the economics of the iron ore and steel markets with the Australian export benchmark price climbing 164% so far this year.

Metallurgical coal was exchanging hands at $206.40 on Monday according to data provided by Steel Index as it consolidates at higher levels following weeks of panic buying not seen since 2011, when floods in key export region in Queensland sent the price surging to $335 a tonne (albeit not for long).

The rally was triggered by Beijing’s decision to limit coal mines’ operating days to 276 or fewer a year from 330 before as it seeks to restructure the industry. Safety closures and weather related supply curbs in China and Australia only added fuel to the fire.

sgx-hot-metal-spread

Source: TSI, Bloomberg, SGX

The price of Iron Ore has also risen by 31% to around $55/tonne, but, as the chart above makes clear, the ratio between the price of iron ore and coking coal is now at its lowest this century.

China’s coking coal output has fallen more than 10% due to the government edict to curtail domestic production. In response import volumes rose 45% in August alone. Goldman Sachs and Macquarie have both increased their price forecasts for 2017 and 2018.

The National Development and Reform Commission (NDRC) – the agency responsible for implementing production cuts – had achieved only 39% of the annual target for reducing coal capacity and 47% of the annual reduction in steel capacity as of the end of July. The Peterson – Institute – State of Play in the Chinese Steel Industry explains the reasons for this policy. Suffice to say, China’s domestic steel production tripled between 2005 and 2015 taking its share of global steel production from 31% to 50%. Under WTO rules it will have Market Economy Status from December 2016 – a wave of anti-dumping laws suits may well follow unless it curtails production.

Despite common knowledge of official policy, commentators have suggested that the recent production cut was intended to deliberately squeeze coal prices, allowing heavily indebted coal producers to repay loans to domestic Chinese banks. After two meetings between the China Iron and Steel Association and the NDRC, coal producers will now be allowed to produce an additional 50 tonne/day from October to alleviate shortages.

The steel industry was under margin pressure even before the rise in coal prices – the government has been forcing an industry wide consolidation. The high price of coal accelerates this “oligopolisation” of the sector. It is part of a broader reform and consolidation of State Owned Enterprises (SOEs). The Peterson Institute – China’s SOE Reform—The Wrong Path takes issue with this policy. It has its attractions in the short-term nonetheless – consolidation reduces competition within industries, the pricing power of these consolidated “oligopolies” should rise, enabling them to increase profitability and reduce their indebtedness. President Xi has called for “Stronger, bigger, better” state-owned enterprises. I fear for the squeezed private sector in this environment.

A more important structural reform was announced last month when the Supreme People’s Court ordered the establishment of more special divisions to handle liquidation and bankruptcy cases in intermediate courts. China has an undeveloped bankruptcy code – defaulting borrowers linger, acting as a drag on the economy. At the G20 summit President Xi said, “China has taken the most robust and solid measures in cutting excess capacity and we will honour our commitment with actions”. An efficient method of “zombie corporation liquidation” would expedite this process.

Another explanation for the government’s decision to reduce the number working days at coal mines is its commitment to reducing pollution. Brookings – The end of coal-fired growth in China looks at the bigger picture:-

China’s coal consumption grew from 1.36 billion tons per year in 2000 to 4.24 billion tons per year in 2013, an annual growth rate of 12 percent. As of 2015, the country accounts for approximately 50 percent of global demand for coal. In other words, China’s economic miracle was fueled primarily by coal.

…China’s coal consumption decreased by 2.9 percent in 2014 and 3.6 percent in 2015, and the economy has maintained a moderate speed of growth. This indicates that there is a decoupling of economic growth from the growth in coal consumption. China’s coal consumption might have in fact already peaked.

Over the past 35 years, coal powered the engine of China’s rapidly developing economy. Coal represented 75 percent of overall energy consumption. This number decreased to 64.4 percent in 2015—the lowest in China’s modern history—as the country’s energy intensity decreased by 65 percent relative to 35 years ago. In fact, though rarely noticed until the recent peak, this has been part of a fundamental shift in the Chinese economy’s relationship with coal.

The authors present three arguments to support their view that China’s reliance on coal is in structural decline. Firstly, a decrease in manufacturing and construction, which have seen over-investment during the last decade or more. Second, policies on climate change and air pollution—especially the Paris Agreement’s, signed this month, which calls for a 20% clean energy target by 2030. Read China-United States Exchange Foundation – After the Paris Climate Agreement, What’s Next? for more details. Finally, China’s adoption of technological innovation in energy, communications, and manufacturing.

In his G20 speech President Xi said “…green mountains and clear water are as good as mountains of gold and silver”. The problem of clean water is probably the single greatest resource challenge facing China today as this article from CEAC – China that once thrived on water, faces water problems today points out:-

The total amount of water resources in China is so huge as to reach 2325.85 billion cubic meters, which is the 4th largest in the world. However, Chinese population is so large that the per capita amount of water resources is only 1730.4 cubic meters. This is extremely small in the world. Moreover, water resources are distributed unevenly by the region. Generally speaking, water is scarce in northern parts of China, including the Northeast, the North, and the Northwest regions. Beijing is in the North region. On the other hand, water is abundant in the South Central, the South, and the Southwest regions. The problem is that water is growing scarcer, while its consumption is rising. Particularly, people in Northwest China suffer from chronic shortage of water.

…It is not the quantity of water that matters critically in China. The quality of water is deteriorating rapidly. According to “The Monthly Report of Ground Water” which was released by the Ministry of Water Resources of China this January, they conducted water quality observation researches of 2,103 wells in the Songliao plain of the Northeast region and the Jianghan plain in an inland area last year, and it turned out that 80% of ground water is too severely contaminated to drink. Ground water pollution is serious, particularly in the regions of water scarcity.

In the shorter-term there has been some increase in demand. Steel usage has risen in response to the mini-stimulus package implemented in April. It was aimed largely at railway and housing construction. Electricity demand picked up again in May +2.1% from April +1.9%, fuelling an increase in demand for thermal coal. Other leading indicators, also suggest that the slowdown in Chinese growth may have run its course. There has been an increase in railway freight volumes and pickup in copper output:-

copper-5

Source: Market Realist, National Bureau of Statistics

Outside China the picture looks mixed. LME stocks of Copper and Zinc have recovered but Nickle and Aluminium stocks remain depleted. Global demand still appears to be subdued.

Chinese economy is unlikely to return to the double digit growth rates seen prior to the great recession, but, despite its indebtedness, the world’s largest command economy may be able to avoid an imminent banking crisis.

The Debt to GDP ratio continues to rise. A source of grave concern which is noted in the BIS Quarterly Review, September 2016. At the end of July total Chinese debt reached $28trln – greater than the government debt of the US and Japan combined. Corporate debt, which is fortunately denominated primarily in local currency, now stands at 171% of GDP whilst total debt stands at 255%. A favourite BIS measure is the Credit to GDP gap. A figure above 10 is a warning signal that an economy may be approaching a “Minsky Moment” – China scores 30.1, the highest of any large economy.

China has also continued to reduce its vast foreign exchange reserves, although at a more moderate pace than in 2014 and 2015. In July it reduced its holding of US Treasuries by $22bln – the largest one month decline in three years. It also released information about its gold holdings which, as many market participants had predicted, have risen substantially – it last reported this information in 2009. The US Bond sales may, therefore, have been to insure the stability of the RMB versus the US$ ahead of the G20 summit which was hosted by China this month.

Should we be concerned about a Chinese banking crisis? According to Michael PettisChina Financial Markets – Does it matter if China cleans up its banks? banking solvency is not the issue, but the indebtedness of the economy is:-

The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

…If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), then for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or

Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

Pettis remains pessimistic about China’s ability to grow its way out of debt. History is certainly on his side in this respect, however, policies such as the One Belt One Road Initiative, which aims to improve cross-border infrastructure in order to reduce transportation costs between China and its trading partners, still makes sense at this stage of China’s development. Comparisons have been made with the US Marshall Plan which helped to regenerate Europe after WWII but with an indicated aim of financing $4trln of new projects, its scale is much larger. Chatham House – Westward ho—the China dream and ‘one belt, one road’: Chinese foreign policy under Xi Jinping reviews the policy in detail, as does Peterson Institute – China’s Belt and Road Initiative.

Meanwhile, the great rebalancing towards domestic consumption continues, at what, in other countries, would be considered break-neck speed. This may, nonetheless, be too slow for China – the mini-stimulus package, in April, was a clear political capitulation. The Kansas City Federal Reserve – Consumer Spending in China: The Past and the Future looks at the success of rebalancing to date and the prospects going forward. They point out that Chinese consumption as a share of GDP declined between 1970 and 2000 largely as a result of demographic forces – low birth rate and aging population – together with urbanisation. Post 2000 rapid house price appreciation accelerated this trend. Since 2010 consumption has begun to rise from a low point of 37% of GDP, this coincides with the peak in household savings at 42% – it is now around 38.5%. The authors predict:-

In a benchmark scenario of relatively stable income growth and a further modest decline in the household saving rate, consumption growth in China remains at around 9 percent per year over the next five years, causing the share of Chinese consumption in GDP to increase by about 5 percentage points to 44 percent by 2020. This scenario has two implications. First, it suggests that strong consumption growth is sustainable in the near future, allowing China to continue transitioning toward a consumption-driven economy. Second, it suggests that strength in near-term Chinese consumption growth will partly rely on a further decline in the household saving rate. As the household saving rate cannot decline indefinitely, consumption growth may need to rely more heavily on household income to be sustainable in the long run.

Parallels have been made with Japan where the savings rate has declined from 40% to 19% of GDP since 1970. If China follows this pattern, savings as a percentage of income will continue to decline. The transition could be relatively smooth provided the residential property market does not collapse in the interim. The FRBKC article concludes:-

The declining saving rate in China reflects both a changing demographic structure—an expected increase in the young dependency ratio after multiple decades of decline—and a changing consumption pattern of young people, who face less pressure to save thanks to financial support from their parents and grandparents.

In the long run, transitioning to a consumption-driven economy may require some policy changes. Specifically, China may need to implement successful supply-side reforms—which are on the government’s agenda but haven’t yet been significantly pushed forward—to enable domestic production to meet rising domestic demand. Although the Chinese household saving rate is declining from a very high level, the downward trend cannot last forever. A truly consumption-driven economy must rely on strong household income growth, which is ultimately driven by improved technology and investment.

In the long run, demographic forces will affect China more than any other factor. According to the Ministry of Human Resources China’s working population hit a record 774.5mln in 2015, however, the UN estimate China will have 212mln fewer workers by 2050. The UN Demographic Profile is found on page 189.

Market impact and investment opportunities

Next week the RMB will be included in the SDR – the Peterson Institute – China’s Renminbi Is about to Break the Financial Glass Ceiling discusses this in more detail. There is widespread speculation that the PBoC will widen the RMB currency bands at any moment. In other respects the PBoC is in a more difficult position. The RMB has already weakened by 5% against the US$ this year. Cutting interest rates would probably cause the currency to weaken further, riling the US voters ahead of the election. They are not impotent, however, and injected a record RMB 310bln into the money market in August – part of an overt policy to support the official banking sector, diminishing the influence of shadow banks.

Domestic investors have favoured bonds over equities for the past couple of months, while the spread between corporate bonds and government bonds has narrowed. Chinese 10yr government bond yields have fallen around 50bp this year, but official policy, encouraging investors to purchase higher yielding bonds and reduce their exposure to leveraged wealth management products and other non-standard assets, is boosting demand for corporate issues.

Retail investors, who were badly burnt in the stock market collapse of 2015, remain obsessed with the property market despite massive over-supply. Equity broker margin balances remain low. Institutional portfolio managers have reduced exposure to stocks from 62% in July to 49% this month. In the post-crash environment IPO issuance has been subdued with only RMB 955bln of capital raised in the seven months to July. This compares to RMB 1.55trln in 2015. The final quarter may see better sentiment. Stocks may get a boost from local government spending in Q3 and Q4 – if only to insure their budgets are not reduced next year. The table below, from Star Capital, ranks forty of the world’s major stock markets. Using their metrics, China is second cheapest and has the lowest PE, Price to Cash flow and Price to Book:-

Country CAPE PE PC PB PS DY Rank
Russia 4.9 7.5 3.6 0.8 0.8 4.10% 1
China 12.4 6.1 3.2 0.8 0.6 4.70% 2
Brazil 8.5 44.1 6.6 1.4 1.1 3.40% 3
South Korea 12.6 11 5.5 1 0.6 1.80% 5
Hungary 9.9 ? 5.1 1.2 0.6 2.80% 6
Czech 8.7 11.8 5.5 1.2 1 7.50% 8
Turkey 9.7 10.8 6.2 1.3 0.9 2.70% 9

Source: Starcapital.de

The Shanghai Composite Index (SHCOMP) is down 8.85% YTD and by 41.84% since its high in June 2015, however it is up 48.25% from June 2014. Russia’s RTS Index by contrast is up 72.81% from its December 2014 low but still 29.68% below its level of June 2014.

