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China: Once the Statistical Blackout Is Over, How Will the Economy Look?

BLOG - 28 January 2019

Let us turn our attention to China, a country full of paradoxes and contradictions. In few days, we will also discuss the US conundrum, a never-ending end-of-cycle.

Just before the start of the statistical blackout caused by Lunar New Year celebrations - a blackout precisely because it is an event of the lunar calendar - China displayed worrying signs of weakness, which have reverberated in global financial markets. The difficulty for analysts is to disentangle structural trends – a steady decline in potential growth — from short term gyrations. Structural factors, starting with a declining labor force and including the forced deleveraging of corporate China, will trim potential growth, currently around 6.5%, down to 5%, if not lower, over the next five years. Short term gyrations are harder to predict because they are often caused by the feedback loop between economic policy, which struggles to manage an ever more complex economy, and the real economy itself. Given that we know the rationale behind this loop (though not its details), it is possible to sketch a scenario for 2019.

The freshly released fourth quarter GDP estimate – a 1.5% increase in real terms from Q3.

The freshly released fourth quarter GDP estimate – a 1.5% increase in real terms from Q3, or a 6.4% increase from a year ago — seems at odds with other metrics, such as the significant slowdown in real retail sales (up 5.8% in November, compared to 7.5% in the first half of the year), a 17% drop in car production in November and a sharp contraction of Japanese exports to China, dragged down by low demand for semiconductors, which is itself a by-product of the trade war with the US.

Chinese data from the National Bureau of Statistics (NBS) are often criticised as unreliable and politically skewed. I have a more balanced view: NBS officers do their best to extract information from an outdated statistical system, still shaped by soviet concepts such as quantities, rather than values and volumes, and which is unfit to gauge an economy now dominated by services. Perhaps because of the poor quality of their data, statisticians tend to iron out cyclical gyrations, and thus to underreport both downturns and upturns. And when it comes to nowcasting exercises, such as this preliminary GDP estimate, they presumably adopt a very conservative stance. Even so, financial markets and private analysts are not fooled and they have already priced in a GDP stagnation, if not a contraction, in the fourth quarter, with a possible spillover in the first months of 2019.

What has sparked this downturn? The most obvious cause is the impact of Trump’s tariff war and US sanctions, or at least their threat, against intellectual property acquisitions by Chinese technology firms. The latter may indeed have started to disrupt Asian supply chains in this hot and strategic sector. But there are also two important domestic factors.

  • First, policymakers have been continuously switching from credit expansion – leading to excessive leverage — to credit restriction, since the massive stimulus that prevented the Chinese economy to collapse in 2009. Given that credit expansion is opaque and opens the door to corruption – because of state-owned banks often linked to local party officials, or of peer-to-peer lending via Internet platforms —, credit restrictions engineered by the central bank (People’s Bank of China, PBC) may be amplified by political factors, such as the official pledge to fight corruption. This could explain what happened at the end of 2018, after a significant and politically unwelcome increase in corporate leverage at the beginning of the year.
     
  • Second, a car sales tax rebate ended in early 2018, which led consumers to frontload their purchases at the end of 2017, causing a sharp contraction afterwards. Politicians seem to have been caught off-guard, and an official advisory body has recently alluded to the idea of another tax rebate in early 2019. Ironically, this may depress car sales further: rational consumers will postpone their purchases until the tax rebate is enacted. But of course, a powerful rebound would follow suit, to the great relief of officials. The Chinese car market is far from being saturated, and the long-term trend of new car sales should recover, although at a much slower rate than it did 10 years ago. Car production had almost tripled from 2009 to 2011. That was then.

The most reliable evidence of a broad slowdown is the PBC’s reaction, as it has already opened the liquidity tap by reducing the reserve ratio commercial banks must abide with by one point, thus injecting 570 billion yuan in the economy. Even combined with a hypothetical tax cut on car sales, this won’t be enough to kickstart the economy: the liquidity injection only amounts to 0.7% of GDP. Although China may offer enough concessions to fend off another American tariff hike, there is a distinct possibility that trade negotiations with the US fail. If this were to happen, China would have no other choice but to resort to a more significant monetary and fiscal stimulus. It is also possible that the PBC will be instructed to be less stringent on credit quality and temporarily suspend the deleveraging process. Once again, a policy-driven credit cycle would challenge the long-term goals advocated by Xi Jinping, such as financial stability. Japan has already been there, and Chinese leaders remember how it ended.

