Yesterday HSBC released its ‘flash’ PMI estimate of manufacturing activity in China’s economy. It rose to 50.4 in November, up from 49.5 in October. For the first time in 12 months, China’s manufacturing sector expanded!
There was much rejoicing in stock markets around the world. The Aussie market jumped around 1%, Europe and most Asian markets rose too. The US, busy eating turkey for Thanksgiving, was more subdued. And Chinese stock market? It fell on the news. Hmmm…
The West has a knee-jerk response to ‘good’ news on China’s economy. The Shanghai Stock Exchange, having a better view of China’s maladjusted and credit bubble driven economy, is not so enamoured.
That China’s manufacturing sector is enjoying a weak recovery is not in dispute. But it’s the inferences made from this so-called ‘recovery’ that we caution against. The China bulls interpret it as a return to strong growth. The AFR says HSBC Greater China economist Donna Kwok ‘is forecasting 7.8 per cent economic growth for China’s economy this year and 8.6% next year, driven by infrastructure investment, domestic tax changes and subsidies that would help domestic demand.’
In other words, HSBC isn’t betting in economic rebalancing. Rather, it’s assuming more of the same stuff that generated China’s past decade of record expansion, that is, infrastructure investment.
The bears, including us, think that’s wishful thinking. The bears assume economic rebalancing will take place…that there will be less infrastructure investment, not more. If this doesn’t happen soon, China’s eventual day of reckoning will be that much harder. And in such a scenario, maintaining social order and Communist Party dominance will not be easy.
So best to get the rebalancing underway as soon and as subtle as possible.
But the bears also understand that whichever way you go about it, rebalancing will be a painful economic process.
We’ve babbled on about this plenty of times in the past. We’ve said the same thing in a number of different ways. But maybe not the way UBS’s George Magnus does. Here’s his view, courtesy of Alphaville (their emphasis, with which we concur):
‘The maths are problematic. If investment is 50% of GDP and the growth rate falls from 15% to say, 5% per annum, consumption growth has to accelerate from about 8% to an unprecedented 12% per annum or so if the underlying GDP growth rate is to stay at 7.5%. You can do the maths of alternative scenarios at leisure, but the bottom line is that rebalancing requires investment to grow more slowly than GDP, and consumption significantly faster over an extended period of time. Otherwise the model isn’t changing.
‘The more structural reason is that the mechanisms that would allow consumer spending to strengthen further don’t yet exist, and would, in any event, compromise the legacy sources of economic growth that have generated structural imbalances in the first place. For example, higher wages dent corporate profits and investment; higher interest rates and a stronger exchange rate help consumers, but to the disadvantage of companies, whose debt-servicing capacity would be compromised; pro-household tax, income and social security reforms have to be financed, one way or another, by companies, or the government.
‘The issue, specifically in China, is more about the speed of capital accumulation, and misallocation of capital, given that, uniquely, the investment share of GDP has been in a range of 40-50% for about a decade now. Roughly two-thirds of the stock of capital has been built in the last decade, and half of infrastructure investment since 2000, for example, has been in transportation projects, many of which serve the same objectives, and must, for a while at least, be redundant or not viable commercially. And while total factor productivity growth, which is a measure of the efficiency of capital and labour utilisation, did rise strongly during the 2000s to about 4% per annum as the pre-imbalances capex boom gathered momentum, it has fallen back to around 2% per annum since.
‘Once you frame the issue this way, it changes because rapid accumulation of capital goes hand-in-hand with the gradual, and then more rapid, accumulation of financial liabilities incurred to finance it. In other words, a rise in the credit intensity of investment. If you cast your minds back to the publicity in 2007-09 given to Hyman Minsky’s explanations about how and why investment booms lead to instability, you’re in for another treat in China. The essence of instability, by way of a reminder, is that over time, borrowers accumulate debt that becomes increasingly hard to service as returns to investment, profits, cash-flows and asset prices decay.’
That’s a lengthy excerpt but we think it explains very well why you can’t assume a China economic recovery happens next year…just because you think ‘the worst is over’.
Don’t forget, China just went through a credit bubble that was bigger than the US bubble that gave us sub-prime loans and a global credit crisis. Granted, China’s less sophisticated financial system kept all the financial liabilities within the country (whereas the US spread its liabilities far and wide) so the fallout from China’s bubble bust will be very different.
But there will be fallout nonetheless. And as Australia’s largest trading partner, it will hit the Australian economy disproportionately hard. We’ve suffered the first round effects of the slowdown…lower commodity prices and sharply reduced expectations of the fruits of the mining boom. The second round effects depend much on how the new Chinese leadership handles the necessary economic rebalancing.
But don’t forget, these men are just humans, not wizards. They can’t conjure growth from nowhere and they certainly are not working with the same set of economic circumstances that the Politburo Standing Committee before them enjoyed.
That is, they don’t have an abundant flow of economic growth enhancing liquidity to benefit from. Traditionally, this liquidity came via the yuan/US dollar peg. By maintaining an undervalued currency, US dollars would flow into China (representing China’s trade surplus with the US…or the US’s trade deficit with China).
In order to maintain the peg, the People’s Bank of China (PBoc) would buy the US dollars and print new yuan (and therefore create liquidity for the Chinese economy). The PBoC would then buy US Treasury bonds with the proceeds of the US dollars, which boosted its foreign exchange (FX) reserves.
PBoC FX reserve growth became a barometer for China’s liquidity growth, as well as an important source of US government funding.
But as CSLA’s Russell Napier point’s out in what he calls ‘the most important chart in the world’ (courtesy of ZeroHedge) China’s FX reserve growth is non-existent. This is why the PBoC is very active in the market, doing lots of liquidity enhancing ‘repo’ transactions.
‘It is the most important chart in the world. The growth in Chinese reserves has determined all the key developments in financial markets in the last two decades. It printed lots of currency and artificially depressed the US yield curve. It has been the cornerstone of global growth, and now it’s over.’
So now that’s over, we watch and wait for something to begin.
for Markets and Money
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