Looking outside China, several Australia-centric mining stocks have already risen on the back of the move in coking coal but it seems unlikely that the supply imbalance will prove protracted. Anglo American (AAL) is still looking to sell more of its Australian coal mines – they may well find Chinese buyers.

Outside of China, infrastructure investment across Asia Pacific is on the rise, which is supportive for industrial commodities in general. KPMG – 10 emerging trends in 2016, published in January, takes a very optimistic long term view:-

Ultimately, however, we believe that this may well be the tipping point that ushers in 50 years (or more) of prosperity as capital starts to match up with projects which, in turn, will drive economic growth in the developing world and shore up retirement savings in the mature markets.

Commodity markets tend to exhibit very individual characteristics, however, several industrial and agricultural commodities have formed a longer term base this year. Is this the beginning of the next commodity super-cycle? It’s too soon to call, but without a rise in global demand the prospects for substantial gains are likely to be limited – Indian GDP growth is slowing. The IMF WEO July update revised its India GDP forecast for 2016 to 7.4% from 7.5% – in 2015 it was 7.6%. Its China forecast was revised up 0.1% and its overall Emerging Market and Developing Economy forecast for 2016 and 2017 was unchanged at 4.1% and 4.6%, although, world economic growth was revised 0.1% lower.

China’s stock market remains cheap by many metrics, but the level of indebtedness is an impediment to economic growth. The property market, although over-supplied, continues to attract investment, but this is economically unproductive in the long run. Government policy is attempting to steer the economy towards higher domestic consumption and technologically driven, productivity enhancing, investments. Environmental issues are finally being addressed, yet the challenge of clean water remains substantial.

Near term, debt reduction – and it has yet to begin – will hamper growth, which will, in turn, reduce the attractiveness of Chinese stocks. Reform of the SOEs will involve consolidation into a smaller number of vast enterprises. Private enterprises will suffer. “Zombie” companies will start to be dealt with as bankruptcy procedures become standardised, but, as with all policy in China, a gradualist approach is likely to be implemented. Commodity markets may continue to rise due to supply side factors but I doubt that Chinese demand will rebound even to the level of 2013/2014, let alone the early part of the century.

China – Rebalancing, Debt and the Stock Market

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Macro Letter – No 58 – 08-07-2016

China – Rebalancing, Debt and the Stock Market

  • Chinese growth has been slowing since 2007
  • Total debt to GDP has risen from 148% in 2007 to 237% today
  • Oversupply in real-estate is still a concern but lower interest rates are helping
  • Infrastructure spending may help and Chinese stocks are cheap

I was prompted to write this rather longer letter by the recent weakness of the Chinese currency. The chart below tracks the progress of the USDCNY over the last three years, compared with many emerging markets the devaluation is minimal:-

china-currency 2yr

Source: Trading Economics

A longer term chart shows how far the currency has travelled over the last 12 years:-

china-currency 12 yr

Source: Trading Economics

It was at the National People’s Congress of March 2013 that the policy of “rebalancing” was introduced, however, the CNY continued to strengthen. This gradual appreciation against the US$ had created large imbalances within the Chinese economy. The economic-policy adjustment of “rebalancing” had one objective: shifting China from a production-oriented economy to one focused on household consumption. If, in the process, it could alleviate international pressure on the Chinese administration to allow the CNY to float freely, so much the better. Now it looks as if the outcome of allowing the CNY to float freely would see it sink like a stone.

A Review of Rebalancing

A detailed analysis of the rebalancing challenge is contained in this February 2013 paper from the ECB – China’s Economic Growth and Rebalancing it highlights international concerns:-

China’s leadership is well aware of the limitations of the producer-biased and export-led model. Interestingly, there is no major disagreement between the Chinese and the international community about the need for rebalancing policies to ensure China’s smooth transition to a more sustainable model. The disagreement is more about how fast the reform measures should be implemented.

It has been argued that intertwined economic and political interests make China’s rebalancing more difficult and cause the reform process to advance slowly. Political resistance to the reforms stems from various sources. First, in a system where political success at the local level has been historically dependent on quantitative growth, reforms that emphasise the quality of growth are bound to meet some resistance. Second, the current growth model required to keep some strategic sectors of the economy closed and under state control (e.g. financial markets, services, heavy industry). The planned opening up of these sectors to competition does not only meet resistance from SOEs and banks, but is also questioned in government circles owing to worries about exhausting the “privilege” of direct macroeconomic policy management. Not surprisingly, major resistance is observed in the export lobby, which is one of the most influential in China and the one which reforms affect most directly.

Reviewing the policy initiative in June 2014 – shortly after the, once in a decade, handover of power from President Hu Jintao and Premier Wen Jiabao to Xi Jinping and Li Keqiang – McKinsey – China’s great rebalancing: Promise and peril concluded:-

Of course, there is no guarantee that rebalancing will succeed. Part of the problem is that the politics associated with it—boosting the income of Chinese households at the expense of state-owned companies and other large investment-oriented entities—is actually more complicated than the economics. But one thing is certain. China is rapidly reaching the point of diminishing economic and political returns from its investment-driven model, which is headed for change one way or another: either through a proactive rebalancing, with reforms and policy adjustments, or a forced rebalancing precipitated by rising stresses in and beyond the financial system. So far, the signs are encouraging that the new leadership is serious about changing China’s growth model, and this is reason enough for global firms that have benefited from China’s investment boom to rethink their strategies for the years ahead.

Three years on the challenges of rebalancing an $11trln economy of 1.4bln people are becoming evident. McKinsey – China’s Choice – Capturing the $5 Trillion Productivity Opportunity, published last month, makes the case for continued reform based on boosting productivity:-

…Government can do a great deal to improve the odds of success by transforming institutions in six priority areas:

I. Open more sectors up to competition. SOEs still account for 43 percent of service sector fixed-asset investment, compared with 8 percent in manufacturing

.…In telecommunications, for instance, an effort to introduce mobile virtual network operators to target underserved segments has not yet had a substantial impact because the big three players in the sector still have considerable clout in negotiations and strong influence on pricing. In health care, fixing the economics model to make hospitals less dependent on drug sales and encourage more qualified doctors to work at private hospitals could help improve the quality of service.

II. Improve the breadth and quality of capital markets. China would benefit from a financial system where market forces allocate capital efficiently; that means well functioning bond and equity markets that attract a diverse set of investors, including institutional and overseas players. The municipal bond market could lower financing costs for local government while bringing market discipline to managing investment projects. To facilitate this shift, China needs to strengthen the foundations of an effective financial system, such as strong, independent credit-rating agencies, more transparent public data on the economy, and more effective communication about government monetary policy. Inviting new players (such as internet banks) to supply capital and helping banks build capabilities to undertake more lending for underserved segments such as small and medium-sized enterprises and rural consumers will be important.

III. Enable corporate restructuring. Shifting successfully to a productivity-led growth model will mean a sea change—letting inefficient companies fail rather than protecting and propping them up and rationalizing excess capacity.

…enforcing bankruptcy law and improving the bankruptcy process. Strengthening capabilities of asset-management companies tasked with handling restructuring could help to turn around companies in default. China will need to expand the securitization of non-performing loans to be prepared for any larger-scale bad debt situation and to ensure that banks put effective risk management in place.

IV. Invest in talent and enhance labor mobility. China has made great strides in educating its people, but more is needed. Among the measures that the government could now take are providing more funding for education, designing programs that rotate effective teachers to places they are most needed, and engaging the private sector to define job-ready skills, build those into curricula, and establish an education to-employment pipeline. On top of this, the government could enhance labor mobility to optimize employment across different regions of the country. Expansion of unemployment insurance and training can help smooth the transition for displaced workers and help them back into jobs. Ensuring gender equality in opportunities in education and in the labor market, while supporting women as well as men as they develop their careers, can further strengthen China’s talent base.

V. Boost aggregate demand. As inequality grows, the government can revise fiscal and tax policies to give households more spending power. For families in need, it could consider conditional cash transfers. Improving social safety net programs by raising health-care and retirement benefits, for example, can reduce the need for precautionary saving for out-of-pocket medical expenses, facilitate consumption, and reduce income inequality. Broadening affordable-housing programs to include migrant workers, with market-based subsidies on both the supply and demand side, can also help low-income families to consume more.

VI. Improve public-sector effectiveness. Ensuring that government raises its own productivity is an important part of any transition to a productivity-led model. Such an effort can start by using household income and productivity indicators to evaluate officials and departments rather than rewarding them largely for the GDP growth their cities or regions achieve. Digitizing government operations and service delivery is an important part of the mix. Government also needs to develop better conflict-resolution capabilities to mediate between different stakeholders so that restructuring and reforms can proceed.

Another aspect of President Xi’s reform is in foreign policy, it has been dubbed the “One Belt, One Road” (OBOR). Last week the Economist – Our bulldozers, our rules discussed the potential of the initiative:-

…Asia needs new infrastructure—about $770 billion a year of it until 2020, according to the Asian Development Bank. This demand should eventually ease today’s worries about a lack of projects. Bert Hofman, the World Bank’s chief in Beijing, adds that individual countries will benefit more if they align their plans with one another and with China. It does not pay to plan and build separately.

Next, China needs OBOR. At home, its businesses are being squeezed by rising costs and growing demands that they pay more attention to protecting the environment. It makes sense for them to shift some manufacturing overseas—as long as the infrastructure is there.

Lastly, Xi Jinping needs it. He has made OBOR such a central part of his foreign policy and has gone to such lengths to swing the bureaucracy behind the project that it is too late to step back now.

None of this means the new Silk Road will be efficient, nor does it mean China’s plans will always be welcome in countries suspicious of its expanding reach. But the building blocks are in place. The first projects are up and running. OBOR is already beginning to challenge the notion of Europe and Asia existing side by side as different trading blocs.

This is reminiscent of the economic development of Japan during the 1970’s and 1980’s.

Despite these policy initiatives, the Chinese economy has been slowing for the past six years. An excellent overview of the current situation was provided last month by the China-United States Exchange Foundation – China’s Incomplete Growth Strategy, in which they highlighted the policies for and challenges to achieve growth, both in the long and short run. Most of the problems are associated with the oversupply evident in the real-estate market and the economic drag from the debt associated with this over-supply. Their solution, as McKinsey suggested above, is infrastructure development:-

…last November, they officially placed the blame on long-term supply-side shortcomings, which they pledged to address with far-reaching structural reforms.

…the supply-side focus largely ignores the present. China faces two separate challenges: the long-term issue of a declining potential growth rate and the immediate problem of below-potential actual growth.

Among the long-term factors undermining potential growth are diminishing returns to scale, a widening income gap, and a narrowing scope for technological catch-up through imitation. Moreover, even as the country’s demographic dividend dissolves, its carrying capacity (the size of the population the environment can sustain) is being exhausted – a situation that high levels of pollution are certainly not helping. Finally, and most important, the country is suffering from inadequate progress on market-orientated reform.

While some of these factors are irreversible, others can be addressed effectively. And, indeed, the government’s supply-side reform strategy will go a long way toward doing just that, ultimately stabilizing and even raising China’s growth potential. But, contrary to popular belief, they will not boost China’s actual growth rate today.

Why are so many economists convinced that a long-term reform strategy is all China needs? One reason is the widely held notion that today’s overcapacity reflects supply-side problems, not insufficient demand. According to this view, China should implement policies like tax cuts to encourage companies to produce products for which there is genuine demand. That way, the government would not inadvertently sustain “zombie enterprises” that cannot survive without bank loans and support from local governments.

But only some of China’s overcapacity can be attributed to bad investment decisions. A large share has emerged because of a lack of effective demand. And that is, at least partly, a result of the government’s effort to moderate real-estate investment, which has caused the sector’s annual growth to tank, plunging from 38% in 2010 to 1% at the end of 2015.