This raises an obvious question: with corporate debt reaching 160% of GDP (as of mid-2018, according to the BIS Quarterly Review, December 2018), will the economy crash on the infamous ‘wall of debt’? Paul Krugman discussed this very topic in a recent Op-Ed ("Will China’s Economy Hit a Great Wall?" The New York Times, 15 January 2019). He confessed thinking it would happen eight years ago, and concluded that, although the macroeconomic fundamentals are now worse than they were then, this hypothesis is not yet compelling. Chinese financial markets could provide hints regarding the sustainability of corporate debt this year, if politicians refrain from meddling.

The amount of failing bonds was 150 billion yuan, less than 0.2% of GDP.

Credit events, i.e. corporate bond defaults, increased tenfold last year compared to the 2015-2017 average, but their size remains quite marginal: the amount of failing bonds was 150 billion yuan, less than 0.2% of GDP. Since China desperately needs its financial markets to be more efficient, both in order to help allocate resources more effectively and to offer a wider spectrum of reliable savings products to its population, a steady rise of corporate defaults is good news. Indeed, a well-documented history of defaults is the only way for the markets to correctly price corporate bonds. Although they understand the rationale behind letting companies default on their bonds when things turn bad, Chinese authorities can’t help but meddle with the market forces when they fear things will get worse and fuel the anger of individual savers. Reading between the lines of credit events will be important this year.

Even if the wall of debt is not close enough to justify doomsday scenarios in the short term, the question will remain open for as long as policy makers continue to use credit expansion to prevent downturns and keep meddling with the markets. In my view, China’s debt-reckoning day will eventually come, but this need not be as catastrophic as some analysts predict. The reason is that the Chinese government debt remains very low by international standards, slightly below 50% of GDP. This is more than sustainable for an economy that is still growing at a 9% rate in nominal terms. One may even argue that the government debt, which, in the world of fiat currency, is the ultimate safe and liquid asset, is too low for the financial system and the savings industry.

China’s debt-reckoning day will eventually come, but this need not be as catastrophic as some analysts predict.

When a large-scale credit crisis unfolds, I think the following will happen: Chinese authorities will bail out banks and shadow banks, by fear of a systemic crisis. Lead will be transmuted into gold, which means low-quality private debt will partly become high-quality government debt: China will do exactly what each and every single developed economy did when they faced a debt crisis. Take the example of Spain: back in 2008, its public debt amounted to 35% of GDP, while its corporate sector leverage had reached 130% of GDP. Today, Spain’s government debt nears 100% of GDP, but the private sector has repaired its balance sheet. In the meantime, Spain went through a deep recession, though not a depression.

China will do its best to avoid even a Spanish-style scenario – its social safety net is not robust enough to endure such an ordeal. It will succeed in doing so, because, contrary to Spain, which was a net international debtor, it is a net international creditor, and, last but not least, the country keeps a tight control over the borders protecting its capital.

At this stage, the Chinese economy’s strengths – massive investment in technology, very high savings, the rise of a numerous and well-educated middle class, vivid entrepreneurship spirit and cut-throat competition in the domestic market — are probably outweighing its weaknesses – unsustainably high level of corporate debt, inefficient capital markets, rising dependency ratio, weak rule of law and poor social safety nets. As it stands, the government has enough leeway to compensate any serious shortfall in aggregate demand through targeted fiscal and monetary stimulus. On balance, Chinese authorities are more likely to use fiscal instruments than to resort to a large depreciation of the yuan, which would cause capital flight and would be at odds with China’s voluntarist foreign policy.
 
Be prepared for a hefty rebound once the economy reemerges from the statistical blackout and enjoy it while it lasts. In the end, the deep structural forces that are slowing the Chinese economy will have the upper hand. The only question is: will China manage to avoid the middle-income trap? The jury is still out on that one.

 

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