With real-estate investment still accounting for more than 14% of GDP last year, plummeting growth in the sector has put considerable downward pressure on the economy as a whole, helping to push China into a debt-deflation spiral. As overcapacity drives down the producer price index – which has now been falling for 51 consecutive months – real debt rises. This is undermining corporate profitability, spurring companies to deleverage and reduce investment, and fuelling further declines in PPI.

The enduring importance of real-estate investment to China’s economic growth is reflected in trends from the first quarter of this year. Annual GDP growth of 6.7%, despite being the slowest rate for any quarter in seven years, exceeded market expectations. And it was driven partly by an unforeseen increase in real-estate investment growth, to 6%.

This is not to say that what China needs is more real-estate investment. According to the National Bureau of Statistics, China had 718 million square meters of unsold commercial and residential floor space at the end of 2015; when space under construction is factored in, inventory expands to more than five billion square meters. With an average of only 1.2 billion square meters of housing being sold each year, the best way to reduce this supply glut is clear: limit future construction. One of the most important reasons for the recent investment surge was abundant liquidity driving speculative demand – and that is hardly sustainable.

…Infrastructure investment, in particular, may well be the key to tackling China’s economic woes. After all, such investment, which grew at 19.6% in the first quarter of 2016, has already proved to be a critical driver of economic growth – and, unlike real-estate investment, it has not worsened China’s resource allocation or set the stage for major imbalances.

When there is slack in the economy, the only way to escape the debt-deflation trap is to grow strongly. Given that China is saddled with large local-government and corporate debts, but also enjoys large domestic savings and a strong fiscal position, this message could not be more pertinent. In an ideal world, domestic consumption would serve as the main engine of growth; under current circumstances, infrastructure investment is the most reliable option.

In the short term, when overcapacity and deflation are the main obstacles, infrastructure investment boosts growth through the economy’s demand side. In the long run, it operates through the supply side to boost productivity and thus raise growth potential. China can fund such investment with fiscal deficits, given strong demand for government bonds. And, with China’s major banks still state-owned, and capital controls still in place, the risk of an imminent financial crisis is very low.

Of course, China’s government must uphold its commitment to implement structural reforms. But infrastructure investment is also badly needed, not just to prevent the economy from sliding further, but also to enable China to generate the sustained long-term growth that it requires to achieve developed-country status.

The slowdown in Chinese growth has finally prompted concerns around the world. In their May Economic Letter, the Dallas Fed – Impact of Chinese Slowdown on U.S. No Longer Negligible noted that the knock on effect of slowing Chinese growth had taken 20% off US GDP. The chart below shows Chinese and US annual GDP growth over the last 10 years, China is the left hand scale, the negative impact of Chinese growth on US GDP since 2010 has been roughly 0.4%:-

China vs US GDP 10 yr

Source: Trading Economics

The Problem of Debt

The current environment in China – as it is in much of the rest of the world – is dominated by the incessant increase in debt. In May, in what many observers regard to be a reversal of their opinion on the dangers of China’s debt mountain, the Economist – The coming debt bust attempted to quantify the magnitude of the problem facing the Chinese financial system:-

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

When the debt cycle turns, both asset prices and the real economy will be in for a shock. That won’t be fun for anyone. It is true that China has been fastidious in capping its external liabilities (it is a net creditor). Its dangers are home-made. But the damage from a big Chinese credit blow-up would still be immense. China is the world’s second-biggest economy; its banking sector is the biggest, with assets equivalent to 40% of global GDP. Its stockmarkets, even after last year’s crash, are together worth $6 trillion, second only to America’s. And its bond market, at $7.5 trillion, is the world’s third-biggest and growing fast. A mere 2% devaluation of the yuan last summer sent global stockmarkets crashing; a bigger bust would do far worse. A mild economic slowdown caused trouble for commodity exporters around the world; a hard landing would be painful for all those who benefit from Chinese demand.

Brace, brace

Optimists have drawn comfort from two ideas. First, over three-plus decades of reform, China’s officials have consistently shown that once they identified problems, they had the will and skill to fix them. Second, control of the financial system—the state owns the major banks and most of their biggest debtors—gave them time to clean things up.

Both these sources of comfort are fading away. This is a government not so much guiding events as struggling to keep up with them. In the past year alone, China has spent nearly $200 billion to prop up the stockmarket; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. To help pump up growth, officials have inflated a property bubble. Debt is still expanding twice as fast as the economy.

…“shadow assets” have increased by more than 30% annually over the past three years. In theory, shadow banks diversify sources of credit and spread risk away from the regular banks. In practice, the lines between the shadow and formal banking systems are badly blurred.

That creates two risks. The first is higher-than-expected losses for the banks. Hungry for profits in a slowing economy, plenty of Chinese banks have mis-categorised risky loans as investments to dodge scrutiny and lessen capital requirements. These shadow loans were worth roughly 16% of standard loans in mid-2015, up from just 4% in 2012. The second risk is liquidity. The banks have become ever more reliant on “wealth management products”, whereby they pay higher rates for what are, in effect, short-term deposits and put them into longer-term assets. For years China restricted bank loans to less than 75% of their deposit base, ensuring that they had plenty of cash in reserve. Now the real level is nearing 100%, a threshold where a sudden shortage in funding—the classic precursor to banking crises—is well within the realm of possibility. Midsized banks have been the most active in expanding; they are the place to look for sudden trouble.

Pandamonium

The end to China’s debt build-up would not look exactly like past financial blow-ups. China’s shadow-banking system is big, but it has not spawned any products nearly as complex or international in reach as America’s bundles of subprime mortgages in 2008. Its relatively insulated financial system means that parallels with the 1997-98 Asian crisis, in which countries from Thailand to South Korea borrowed too much from abroad, are thin. Some worry that China will look like Japan in the 1990s, slowly grinding towards stagnation. But its financial system is more chaotic, with more pressure for capital outflows, than was Japan’s; a Chinese crisis is likely to be sharper and more sudden than Japan’s chronic malaise.

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.

Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

An article in Bruegal – Chinese banks: the way forward, which was published in April, looks in greater detail at the expansion of Chinese bank credit:-

The extensive credit expansion in January and February, especially from the banking sector, has several implications. First, it masks the growth of the non-performing loan ratio as the denominator has experienced such a big increase. Second, such surge in credit granted must have had a surge in demand as well. Whether that new demand reflects an improvement in the economy or simply more financing needs is a key question. If it is the latter then it reflects an increasing demand for new funds to repay outstanding loans.

Having said that, China had a bad-loan coverage ratio of 150%, which is considered high for international standards. However, there is rumor that this will be lowered to 120%. In any event, credit risk is rapidly rising in China as the economy slows down and financial conditions are lax enough for corporates to continue to leverage. The question, thus, is how weak are Chinese banks in the current circumstances.

No review of the financial position of China would be complete without a comment from Michael Pettis; last month he wrote Rebalancing, wealth transfers, and the growth of Chinese debt, this is a long research paper so I have only included extracts below:-

There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Pettis then produces a set of scenarios, firstly with growth remaining at current levels:-

Growth remains at 6-7% 2016 -2019 2020-2023
No government transfers

 

 

 

 

 

 

·    Debt growth is steady at 12-14%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing

 

·    Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP

·    Debt growth rises to 15-18%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing

 

Growth remains at 6-7% 2016 -2019 2020-2023
Annual government transfers of 1-2% of GDP

 

 

 

 

 

 

·   Debt growth drops to 9-10%

·   Investment growth declines by 2-3 percentage points

·   Consumption growth rises by 2-3 percentage points

·   Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly

·   Minimal rebalancing

 

·   Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·   Debt growth rises to 11-13%

·   Investment growth declines by another percentage point

·   Consumption growth is steady

·   Growth in household income is steady and household share of GDP rises

·   Gradual rebalancing

 

Growth remains at 6-7% 2016 -2019 2020-2023    
Annual government transfers of 3-4% of GDP

 

 

 

 

 

 

 

·    Debt growth drops to 8-10%

·    Investment growth declines by 6-7 percentage points

·    Consumption growth rises by 6-7 percentage points

·    Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher

·    Material rebalancing

 

·    Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·    Debt growth rises to 6-8%

·    Consumption growth declines by 1-2 percentage points

·    Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher

·    Material rebalancing

 

 

Next, Pettis looks at the same scenarios adjusting growth lower:-

Growth drops to 3-4% 2016 -2019 2020-2023
No government transfers

 

 

 

 

 

 

 

 

·    Debt growth drops to 6-8%

·    Investment growth declines by 4-6 percentage points

·    Consumption growth declines by 2-4 percentage points

·    Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher

·    Material rebalancing

 

 

·    Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·    Debt growth is steady at 6-8%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady at current levels and household share of GDP is materially higher

·    Material rebalancing

 

Growth drops to 3-4% 2016 -2019 2020-2023
Annual government transfers of 1-2% of GDP

 

 

 

 

 

 

 

 

 

·   Debt growth drops to 5-6%

·   Investment growth declines by 7-9 percentage points

·   Consumption growth is flat

·   Growth in household income is flat and household share of GDP is higher

·   Material rebalancing

 

 

 

·   Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth is steady at 5-6%

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is materially higher

·   Material rebalancing

 

 

 

Growth drops to 3-4% 2016 -2019 2020-2023
Annual government transfers of 3-4% of GDP

 

 

 

 

 

 

 

·   Debt growth drops to close to zero

·   Investment growth is zero

·   Consumption growth rises from current levels

·   Growth in household income rises from current levels and household share of GDP is materially higher

·   Substantial rebalancing

 

·   Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth drops to well below GDP growth

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is substantially higher

·   Substantial rebalancing

 

Pettis concludes:-

A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.

Conclusion and Investment Opportunities

China, like many other countries has a problem with debt. The FT recently published an estimate that the Chinese debt to GDP ratio was only 237% (lower than the Economist’s 260%) and government debt to GDP is only 43.9%, whilst household debt to GDP is 39.5%. The Heritage Foundation – Index of Economic Freedom 2016 – estimates China’s government spending to GDP at 29.3%, below that of many developed nations. The Rahn curve below shows how government spending can help to accelerate growth but the diminishing return once it rises above 15% of GDP:-

1DFA0969D85ED690F4E4B05858404992

Source: The Heritage Foundation, Peter Brimelow

Nonetheless, China compares favourably with Japan where government spending is 40.2%.

Stocks, Bonds and the Currency

The Shanghai Composite, shown below, has turned higher since the middle of May. A break above 3,075 could see it retest the highs of 2015 but this is unlikely to be the policy of the Xi administration:-

china-stock-market 10 yr

Source: Trading Economics, Shanghai Stock Exchange

 

10 year Chinese Government bonds have declined in yield as a result of the international turmoil created by Brexit, but, unlike many of major, international government bonds, they have not made new lows so far:-

china-government-bond-yield 1 yr

Source: Trading Economics, Chinese Ministry of Finance

I believe the recent rally in stocks is a function of the lower yield on bonds. The Chinese government has the whip hand. During the rally and subsequent collapse in the stock market during 2015, the government did not respond in a coordinated manner. Amongst a plethora of initiatives, and I may well have missed some, they relaxed margin requirements, fuelling the speculative bubble,  then, as the shake out gathered momentum, suspended the trading in shares listed on multiple markets. As liquidity conditions became more severe they froze 38 individual trading accounts – including certain algorithmic liquidity providers. The regulators also banned short selling and margin loans enabling investors to sell short on T=) settlement. They forced certain brokers to execute buy orders; one broker was bailed out with a CNY 260bln cash injection.

The rules on insurance companies purchasing stock were relaxed, certain shareholders (specifically SOE’s) were prohibited from selling and, under Announcement 18, senior managers and major shareholder (ones holding a stake of 5 % or more) were threatened with “severe punishment” if they sold shares of any listed company during a period of six months. IPO issuance was also suspended – a recent article from the  FRBSF – China’s IPO Activity and Equity Market Volatility looks at possible reforms of the IPO market. The authorities will not want to make the same mistakes a second time.

Margin lending has, so far, remained subdued. The chart below has data up to March 2016. Chinese investors were wounded last year but 10 year bond yields have fallen 80bp since June 2015:-

BN-NE269_CMARGI_G_20160321002958

Source: Wind Information Co, WSJ

Returning to the first chart, tracing the fortunes of the CNY, China appears to be exporting its way out of trouble at the expense of its trading partners. Its largest export market is the EU, US followed by Japan and South Korea.  Here is the US census bureau data for US-China trade since 2008:-

Month Exports Imports Balance
Jan-16 8212 37146 -28934
Feb-16 8049 36161 -28112
Mar-16 8952 29853 -20901
Apr-16 8667 32973 -24306
May-16 8518 37535 -29017
Month Exports Imports Balance
Jan-15 9482 38588 -29107
Feb-15 8759 31574 -22814
Mar-15 9882 41139 -31257
Apr-15 9307 36116 -26809
May-15 8763 39073 -30310
Jun-15 9622 41455 -31833
Jul-15 9514 41216 -31703
Aug-15 9169 44142 -34973
Sep-15 9424 45718 -36294
Oct-15 11410 44319 -32908
Nov-15 10618 41908 -31290
Dec-15 10122 37996 -27874
Year
2015 116072 483245 -367173
2014 123621 468484 -344863
2013 121746 440430 -318684
2012 110517 425619 -315103
2011 104122 399371 -295250
2010 91911 364953 -273042
2009 69497 296374 -226877
2008 69733 337773 -268040

 

Source: US Census Bureau

To help stem the decline in Chinese growth the National Bureau of Statistics has revised the way it calculates GDP. Zero Hedge – China To Boost “Economic Growth” By Changing Definition Of GDP quotes Yu Song of Goldman Sachs:-

Under the new method, the size of the economy is larger than previously estimated2015 GDP was revised up by 1.3% to 11tn USD, the Real growth rate was also revised up (rates vary from year to year and averaged 0.06% (6 bps) over the past 5 years). The upward revision is because China’s R&D expenditure growth has been consistently faster than that of overall GDP–though the difference the change makes to the GDP growth rate is small as R&D is a small part of the economy. The NBS announced 1Q real growth was revised up by 0.04% (4bps), but it did not specify whether the growth rate is now 6.8% yoy or remains at 6.7% yoy. We believe the latter case is slightly more likely as an upward revision would have been highlighted. A higher trend level would mean 2Q GDP growth should be higher as well. As a result, we revise our Q2 real GDP growth forecast to 6.7% yoy from 6.6% yoy previously with slight upside risk to our full-year forecast of 6.6% yoy.

Whether the markets are taken in by this sleight of hand remains to be seen, but, when statisticians are making comparisons in a couple of years from now, the higher growth rate will most likely be taken as gospel.

State Owned Enterprises are investing even as the private sector continues to withdraw – Reuters – China needs the private sector to step up. Residential and commercial construction continues to grow despite 718 M2 of vacant floor space. It is worth remembering that 75% of Chinese individual net worth is tied up in Real-Estate – in the US the figure is 28%. Lagarde’s second in command, David Lipton, of the IMF said China had made only “limited progress” in reducing its debt load but government bonds are near historic lows, making non-performing loans easier to extend. Back in the summer of 2014 I wrote about the importance of the housing market – Macro Letter – No 18 – 29-08-2014The second arrow of Likonomics and the Chinese property market, the stock market subsequently rallied but then collapsed. Now the policy of “rebalancing” seems to be taking a breather.

Chinese stocks, meanwhile, are cheap relative to many other markets. As at the end of June the CAPE was 12.4, PE 6.1 – the lowest of any major stock market globally, PC 3.2, PB 0.8, PS 0.6 and the dividend yield was 4.7%. Only the differential between the dividend yield and the 10 year bond yield (1.93%) looks unremarkable.

Chinese Q2 GDP data is released next week, an unnamed official suggested the PBoC might still have room to cut interest rates, although any further loosening of bank reserve requirements appears unlikely. As we head into the summer lull, Chinese stocks, especially those with an exposure to infrastructure, may offer an excellent buying opportunity.

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

400dpiLogo

Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

Flash-Gordon-flash-gordon-23432257-1014-1600

Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.

China

The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-

Demand_Growth_in_Asia

Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.

India_moving_to_centre

Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.

A_new_chapter_in_Chinas_growth_story

Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”

A_new_balancing_item_in_the_oil_market

Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.

Power_is_leading_the_transformation

Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.

Technology

“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.

US_Index_-_5_yr_Marketwatch

Source: Marketwatch

Is the ascension of the RMB to the SDR basket more than merely symbolic?

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Macro Letter – Supplemental – No 2 – 11-12-2015

Is the ascension of the RMB to the SDR basket more than merely symbolic?

  • Chinese rebalancing towards domestic consumption changes the balance of trade
  • China’s largest trading partner remains the EU, making a US$ peg sub-optimal
  • SDR currencies offer the best liquidity for intervention or speculation
  • International investment will be dramatically enhanced by full convertibility

I’ve changed my view of the importance of the RMBs inclusion in the SDR. Initially I thought this a purely symbolic action but, having discussed the issue with several economists and ex-Central Bankers (including one from the PBoC) I believe this a logical move towards free convertibility of the RMB.

For many years the RMB has been pegged to the US$. During the early part of this century it rose relative to its neighbours. This was not such a great imposition on the economy since annual GDP growth was still in double figures.

After the great financial recession of 2008 things changed. New economic policies focused on increasing domestic consumption. At the same time the Chinese economy began to slow dramatically as a result of over-investment, especially in primary industries, meanwhile, the benefits of cheap labour, which had driven China’s mercantilist expansion during the past 25 years, showed signs of fatigue.

After 2008, the US embarked on aggressive quantitative easing which eventually began to foster new domestic employment opportunities – in turn leading to a recovery of the fortunes of the US$. Earlier this year the PBoC devalued the RMB albeit to a small degree.

If you were the PBoC what would you do?

China is rebalancing towards domestic consumption at a pace which would be almost inconceivable in any other country. The implications of this shift include an increase in imports and a structural adjustment in the momentum of the trade surplus. China is moving on from simply being the world’s manufacturer to become a trading nation. A freely convertible currency would reduce frictions in trade and encourage foreign direct investment. The downside to this regime change is the volatility of the exchange rate.

At $3.5trln the PBoC has the largest foreign reserves of any Central Bank. This has primarily been a function of their peg against the US$, although they have actively sought to diversify in to EUR and even the “barbarous relic” gold. During the last 18 months the bank has drawn down on some of those reserves (they peaked at $3.9trln in May 2014) as it managed a devaluation versus the US$ which has fallen from RMBUSD 6.05 in January 2014 to RMBUSD 6.49 today (8-12-2015).

Has the benefit of the US$ peg now run its course? During the period of strong – export led – growth, China was under significant international political pressure to allow the RMB to rise against the US$. The perception is that they resisted international interference, but over the last 20 years the RMB has risen by around 30%. Nonetheless, market commentators immediately seized on the devaluation – especially since August – as a sign that the Chinese were engineering an export led recovery at the expense of the US. This 2013 paper from the Bundesbank – China‘s role in global inflation dynamics suggests there may be some substance to these concerns:-

The overall share of international inflation explained by Chinese shocks is notable (about 5 percent on average over all countries but not more than 13 percent in each region). This suggests that monetary policy makers should take macroeconomic developments in China into account when stabilizing domestic inflation rates; (ii) Direct channels (via import and export prices) and indirect channels (via greater exposure to foreign competition and commodity prices) both seem to matter; (iii) Differences in trade (overall and with China) and in commodity exposure help explaining cross-country differences in price responses.

Nonetheless, the authors note that, between 2002 and 2011, the “supply shock” from cheap Chinese goods explained only 1% of changes in consumer prices outside China, whilst the “demand shock”, from rapid Chinese, growth accounted for 3.6% of changes in global consumer prices. 95% of the variation in global inflation were due to non-Chinese factors.

As the Trans Pacific Partnership comes into effect, China needs to embark on a series of bilateral trade agreements. After the US, its largest trading partners are Japan, South Korea, Taiwan, Germany, Australia and Malaysia, however, as a currency trading block the Euro Area is preeminent.

There are two alternatives to a US$ peg, the first is to manage the RMB effective exchange rate, but this would be expensive due to the multiple currencies involved, the second option is to peg the RMB to the SDR basket. Both politically and economically this acknowledges China’s position as the second largest economy. It also heralds another incremental change in perception about the pre-eminence of the US$ as a reserve currency.

The RMB will be included in the SDR from October 2016. As the Chinese administration moves towards free-convertibility it is likely that they will start by widening the degree to which the currency can fluctuate. By managing the RMB versus the other SDR currencies they can take advantage of the liquidity these currencies provide and the lower volatility that the SDR basket has relative to its constituents. This will also allow the PBoC to intervene to stem the largest speculative currency flows. Table below shows the annual level of trade by region (2011):-

Region Exports Imports Total trade Trade balance
 European Union 356 211.2 567.2 144.8
 United States 324.5 122.2 446.7 202.3
 Hong Kong 268 15.5 283.5 252.5
 ASEAN 170.1 192.8 362.9 -22.7
 Japan 148.3 194.6 342.9 -46.3

 

Source: China National Statistics Bureau

Capital Flows

Trade is one aspect of China’s development, the other is capital; the Kansas City Federal Reserve Macro Bulletin – Global Capital Flows from China – takes up the story:-

In 2014-15, China experienced five consecutive quarters of capital outflows for the first time since 2000, and the annual volume of outflows is at a record level. If growth expectations continue to soften, this trend may continue in the near future.

China has been an active investor in Africa and other resource-rich regions, but, as its competitive advantages from labour dissipate, external investment will become far more important. Another reason to allow full convertibility.

Technical issues and challenges

The two requirements for joining the SDR are; being a larger exporter – which is no issue for China -and having a freely accessible currency. They still have some way to go on the latter, but China now has more than two dozen swap lines with foreign central banks, has promoted offshore trading and abolished quotas for foreign central banks and sovereign wealth funds investing in mainland bonds. 

RMB fixing – the PBoC as a participating SDR central bank, must provide the IMF with a daily fix. Currently there is a gap between domestic and the offshore RMB rate, closing that gap will be an operational challenge.

SDR currencies are weighted based on trade and reserve status – Marc Chandler – China And The Pull Of The SDR – elaborates:-

Given China’s export prowess, it suggests the yuan should be a major currency in the SDR. However, as a reserve asset, it is very small. The IMF estimates the yuan’s share of reserves at a minuscule 1.1%.

For more on the technical aspects of the SDR this paper from Europacifica – The RMB in the SDR and why Australia should care offers more insights.

In October China issued its first Treasury bill on the international market. Here is how it was reported by the FT – China completes first London debt sale:-

Spencer Lake, global head of capital financing at HSBC, one of the banks that arranged the sale, called the transaction a milestone in the internationalisation of the renminbi, noting that it was the first debt offering in any currency from the PBoC outside China.

“This strategic move demonstrates the clear commitment by the Chinese authorities to grow the offshore bond market and the confidence in the City of London as a leading renminbi hub for future activities,” he said.

“The PBoC bond will give a genuine boost to liquidity, market confidence and provide investors with the quality that they demand.”

Who will buy the non-performing loans?

Another reason China may want to move towards free convertibility is to encourage foreign investment. An article from Zero-Hedge – One Analyst Says China’s Banking Sector Is Sitting On A $3 Trillion Neutron Bomb explains:-

If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 20% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $3 trillion. 

That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven’t done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall. 

Conclusion

I believe the inclusion of the RMB in the SDR is more than simply symbolic. It will allow the PBoC to move away from a US$ peg, widen it trading bands and balance its currency more effectively relative to its main trading partners. PBoC Intervention can be generally confined to SDR currencies which, due to their high liquidity, will be the cross-currency pairs of choice for speculators.

China versus India – Currencies, Reform and Growth

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Macro Letter – No 31 – 06-03-2015

China versus India – Currencies, Reform and Growth

  • India announced a reformist budget, short on detail but market friendly
  • The PBoC cut interest rates again but are still behind the curve
  • Chinese and Indian Real-Estate prices continue to decline in real terms
  • INR/CNY exchange rate will move higher

Last month PWC – The World in 2050 – produced a long-term forecast for economic growth in which they predicted that India could become the second largest economy in the world by 2050 in purchasing power parity (PPP) and third largest in market exchange rate (MER) terms. Putting the scale of world economies in to perspective they say:-

China has already overtaken the US for the number one spot, and will remain as the world’s largest economy in 2050. India could narrowly overtake the US for the number two spot by 2050. However, the gap between the third largest economy and the fourth largest economy will widen considerably. In 2014, the third biggest economy (India) is around 50% larger than the fourth biggest economy (Japan). In 2050, the third biggest economy (the US) is projected to be approximately 240% larger than the fourth biggest economy (Indonesia).

The prospects from the BRIC economies are mixed. Russia is entangled in the geo-politics of the Ukraine and its economy has suffered from falling energy prices as this article from Chatham House – Troubled Times: Stagnation, Sanctions and the Prospects for Economic Reform in Russia explains. Meanwhile Brazil, still reeling from the stagnation of 2013, looks set to head into a fully-fledged recession exacerbated by high, wage-squeezing, inflation resulting from the near 30% decline in its currency. The prospects for India and China are much better.

India

Last week Arun Jaitley, India’s finance minister, announced a budget which he described as “a quantum jump”. Among other things, he intends to:-

  • Implement an RBI inflation target
  • Maintain a national government budget deficit of 4.1% of GDP in cash terms
  • Target a budget reduction to 3% of GDP in 2017-2018
  • Increase Spending on road construction and power generation
  • Streamline subsidies and accelerate the de-nationalization of state industries
  • Introduce a harmonised goods and sales tax, by April 2016, to replace state and federal levies – potentially adding 2% to GDP by creating an India-wide “common market”
  • Rationalise direct-taxation – cutting corporation tax but closing loopholes, abolishing a wealth tax in favour of an income tax surcharge on higher earners

This amounts to a decidedly reformist agenda, although the speech was light on detail. It removes several barriers to investment in India, although the issue of reform of land laws remains unresolved.

China

Meanwhile, last Saturday, the People’s Bank of China (PBoC) cut interest rates. This is the third accommodative move in as many months. Their motivation appears to be three-fold:-

  • Stimulate Credit Growth.
  • The fall in credit as measured by “total social financing” -13.5% y/y in January 2015 versus a +17.5% in January 2014. This may also allow SOEs and SMEs to service existing debt acquired during the indiscriminate credit expansion of 2009.
  • Alleviate Falling inflation.
  • The inflation rate has declined by 1.7% since Q4 2014. Lending rates are only 20bp lower over the same period. In other word a “real” tightening of 1.5% has occurred.
  • Stem Capital Outflows.
  • The capital and financial account deficit hit a decade high of $91.2bln in Q4 2014. This is a sharp deterioration, in 2013 the capital account surplus for the year was $326.2bln

This action may still not be sufficient to re-invigorate the Chinese economy. It fuels hopes for further accommodation later this year. This could take the form of lower interest rates, additional liquidity, reduction in bank reserve requirements or some form of fiscal stimulus. Last year the Chinese government budget deficit was 2.1% of GDP, there is plenty of room for manoeuver.

China and India as economic dynamos

Before delving into the details of monetary policy in each country, it is worth taking a broad overview of the Chinese and Indian economies from a global perspective.

The table below shows the major economic regions of the world ranked by population: –

Country GDP-YOY Interest Rate Inflation Rate Jobless Rate Debt/GDP C/A Population
China 7.30% 5.35% 0.80% 4.10% 22.40% 2 1360.72
India 7.50% 7.75% 5.11% 5.20% 67.72% -1.7 1238.89
EA 0.90% 0.05% -0.30% 11.20% 90.90% 2.4 334.57
USA 2.40% 0.25% -0.10% 5.70% 101.53% -2.3 318.86
Brazil -0.20% 12.25% 7.14% 5.30% 56.80% -4.17 202.77
Russia 0.70% 15.00% 15.00% 5.50% 13.41% 1.56 143.7
Japan -0.50% 0.00% 2.40% 3.60% 227.20% 0.7 127.02

 

Source: Trading Economics

India and China stand out as the engines of economic growth. They have a combined population of more than 3.5bln. On a GDP per capita basis both countries have far to go. Indian GDP/Capita is $1,165 and China $3,583, compared to Euro Area $31,807 and USA $45,863. However, as PWC say in their report, the gap between the rich and these relatively poor countries is likely to narrow in percentage terms significantly by 2050.

Here are some more statistics which help to show the similarities and differences between the two economies:-

Criteria China India
Age structure 0-14 years: 17.1% 0-14 years: 28.5%
15-24 years: 14.7% 15-24 years: 18.1%
25-54 years: 47.2% 25-54 years: 40.6%
55-64 years: 11.3% 55-64 years: 7%
65 years and over: 9.6%(2014 est.) 65 years and over: 5.8%(2014 est.)
Median age total: 36.7 years total: 27 years
male: 35.8 years male: 26.4 years
female: 37.5 years (2014 est.) female: 27.7 years (2014 est.)
Population growth rate 0.44% (2014 est.) 1.25% (2014 est.)
Birth rate 12.17 births/1,000 (2014 est.) 19.89 births/1,000 (2014 est.)
Death rate 7.44 deaths/1,000 (2014 est.) 7.35 deaths/1,000 (2014 est.)
Net migration rate -0.32 migrant(s)/1,000 (2014 est.) -0.05 migrant(s)/1,000 (2014 est.)
Urbanization – Urban 50.6% of total population (2011) 31.3% of total population (2011)
Rate of Urbanization 2.85% annual (2010-15 est.) 2.47% annual (2010-15 est.)
Major cities – population Shanghai 20.2mln                                                            BEIJING (capital) 15.6mln (2011) NEW DELHI (capital) 22.6mln                                        Mumbai 19.7mln (2011)
Infant mortality rate 14.79 deaths/1,000 live births 43.19 deaths/1,000 live births
Life expectancy at birth 75.15 years 67.8 years
Total fertility rate 1.55 children born/woman (2014 est.) 2.51 children born/woman (2014 est.)
Infectious diseases degree of risk: intermediate degree of risk: very high
Literacy – age 15 (can read and write) total population: 95.1% total population: 62.8%
male: 97.5% male: 75.2%
female: 92.7% (2010 est.) female: 50.8% (2006 est.)
School life expectancy 13 years 12 years
Education expenditures NA 3.2% of GDP (2011)
Maternal mortality rate 37 deaths/100,000 live births (2010) 200 deaths/100,000 live births (2010)
Children under weight <5yrs 3.4% (2010) 43.5% (2006)
Health expenditures 5.2% of GDP (2011) 3.9% of GDP (2011)
Physicians density 1.46 physicians/1,000 population (2010) 0.65 physicians/1,000 population (2009)
Hospital bed density 3.8 beds/1,000 population (2011) 0.9 beds/1,000 population (2005)
Adult Obesity 5.7% (2008) 1.9% (2008)

 

Source: Index Mundi

From a Chinese perspective the main elements which stand out in the table above are:-

  • Slower birth rate, aging population and lower fertility rate – according to the UN China’s working age population will decline by 16% between now and 2050
  • Higher literacy, especially female literacy
  • Lower mortality rate and higher health expenditure

For India, improvements in education, sanitation and healthcare are key factors.

Indian Monetary Policy

The Reserve Bank of India (RBI) cut their key Repo Rate in December 2014. Despite falling oil prices they have left this rate unchanged as the effects of the currency devaluation of 2013 work their way through the economy. This is an extract from the RBI Bulletin – February 2015:-

On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:-

  • keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 7.75 per cent;
  • keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL);
  • reduce the statutory liquidity ratio (SLR) of scheduled commercial banks by 50 basis points from 22.0 per cent to 21.5 per cent of their NDTL with effect from the fortnight beginning February 7, 2015;
  • replace the export credit refinance (ECR) facility with the provision of system level liquidity with effect from February 7, 2015;
  • continue to provide liquidity under overnight repos of 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and
  • continue with daily variable rate term repo and reverse repo auctions to smooth liquidity

They go on to defend their hawkish stance on inflation:-

The upside risks to inflation stem from the unlikely possibility of significant fiscal slippage, uncertainty on the spatial and temporal distribution of the monsoon during 2015 as also the low probability but highly influential risks of reversal of international crude prices due to geo-political events. Heightened volatility in global financial markets, including through the exchange rate channel, also constitute a significant risk to the inflation assessment. Looking ahead, inflation is likely to be around the target level of 6 per cent by January 2016.

Their growth forecasts are also cautious:-

The outlook for growth has improved modestly on the back of disinflation, real income gains from decline in oil prices, easier financing conditions and some progress on stalled projects. These conditions should augur well for a reinvigoration of private consumption demand, but the overall impact on growth could be partly offset by the weaker global growth outlook and short-run fiscal drag due to likely compression in plan expenditure in order to meet consolidation targets set for the year. Accordingly, the baseline projection for growth using the old GDP base has been retained at 5.5 per cent for 2014-15. For 2015-16, projections are inherently contingent upon the outlook for the south-west monsoon and the balance of risks around the global outlook. Domestically, conditions for growth are slowly improving with easing input cost pressures, supportive monetary conditions and recent measures relating to project approvals, land acquisition, mining, and infrastructure. Accordingly, the central estimate for real GDP growth in 2015-16 is expected to rise to 6.5 per cent with risks broadly balanced at this point.

Since this report GDP data has surprised on the upside and the Indian Finance Ministry even suggested their own forecast could be revised to 8.5% – this is how the Wall Street Journal reported it, last week:-

India is in a “sweet spot,” the report said: Inflation has eased, international investors are bullish on India and the government in New Delhi has a strong mandate for change.

If the Modi administration continues improving the business environment and reducing government interference in the prices of food, fuel and other basic goods, the survey said, India’s GDP eventually could experience double-digit growth. That would give the country more resources to help its poor and provide opportunities for its young, growing middle class.

The combination of a relatively weak currency, declining inflation, accelerating growth and a structural reform package, from a government with a strong mandate from its electorate, are a heady cocktail. The RBI underpins these developments by holding back on interest rate cuts. The INR has taken this to heart as the chart below shows. It is still dangerous for the RBI to aggressively cut interest rates – the moderation in inflation needs to feed through to inflation expectations – but inward foreign direct investment could lead to a steady appreciation in the INR over the next couple of years. I wait for technical confirmation of this trend which could see at least a 61.8% correction of the 2011/2013 range (44-68) around USDINR 53:-

USDINR 5 yr

Source: Barchart.com

Chinese Monetary Policy

The Peoples Bank of China (PBoC) announced an interest rate cut last Saturday, lowering the one year rate to 5.35% from 5.6% previously. A PBoC official stated Deflationary risk and the property market slowdown are two main reasons for the rate cut this time,” The PBoC press release was somewhat drier:-

The one-year RMB benchmark loan interest rate and deposit interest rate will both be lowered by 0.25 percentage points, to 5.35 percent and 2.5 percent, respectively. At the same time, the upper limit of the floating range for deposit interest rates will be raised from 1.2 to 1.3 times the benchmark level in support of market-oriented interest rate reform. Adjustments are made correspondingly to benchmark interest rates on deposits and loans of other maturities, and to deposit and loan interest rates on personal housing provident fund.

This is the second rate cut in four months. They also introduced a Standing Lending Facility to create better liquidity:-

To implement the decisions adopted at the Central Economic Work Conference as well as the requirements of the 2015 PBC Work Conference and PBC Money, Credit and Financial Market Work Meeting, to improve the central bank’s liquidity support channels for small and medium-sized financial institutions, to address seasonal liquidity fluctuations in the run-up to Spring Festival, and to promote stable functioning of the money market, the PBC has decided, based on the reproducible experience from the pilot Standing lending Facility (SLF) program participated by the branch offices in ten provinces (and municipalities), to introduce SLF operations in branch offices nationwide. As a result, the PBC branch offices will provide SLF on collaterals to four categories of local legal-entity financial institutions, i.e., the city commercial banks, rural commercial banks, rural cooperative banks, and rural credit cooperatives.

This followed on from a cut to Bank Reserve Requirements announced on February 5th:-

The PBC has decided to cut the RMB deposit required reserve ratio for financial institutions by 0.5 percentage points, effective from February 5, 2015. Furthermore, in order to enhance the capacity of financial institutions to support structural adjustment, and to beef up support to small and micro enterprises, the agricultural sector, rural area and farmer, and major water conservancy projects, the PBC has decided to cut the RMB deposit required reserve ratio for city commercial banks and non-county level rural commercial banks that have met the standards of targeted required reserve reduction by an additional 0.5 percentage points, and cut the required reserve ratio for the Agricultural Development Bank of China by an additional 4 percentage points.

The continued pegging of the RMB – within tight parameters – to the US$ means that China is a beneficiary of the rising US$, but this is something of a double-edged sword since the currency appreciation has been damaging for Chinese exporters. The slowing of the Chinese economy over the last few months and PBoC action has heralded a much needed weakening of the CNY rate as this chart shows:-

USDCNH Oct 2012-March 2015

Source: Barchart.com

The PBoC rate cut will probably not be the last action to stimulate economic activity, being pegged to a currency which has been steadily rising on a trade-weighted basis whilst maintaining a substantial interest rate differential is a difficult long-term operation even for an economy as closed to international capital flows as China. The BIS – Assessing the CNH-CNY pricing differential: role of fundamentals, contagion and policy released this week, discusses some of these issues in greater detail, here is the abstract:-

Renminbi internationalisation has brought about an active offshore market where the exchange rate frequently diverges from the onshore market. Using extended GARCH models, we explore the role of fundamentals, global factors and policies related to renminbi internationalisation in driving the pricing differential between the onshore and offshore exchange rates. Differences in the liquidity of the two markets play an important role in explaining the level of the differential, while rises in global risk aversion tend to increase the differential’s volatility. On the policy front, measures permitting cross-border renminbi outflows have a particularly discernible impact in reducing the volatility of the pricing gap between the two markets.

A weaker RMB would help China more than devaluations have aided other emerging market countries since most of China’s debt is denominated in their own currency, however, a major factor acting as a drag on economic growth is over-investment. At more than 50%, China has the highest level of investment as a percentage of GDP of any major economy – in the UK, by contrast, investment amounts to less than 20%.

Asset Markets

Indian Real-Estate

With relatively high short-term interest rates and uncertainty still hanging over the market due to the currency devaluation of 2013, Indian Real-Estate transactions have been sluggish. In 2014 residential sales were down 30% y/y across India’s seven major cities. A growing inventory of unsold properties is weighing on the domestic banks. Real-Estate accounts for around 13% of Indian bank lending. With non-performing loans on the rise, lower interest rates would be very welcome for the banking sector. The chart below shows the age of property for sale and the length of time these properties are taking to sell in the major cities – a region which accounts for around 70% of India’s property development:-

Unsold Indian Property - Frank Knight

Source: Knight Frank

The National Housing Bank – a subsidiary of the RBI – publishes an index of prices. With an inverted government bond yield curve (1yr 7.83% vs 10yr 7.68% – 4-3-2015) and a substantial over-hang of inventory, it is not surprising that prices are struggling to make much real upside even in the best areas:-

NHB - Price Data

Source: National Housing Bank

A new government initiative called the Smart Cities Project was launched last year with $1.2bln of funding for 2015. Long-term, this will help to deliver the housing and infrastructure India needs, but, near-term, Real-Estate is an asset class which remains supressed. Many apartment buildings stand empty and whilst real prices have not declined significantly, market activity remains very subdued. I do see value developing; there will be an opportunity to invest over the next couple of years as the economy responds to structural reforms.

Demand will emanate from urbanisation and an increase in high and middle income workers returning to India – after all, the “quality of life” for skilled workers returning home is compelling. A working paper from the Peterson Institute – The Economic Scope and Future of US-India Labor Migration Issues looks at the positive impact of both temporary and permanent Indian labour on US markets, they go on to raise concerns about recent US immigration policy:-

…but US immigration data show that India is by far the most important partner country for both permanent and temporary US employment-based migration: Indian nationals account for about half of all US employment-based permanent migration (e.g., green cards) in recent years.

…The prospects of a US-India totalization agreement for social contributions/taxation as part of an FTA are evaluated. A TA is likely to result in indirect economic losses to the United States from the loss of payroll taxes paid but never claimed by temporary Indian workers in the United States. The substantial political and economic quid pro quo that India would have to commit to in order to incentivize the United States to negotiate a TA would be daunting and seems likely to diminish the attractiveness of an FTA to India.

This 2012 paper from the Institute for European Studies – India’s Returning Elite Knowledge Workers is an excellent insight into the inward migration of skilled workers to the major cities of India’s North East. Here is a summary of the “Brain-Gain”:-

India’s rising independence in the last decade as an economic actor constitutes new issues in global governance for a large skilled workforce. What once constituted a ‘brain-drain’ for Indian actors that emigrated to the Global North (EU and US economic powers), is now resulting in a ‘brain-gain’ for the sending countries. India, as a representative power of the emerging Global South, has been a leader in creating cross-border social networks for entrepreneurship through ties between the Indian expatriate community and local entrepreneurs in industries that are enticing Western agents. 

This dissertation project investigates how the ‘brain gain’ of high-skilled entrepreneurs of Indian origin has transformed the landscape of infrastructure and social relations within emergent Global South cities in India based upon elite trans-migrant imaginaries of home. India’s growth as a global power attributed to cross border diasporic networks of Indian transnationals has given rise to a generation of permanently returning migrants to India’s cosmopolitan cities. This paper explores the movement of transnational Indian elites returning from the United States and Europe to postcolonial India. Through ethnographic interviews in Silicon Valley, California, I attempt to understand why social and technological entrepreneurs of Indian origin, those who see their return as a new venture or idea, are returning to accommodate a hybridized Western lifestyle within an Indian socio-cultural context. These entrepreneurs are transforming the peripheries of the cosmopolitan global city through the gated communities where they reside and Special Economic Zones where they work toward developing new business and change in India. By examining the narratives and everyday life of elite diasporic returners in their newfound ‘home’ spaces, I question (a) what are the principle motivations that guide entrepreneurs to return to India (b) whether the cosmopolitan Global South city can function as a hybrid ‘home’ and (c) in locating ‘home’ by transforming their spatial and temporal relationships, how are power relations constituted.

Chinese Real-Estate

Shanghai Real-Estate has risen by 650% since 2000 and by 85% since the last peak in 2007, although nationwide the increase in the period from 2008 to 2013 was a more moderate 20%. The driving force behind this price increase has been urbanisation. In the past 12 years 220mln people have move from rural to urban districts in China. A large number of these new, often unskilled, city dwellers have been employed in construction. It is estimated that 27% of urban Real-Estate is unoccupied. This explains the recent downturn in Chinese Real-Estate prices as this chart of newly built housing shows:-

china-housing-index

Source: Trading Economics and National Bureau of Statistics of China

In January the decline was -5.1% versus -4.3% in December and -3.7% in November 2014. Price drops were recorded in 64 of the 70 major cities, compared to 66 in December. Declines are not evenly distributed: the average price of new homes in the country’s four first-tier cities rose for the second consecutive month. The existing housing market is also more buoyant for first-tier cities, rising for the fourth month in a row. In second and third-tier cities prices continue to decline.

Writing in the FT – How addiction to debt came even to China Martin Wolf describes the problem overhanging the Chinese property market:-

China’s huge credit boom has several disquieting features. Much of the rise in debt is concentrated in the property sector; “shadow banking” — that is lending outside the balance sheets of the formal financial institutions — accounts for 30 per cent of outstanding debt, according to McKinsey; much of the borrowing has been put on off-balance-sheet vehicles of local governments; and, above all, the surge in debt was not linked to a matching rise in trend growth, but rather to the opposite.

This does not mean China is likely to experience an unmanageable financial crisis. On the contrary, the Chinese government has all the tools it needs to contain a crisis. It does mean, however, that an engine of growth in demand is about to be switched off. As the economy slows, many investment plans will have to be reconsidered. That may start in the property sector. But it will not end there. In an economy in which investment is close to 50 per cent of GDP, the downturn in demand (and so output) might be far more severe than expected.

Despite this relatively sanguine appraisal of the prospects for the housing market it is worth pointing out that 75% of Chinese individual net worth is tied up in Real-Estate – by way of comparison, in the US the figure is 28%.

Chinese Real-Estate may recover at some point, probably in response to wage growth – currently running at around 8% in real terms, buoyed by state mandated minimum wage increases (13%) and strong growth in private manufacturing (12%). For the present I expect Real-Estate prices to continue to decline. This will eventually exert significant downward pressure on private domestic consumption – an impediment to the policy of “re-balancing”.

Indian Equities

Indian equities have performed strongly due to the currency devaluation, high inflation and relatively strong economic growth. Money supply has moderated in response to higher interest rates but is still sufficient to encourage asset market speculation. The chart below covers the period up to January 2014 but the double digit expansion has continued during the last year:-

India_Money_supply

Source: RBI

The currency devaluation of 2013 has fed through to higher inflation but the fall in oil prices has narrowed the current account deficit, whilst exports have held up well. This, among other factors, has supported a rise in stocks, despite the RBI’s hawkish stance:-

BSE_1yr

Source: Bigcharts.com

The SENSEX Index is trading on a current P/E ratio of 18.52. This is still in the lower half of the 5 year range (16.5 to 24). With growth prospects likely to be revised higher, I believe the market will continue to exhibit strong performance over the coming year.

Chinese Equities

The Shanghai Composite performed strongly in Q4 2014 as markets became cognizant of the PBoCs dovish policy shift. Government policy is also supportive, with the continued development of Free Trade Zones remaining high on their agenda. The Jamestown Foundation – “Hope” versus “Hype”: Reforms in China’s Free Trade Zones provides more detail and suggests they may fail to realize their early promise:-

After a year of the Shanghai pilot FTZ, three new FTZs are now being established in the major sea-port cities of Guangdong, Tianjin and Fujian (South China Morning Post, December 13, 2014). Fujian is the closest mainland province to Taiwan, Tianjin specializes in international shipping and related sectors and Guangdong is adjacent to Hong Kong and Macao and is close to Southeast Asia. However, the troubles of the Shanghai FTZ—despite the personal high-level support of Premier Li—suggest that these new FTZs will face an uphill battle in expanding the grounds of economic liberalization in China.

Most Promises Stand Unfulfilled

China’s slowing growth has led many foreign companies to consider scaling back their expansion plans, and the Shanghai FTZ has failed to deliver on the promises of reform that appear necessary to justify foreign companies’ high hopes for a better future business environment in China.

Bi-lateral Free Trade Agreements are also being contemplated. This paper from ECFR – The European interest in an investment treaty with China explores one with the EU:-

Like the EU, China is a global player. Trade and investment talks cannot be viewed in isolation of moves with third parties. Chinese economic agents – from SOEs turning into multilateral firms, to sovereign funds or more dispersed private actors – are in a decisive phase of capital internationalisation as China maintains a large current account surplus.

Recent trade data, however, paints a vulnerable picture in the near-term. This was the data for January, admittedly a notoriously volatile period as it precedes the Chinese New Year: –

  • Imports -19.9% – forecast -3.2%
  • Exports -3.3% – forecast +5.9%
  • Crude oil imports -41.8%
  • Iron ore imports -50.3%
  • Coal imports – 61.8%

Another factor impacting the stock market is credit and money supply growth, M2 grew 12.2% in December 2014 down from a high of 13.6% in 2013, however it has regained upward momentum in the last couple of months:-

China M2 - Cato

Source: Cato, John Hopkins University and PBoC

 

Unless it can be reversed, this declining trend will act as a drag on economic activity. Nonetheless, the stock market has surged ahead – note the dramatic increase in volume traded – anticipating the effect of the PBoC policy shift:-

Shanghai_Composite_1_yr

Source: Bigcharts.com

A longer-term chart shows that the market has some distance to go until it reaches its old highs:-

china-stock-market 8yr

Source: Trading Economics

The Shanghai Composite is trading on a P/E ratio of 16.33. This is undemanding but the risk of China unpegging and devaluing their currency is a significant risk for the international investor.

Conclusions and Investment Opportunities

Bonds

I have not made much mention of the government bond markets in China or India: it is not because one cannot invest in these markets but due to the relative difficulty of accessing them and their uneven liquidity. They both offer a real yield – China 2.63% and India 2.57% for 10 year (4-3-2015). Both markets are attractive.

Real-Estate

Both China and India are suffering from an overhang of unsold property but the overvaluation is more pronounced in China. India has the additional advantage that interest rates have more room to fall in the event of a sharp downturn in economic activity. India has a younger population and its skilled ex-patriot workers are returning in significant numbers. The Chinese market will take longer to clear. Neither market has finished correcting yet.

Equities

On a price to earnings basis the Shanghai Composite (16.33 times) offers better value than the Sensex (18.52 times) however there is a real risk that the “internationalisation” of the RMB leads to its decline against the US$. The Sensex is making new highs whilst the Shanghai Composite is trading higher after a major correction from the 2008 highs. This is not to suggest that India is trouble free, however, it has more room to grow given its per capita GDP, and less signs of over-investment. Corruption is an issue in both countries but the Chinese administration’s efforts to root out officials who have “feathered their nests” is likely to act as a drag on growth. Indian reform is principally concerned with reducing bureaucratic impediments to the functioning of free markets – closing tax loopholes, reducing state interference in competitive processes and so forth.

The key for growth in both China and India is the inward flow of foreign capital. On January 29th the UN – Global Investment Trends Monitor – announced that China had become the leading destination for FDI in 2014 ($128bln) for the first time since 2003, however, its growth rate was an incremental 3%. India, by contrast, saw FDI surge by more than 26% to $35bln – this follows a 17% rise in 2013. This trend will continue, accelerated by the reforming zeal of the incumbent regime.

Indian and Chinese interest rates will decline, but Indian rates have more room to fall. Chinese and Indian stocks will rise but, with the currency devaluation behind it, Indian stocks – despite their higher P/E ratio – look better placed to rise.

Currency

Risks for the RMB are on the downside whilst for the INR they are on the upside, the trend is underway:-

CNY-INR-2 yr

Source: Exchangerates.org.uk

The second arrow of Likonomics and the Chinese property market

400dpiLogo

Macro Letter – No 18 – 29-08-2014

The second arrow of Likonomics and the Chinese property market

  • The Chinese rebalancing towards domestic consumption continues
  • The shadow banking system is being forced into the light
  • But a slowdown in the property sector poses a potential risk to economic reform

Seven Lucky Gods

The Japanese “Ship of Happiness” containing the seven lucky gods – originally of Chinese and Indian origin

Source: onmarkproductions.com

Back in March I anticipated a stimulus package to avert too dramatic a slow-down in the Chinese economic rebalancing, process: –

By a number of conventional measures China has reached the Ponzi stage. Total debt has increased from $9trln in 2008 to $23trln in 2013 (250% of GDP). Private sector debt has increased from 115% of GDP in 2007 to 193% in 2013. Measures of the multiplier effect of debt to GDP suggest it now takes 4 RMB of debt to create 1 RMB of GDP growth. The Chinese authorities attempts to slow bank lending have led to a significant expansion of shadow bank credit. Much of this lending is to sub-prime borrowers.

Recent action by the PBOC suggests they are now targeting the illusive shadow banking sector. Last week they drained 50 bln RMB via reverse-repos…after strong growth in 2013 the PBOC may be inadvertently engineering a “Minsky Moment” – when asset prices collapse – but the Third Plenum focus on market based reform would suggest this is not the intention…

Since then the PBOC has been actively steering the Chinese “Ship of Happiness” towards more tranquil waters by, among other measures, reducing bank capital requirements. Highlights of China’s Monetary Policy in the Second Quarter of 2014 updates the recent timeline:-

 On April 22, the PBC decided to cut the reserve requirement ratios for county-level rural commercial banks and county-level rural cooperative banks by 200 and 50 basis points respectively, effective from April 25, 2014.

On June 9, the PBC decided to cut, effective from June 16, 2014, the deposit reserve requirement ratio by 0.5 percentage points for commercial banks (excluding those that were subject to the deposit reserve ratio reduction on April 25, 2014) that have complied with prudential requirements and have reached the required ratios in their lending to the agricultural sector, rural areas, and farmers, and to small and micro enterprises. In addition, the RMB deposit reserve requirement ratio of finance companies, financial leasing companies and auto financial companies was cut by 0.5 percentage points.

This change in reserve requirements has dampened the extreme volatility of short term repo rates. Lower volatility and lower rates fuel risk-taking; bank credit surged in June by RMB1970bln – up 90% on June 2013.

Meanwhile, the government, in pursuit of President Xi’s “Chinese Dream”, embarked on a mini-stimulus package – estimated in the local media at around RMB10tln. This has reignited the stock market but begs the question “How can further stimulus solve the problem of excessive liquidity?” The Business Insider – China Unveils ‘Mini Stimulus’ To Boost Its Slowing Economy described it thus: –

“The State Council is responding to the growth slowdown by announcing tax breaks for SMEs (small and medium enterprises), speeding up investment in railways and rebuilding urban shantytowns,” HSBC economists Qu Hongbin and Sun Junwei said in a report Thursday.

“This time the package is small in scale, but it is more targeted and involves reforms on financing to secure funding,” they said. “So this should help China to smooth growth without exacerbating financial stability risks.”

The tax breaks for “small and micro” companies will be extended until the end of 2016, the State Council said in a statement on the central government website.

It also said 6,600 kilometres (4,100 miles) of new railway lines will come into operation this year, 1,000 kilometres more than in 2013.

The plan will also see the creation of a railway fund that will receive between 200-300 billion yuan ($32-$48 billion) each year, the statement said.

… “These measures show that Premier Li’s government aims to stabilise short-term growth with policies which can enhance efficiency while avoiding future financial troubles,” Bank of America Merrill Lynch economists Lu Ting and Sylvia Sheng said in a report Wednesday.

“We believe these measures are the right policy responses to the ‘fiscal cliff’ as a consequence of the anti-corruption campaign, and we think markets will overall welcome them.”

There have been nine reported cases of Trust Fund defaults in the five months to May which matches the total during the whole of 2013, however, several shadow banks are being merged and acquired by licensed banking institutions. Meanwhile, the China Banking Regulatory Commission (CBRC) is helping to ease the pain of rebalancing for the banking system. Caixin – Banks Start Using New Loan-To-Deposit Ratio on July 1looks at the detail: –

Starting July 1 banks in China are using a new method of calculating the loan-to-deposit ratio, a change that the regulator and analysts say will allow for more loans to be extended.

The China Banking Regulatory Commission (CBRC) announced on June 30 the new set of rules for figuring the ratio, which is capped by law at 75 percent, meaning that banks cannot lend out more than three-quarters of the deposits they accept.

A CBRC official has said the regulator will consider adjusting the way the ratio is calculated to allow for more lending. That includes broadening the range of deposits to include “relatively stable” funds.

The new rules differ from the old ones in both loan and deposit calculations, the announcement shows.

Six types of loans can now be excluded from the formula. They include loans linked to the central bank’s re-lending program and proceeds from the sales of a special financial bond that raises money to support small and micro businesses. Loans made using money raised from bonds that investors cannot redeem for at least one year are also excluded under the new rules.

These loans all have clear and stable sources of funding and thus do not need to be matched with general deposits, the regulator said.

Why ease conditions when M2 is growing at 14.7%, M1 at 8.9% and M0 at 5.3% (June 2014)? I believe the easing of conditions is due to official concern that risk in the financial system is substantially understated. This article from the Wall Street Journal  – Risky Business in China’s Financial System – highlights some of the issues: –

Is China heading for a financial crisis? Some risk indicators have risen markedly over the past twelve months: Interbank rates are more volatile, with liquidity shortages increasingly common; there have been a few minor bank runs; and the country experienced its first corporate default in recent history earlier this year.

Loans and Booms - China vs Crisis countries-page1

Source: Oxford Economics, Haver Analytics and Wall Street Journal

Moreover, though official figures suggest that just 1% of loans are non-performing, bank balance sheets likely aren’t as healthy as they seem.

Evidence from a range of countries suggests that credit booms – as China experienced from 2009-‘13 – result in substantially higher levels of non-performing loans (NPLs). A more realistic assumption that 10%-20% of total loans might go bad implies total NPLs of RMB6-12 trillion (US$1-1.9 trillion). The higher end of the range would suggest a bad-asset problem comparable in scale to the one that followed the U.S. subprime loan crisis.

The author goes on to discuss the importance of the shadow banking system. Then he asks: –

What might trigger a crisis in China? The drift downward in property prices could accelerate as the economy cools, leaving substantial oversupply. Property and land are often used in China as collateral for loans, so a sharp fall in house prices would damage bank balance sheets; liquidity would dry up; and institutions with high rollover needs might struggle to find funding.

Higher interest rates also would increase debt-service payments, and banks could see their deposit bases erode as corporate deposits shrink. The growing importance of the shadow-banking system would likely exacerbate these effects.

Such a crisis would have major economic implications not only for China but — through financial and trade linkages – for the whole world. The Oxford Economics Global Economic Model estimates that, in such a scenario, Chinese gross domestic product would grow less than 2% in 2015, and world growth would drop as low as 1%.

Of course, that’s a worst-case scenario, and odds of it happening are only about 10%. With China’s overall government debt relatively low and foreign exchange reserves at an all-time high, authorities have the means to intervene on a large scale if necessary.

Still, as long as interest on deposits is capped by the government, Chinese savings will continue to be invested in riskier and higher-yielding products, adding to distortions in the financial system.

That means the risk of a financial crisis will remain until the government introduces reforms to the financial sector, and manages its way out of the credit boom in an organized fashion.

The deleveraging of the credit boom and reform of the financial sector are the second and third arrows of Likonomics – named after the economic policies of Premier Li Keqiang. Even getting to the second arrow will be difficult given a housing bubble which shows signs of bursting.

Housing, the Achilles heel

Recent official data shows house price declines in 55 out of 70 cities in June vs May and 35 out of 70 cities in May vs April. Sales volumes as measured by floor space are down 9.4% in the first seven months of 2014 vs the same period last year.

The FT – Property bubble is ‘major risk to China’ puts the Chinese government’s dilemma in perspective: –

The government itself has an enormous incentive to keep pumping the bubble up, since all land is technically owned by the state and land sales made up 60 per cent of local government’s budgetary revenues last year, according to estimates from JPMorgan.

Since 2008 land prices have increased fivefold, triggering corresponding asset price rises, but even as prices soared and supply mushroomed, demand for housing and office space pretty much kept up – until this year. More than 90 per cent of households already own at least one home and, for those urban households that own apartments, nearly 76 per cent of their assets are in real estate, according to Gan Li, director of the Survey and Research Center for China Household Finance.

At 90% Chinese home ownership is ranked sixth highest in the world (2012 data). It is slightly lower than Singapore but well above the levels in UK (66.7%) and USA (65.2%). Here is a table from Wikipedia . However, it has been estimated by the China Household Finance Survey  that empty homes make up more than 20% of the housing stock. Of these, the vast majority are investment properties.

Meanwhile the first arrow of Likonomics – a tempering of monetary stimulus – put in place since the great recession, has been accompanied by a swath of anti-corruption policies. President Xi reaffirmed his commitment to anti-corruption measures in a speech on 29th June on the eve of the 93rd anniversary of the founding of the Chinese Communist Party.

Michael Pettis – The Four Stages of Chinese Growth describes the overall reform process being undertaken by the Xi government. The entire essay is a brilliant insight into the economic development of China since 1978 and looks closely at the “social capital” deficit which, if left unaddressed, might undermine the Chinese economic miracle of the last 30 years :-

The second liberalizing period. What China needs now is another set of liberalizing reforms that cause a surge in social capital such that Chinese individuals and businesses have incentives to change their behavior in ways that generate greater productive activity from the same set of assets. These must include changing the legal structure, predictably enforcing business law, changing the way capital is priced and allocated, and other factors that determined the incentives, so that Chinese are more heavily rewarded for activity that increases productivity and penalized, or at least less heavily rewarded, for rent seeking.

But because this means almost by definition undermining the very policies that allow elite rent capturing (preferential access to cheap credit, most importantly), it was always likely to be strongly resisted until debt levels got high enough to create a sense of urgency. This resistance to reform over the past 7-10 years was the origin of the “vested interests” debate.

Most of the reforms proposed during the Third Plenum and championed by President Xi Jinping and Premier Li Keqiang are liberalizing reforms aimed implicitly and even sometimes very explicitly at increasing social capital. In nearly every case – land reform, hukou reform, environmental repair, interest rate liberalization, governance reform in the process of allocating capital, market pricing and elimination of subsidies, privatization, etc – these reforms effectively transfer wealth from the state and the elites to the household sector and to small and medium enterprises. By doing so, they eliminate frictions that constrain productive behavior, but of course this comes at the cost of elite rent-seeking behavior.

Many of the Third Plenum measures are focussed on a root and branch reform of the property development industry. This post from Investing in Chinese Stocks – RMB 8.7 Trillion in Land Finance At Risk provides some fascinating insights, into the dangers these reforms pose to the property development industry: –

A strict audit of 15 trillion in land sales is going to uncover dirt in many Chinese cities. Already, according to the article below, 9 cities have been found to have violated regulations governing land finance, including Shangluo, Hengyang, Neijiang, Xingtai, Huzhou and Suqian. Recall how land finance works:

Chinese local governments sell land to developers who build homes and commercial centers. The revenue from land sales pays for development of supporting infrastructure, everything from roads and subways to schools and parks. Land sales also finance local government debt which exploded after 2008. In the post-2008 economy, developers rushed to build property amidst a real estate bubble and when the government moved to restrict activity in first- and second-tier cities, developers poured into third- and fourth-tier cities and repeated the model. However, developers have run ahead of many local governments. In areas where there are true ghost cities, support infrastructure such as schools and hospitals have not been built. If the real estate bubble bursts and land sales fall, local governments will need to find another revenue source or they may be unable to finance the infrastructure that generates GDP growth and supports the local real estate market, and they may even face a debt crisis in some of the worst hit areas. This ignores all the potential issues with indebted developers, plus overproduction and bad debts in other sectors of the economy.

84 major Chinese cities have borrowed 8.7 trillion, backed by revenue from land sales. If cities have violated regulations or violated the law in their use of land finance, things could quickly come to a head in areas where the governments are borrowing to survive, which is already the case in some cities. The conclusion to the article is a good summary:

“Mortgage financing using state-owned land, borrowing money to promote urban development and stimulating economic growth, this economic growth model is not sustainable, it can very easily bring about hidden volatility in the capital markets and macroeconomic development.” Wang Jianwu told reporters, the key to solving the problem is for the local government to gradually adapt to the “new normal,” get rid of “land hormone” stimulus, while local governments also need to shift from the dominant role of economic development to servicing economic development.

Yet again, the anti-corruption probe lines up with the leaderships vision of economic reform. By squeezing local governments’ ability to borrow through land sales, the shift towards a rebalanced, market-based economy can proceed more quickly.

Concern about the Chinese housing market has even attracted the attention of the Kansas City Fed – China’s slowing housing market and GDP growth – they cover many of the issues already discussed but also look at the longer term impact of demographics: –

Looking further ahead, the real-estate sector will need to adapt to the inevitable decline in demand caused by demographic change. The share of China’s population from 24 to 30 years old, the age group needing to purchase their first home, has declined from 13.4 percent in 2000 to 10.7 percent in 2010. The share of the working age population (15 to 59 year olds) has declined to 68.7 percent in 2013 after peaking at 70.1 percent in 2010, reversing the upward trend of the prior two decades.

…Taking both the short- and long-term factors into account, the real estate sector’s recent slowdown is likely to continue as housing activity stabilizes at a lower growth path. While this adjustment could provide certain long-term benefits, it will generate significant downward pressure on China’s near-term growth.

For a rather more sanguine view of the current situation this policy brief from The Peterson Institute – Is China’s Property Market Heading toward Collapse? Provides a broader historical context, highlighting the fundamental differences between China today and USA in 2008 or Japan during the 1990’s: –

 The fears about China’s property market are likely overblown. First, China’s private housing market is young. It did not exist until 1998. Over the last 16 years, the property sector has seen large swings in both prices and levels of investment. Cyclical downturns have resulted from macroeconomic conditions, credit restrictions, and the government’s attempts to curb either the overheating or overcooling of the sector. This cyclicality is a good thing to the extent that investors tend to avoid making one-way bets on either price appreciation or depreciation, and thereby it works to prevent excessive speculation. Largely owing to limited financial innovations, market developments, and punishing taxes, China’s property market is still less leveraged than is typical in more developed economies. Developers have lowered their debt-to-asset ratios since 2009 and Chinese buyers must offer down payments of at least 30 percent before they can apply for mortgages.

Second imposed more than four years ago to discourage property purchases for investment purposes. Indeed, at the time of this writing, some 30 Chinese cities have started to ease these property curb policies, which were designed to prevent excessive speculation. In addition, the government could also liberalize its urban household registration system, or hukou, to allow migrants to purchase houses and thereby encourage them to settle in their cities permanently.

In the medium term, the government can take a number of other steps, such as reintroducing an urban public housing program in large cities, funded by a property tax, to address income inequality and encourage an increase in rental properties. To reduce banking sector risk, the government could encourage banks to issue covered bonds to reduce the risk of maturity mismatch of their mortgage assets. Furthermore, diversifying property developers’ sources for finance through real estate investment trusts, or REITs, would also reduce their reliance on bank financing. China should also improve its data collection to take into account the quality, location, and other important features of property transactions.

More important, demand for urban properties is expected to remain high over the next decade. It is estimated that another 200 million people could join China’s urban areas by 2023. In this sense, China’s property market bears no resemblance to Japan in the early 1990s or the United States in 2008. As long as urbanization continues and appropriate policies are adopted, this property market downturn should prove to be merely cyclical, and a major correction is unlikely to take place.

The authors expand on the positive long-term factors which support the Chinese property market but remain cognisant of the risks of a near-term bursting of the property bubble. Chinese property has risen 64% since 2010, eclipsed only by Hong Kong where prices are up 94%. Rental yields are 2.66%, higher than Singapore at 2.41% but well below Japan at 5.53%. However, some comfort may be drawn from indications of the rise of zero down payment mortgages – if these become widespread the property bust may be deferred.

Private capital flight

This brings me to another issue which affects the global economy. If 76% of the net worth of Chinese city dwellers is tied up in real-estate, how will they diversify their investment risk? Many of the wealthiest Chinese families have already moved a substantial portion of their net worth abroad. This trend is likely to continue unless the government imposes capital controls. What is the likely impact on domestic asset prices?

A recent article from The Diplomat – Chinese Investors Fuel California Housing Bubble gives an interesting perspective to the debate. Chinese nationals only account for 11% of the foreign buyers of real-estate in the San Francisco area but their marginal impact is significant. Chinese demand is being fueled by uncertainty over domestic Chinese housing policy and fears about the stalling of economic growth:-

As Mark McLaughlin, CEO of Pacific Union, a prominent San Francisco real estate firm, told local CBS affiliate KPIX, “it’s added a demographic of buyers who, generally, take a long-term view. They’re not sellers in the next five to seven years.” Chinese buyers are sitting on much of this property as housing in the Bay Area becomes increasingly scarce, causing its value to skyrocket. The Case-Shiller home price index, released in May, saw Bay Area home prices jump by 23 percent compared with  a year ago.

That may be just the beginning. On average, San Francisco real estate cycles take about five to seven years to run their course from recovery to collapse. The current surge in prices began in early 2012. Home values have shot up 50 percent since then; during the last surge, the prices peaked at 54 percent. Chinese money is likely to add pressure to the current bubble.

Of course Chinese buyers have been evident in many prime real-estate locations including Manhattan, London and Sydney. Earlier this month Wang Jianlin, China’s richest man, invested $HK12.5 bln in Australian real estate including a AUD900 mln resort on the Gold Coast.

A recent article from the Wall Street Journal – The Great Chinese Exodus looks into the migration trends of wealthy Chinese: –

…A survey by the Shanghai research firm Hurun Report shows that 64% of China’s rich—defined as those with assets of more than $1.6 million—are either emigrating or planning to. …The elite are discovering that they can buy a comfortable lifestyle at surprisingly affordable prices in places such as California and the Australian Gold Coast, while no amount of money can purchase an escape in China from the immense problems afflicting its urban society: pollution, food safety, a broken education system. The new political era of President Xi Jinping, meanwhile, has created as much anxiety as hope.

…Last year, the U.S. issued 6,895 visas to Chinese nationals under the EB-5 program, which allows foreigners to live in America if they invest a minimum of $500,000. South Koreans, the next largest group, got only 364 such visas. Canada this year closed down a similar program that had been swamped by Chinese demand. …Beijing makes a crucial distinction between ethnic Chinese who have acquired foreign nationality and those who remain Chinese citizens. The latter category is officially called huaqiao—sojourners. Together, they are viewed as an immensely valuable asset: the students as ambassadors for China, the scientists, engineers, researchers and others as conduits for technology and industrial know-how from the West to propel China’s economic modernization.

…Still, the sheer volume of China’s outbound travel these days, and its massive economic impact, gives it new leverage. In the global market for high-end real estate, Chinese buying has become a key driver of prices. According to the U.S. National Association of Realtors, Chinese buyers snapped up homes worth $22 billion in the year ending in March. Australia called a parliamentary inquiry to find out whether local households were being priced out of the market by Chinese money. (The conclusion: not yet.)

Without fee-paying Chinese students, many colleges in the postrecession Western world simply wouldn’t be able to pay the bills. Chinese students are by far the largest group of foreign students on U.S. campuses, and their numbers jumped 21% last year from the year before—to 235,597, according to the Institute of International Education. Their numbers are increasing at a similar pace in Australia. In England, there are now almost as many Chinese students as British ones studying full-time for postgraduate master’s degrees. …The Chinese government has no desire to slow the flow of students. Its attitude is simple: Why not have the Americans or Europeans train our brightest minds if they want to? President Xi’s own daughter went to Harvard.

Provided the domestic housing market doesn’t collapse and the Chinese authorities resist the temptation to impose capital controls, Chinese buyers will continue to support prime real-estate markets globally. However, this is a risk which needs to be monitored closely.

Conclusion and investment outlook

In order to understand China you need to study its history, this recent essay by The Economist – What China Wants – is an excellent introduction. China has witnessed several long-term “Cycles of Empire” over the past three millennia as this Moneyweb interview with David Murrin – China’s fifth reincarnation as an empire system and its link to Africa. Explains:-

It’s unique in that it is the fifth, could be sixth if you go back far enough, incarnation of a 500 year empire cycle. They’re now 120 years into that cycle so they’re really about the stage where they burst forth onto the world. Every one of China’s cycles has been bigger than the one before, so when people say it didn’t actually ever have influence outside its borders, look at the last incarnation at the peak of the 14th century. Their trading system reached the shores of Africa, they controlled the Indian Ocean, they controlled the whole or parts of the Pacific.

The opportunity to rebalance the Chinese economy has come at an opportune time, with the US in a slow, but steady recovery from the great recession. Moderate US growth is helping Chinese exports to rebound as this article from the China-United States Exchange Foundation-  China-US Trade Boosted by Moderate Growth in the US Economy explains: –

The United States’ economic recovery, albeit moderate, is good for overseas exporters. During the first seven months of the year, Chinese exports of good to the US increased by 6.3% over a year ago, while its global export growth was 3.0%. The US market performed twice as good as the global market. In July alone, exports to the US shot up by 12.3%, contributing 2.1% to China’s global export growth. 

However they recognise the need to maintain good trade relations with the US:-

According to China Customs statistics, Chinese imports worldwide increased by 1.0% during the first seven months of the year. Imports from the US, however, increased by 5.0%, far outperforming its global imports.

Perhaps the greatest risk to the Chinese administration, as it seeks to rebalance the economy, is a collapse in the housing market. So far, the rebalancing has proceeded without a major catastrophe. Chinese stocks remain cheap on a P/E basis (SSE current P/E 10.59) and forecasts for 2015 factor in little earnings growth. The chart below shows the Shanghai Composite vs the S&P500 since August 2010.

Shanghai SE Composite vs S&P500 2010-2014

Source: Yahoo finance

The S&P 500 has risen close to 100% whilst the Shanghai Composite has fallen by 30%. By comparison, the Chinese real-estate index is up 64% over the same period. This chart from the Peterson Institute shows the under-performance of stocks relative to housing:-

China House Prices vs Stock Market and Bank Deposits - CEIC Data Peterson Institute

Source: CEIC, Peterson Institute

A dramatic slow-down in European growth may justify the low valuation for the Shanghai Composite, as may a reversal in the fortunes of the US stock market, nonetheless, on a relative value basis, Chinese stocks look attractive. I believe the US economy will continue to perform, though not so strongly as of late. The ECB will avert an implosion of the major European economies “whatever it takes”. In this environment China will find, quantitatively fuelled, export markets to cushion the pain of domestic reform. Chinese stocks will outperform Europe, and may well outperform the US, over the next couple of years.

The second arrow of Likonomics – a deleveraging of the credit bubble – looks likely to be postponed.