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China Landing: Not Hard, Not Soft, But Long

International | Nov 21 2014

– China landing not hard but longwinded
– Ongoing structural reforms vital
– Commodity industry defaults necessary
– Property market should muddle through

By Greg Peel

The initial saviour of the global economy after the fall of Lehman is 2008 was an unprecedented stimulus package implemented by the Chinese government and central bank. Bail-outs were instigated in the US but it wasn’t until the US Federal Reserve introduced quantitative easing in early 2009 that the US economy began to stabilise. That experiment, to date deemed successful, has now ended.

So explosive was Chinese economic growth as a result of stimulus, nevertheless, that economists soon became concerned a bubble was being created that must eventually burst, particularly with regard Chinese property development. The Chinese economy was headed for a “hard landing”, they shouted from the rooftops, and every year since such those shouts have been echoed.

Beijing quickly shifted its policy stance from an initial shock and awe fiscal package towards more nuanced monetary policy manipulation, coupled with the beginnings of a long, slow process of structural reforms. Specifically targeted was the property bubble. If successful, the government would manage to bring the Chinese economy into a “soft landing”, it was suggested. The hard-soft argument has raged ever since.

Six years on, China has posted its lowest rate of economic growth since the initial 2008 shock, at 7.3%. Arguably, Beijing has successfully brought the Chinese economy in for a soft landing, but the problem is that “landing” is ongoing. China’s slowing economy remains a consistent source of global market angst. The government continues to provide targeted parcels of stimulus, but many in the market, and within China itself, assume another full-blown stimulus package will soon be forthcoming if China’s GDP growth continues to slide.

A team of analysts from asset manager AllianceBernstein recently visited China, travelling to seven cities in four provinces, including Beijing and Shanghai. The purpose of the trip was to gain some sense of how important cyclical sectors of the Chinese economy were performing, including those of banking, basic industries, industrial machinery and property, against a difficult policy backdrop in which the Chinese government is treading a fine line between the need to implement structural reforms while also assuring economic growth remains sufficiently buoyant to avoid inflaming social tensions.

In particular, the AB analysts wanted to test the proposition that targeted stimulatory measures had helped put a base under the economy.

The analysts returned believing those investors assuming Beijing’s current policy tweaking is simply a prelude to another shock and awe nationwide stimulus package similar to that implemented in 2008 are wide of the mark. They see neither a hard nor a soft landing for the Chinese economy but rather a long one, lasting two or three years. During this period commodity-related companies will need to make painful adjustments, and some companies will default and/or collapse.

There are clearly inventory overhangs in the steel, iron ore and coal industries, AB attests. It is difficult to make generalisations about China’s property market given the industry is regionally, rather than nationally, based, but the analysts believe the challenges therein to be broadly manageable. Basic industries linked to property, such as cement production, should fare reasonably well.

It is important to note Beijing has the policy flexibility to make a long landing work. This assumes the Chinese premier sticks to his structural reform agenda. Were the government to abandon its targeted approach and revert to a broad stimulus package, AB’s view on the country would turn negative. The analysts retain their conviction at present, nonetheless, strengthened by last month’s announcement of the establishment of a new anti-corruption body.

There are signs China’s banks actually increased their property exposures in the first half of the year, despite falling property prices and ongoing property development risk. The banks AB spoke to did nevertheless note they were cautious about lending to developers and had tightened their lending practices, preferring to concentrate on specific lending such as to residential loans.

The bigger banks are reducing exposure to industries suffering from overcapacity. It is the first time AB has heard of Chinese banks not rolling over their loans to weak steel mills, which should force a speed-up in the pace of defaults and greater industry consolidation. This would prove positive in the medium term, although smaller banks are likely not reducing their own exposure to such industries as this would create cash flow and balance sheet problems.

With regard China’s infamous “shadow banking” sector, there has been little in the way of reduced exposure from the banks. Indeed one bank has increased its exposure to shadow banking, believing Beijing intends to regulate the sector rather than curtail it.

Despite the massive infrastructure program commenced in 2008, China is still deficient in cargo and passenger capacity across its railways and subways. Infrastructure will thus remain a high growth sector, albeit AB notes profit margins for state-owned enterprises need to improve and notes there are risks around slow payment by local governments. This is nothing new, nonetheless, and banks are confident payments will eventually be forthcoming, but the default of a local government would be a serious issue.

China’s coal industry is problematic, given its high cost base. Shutting down mines is uneconomic unless the shutdowns are permanent, so the alternative is to sell coal at a loss. It is thus a challenge for the sector to cut capacity. Cement producers noted a sluggish property market and slower than expected infrastructure growth as leading to a flat market, but they did not consider oversupply to be severe.

With regard the key property sector, those involved are broadly positive about the industry and believe a short term structural downturn will give way to medium to longer term growth, driven by the country’s ongoing urbanisation. Increasing exposure to property as a means of increasing profitability is nevertheless fraught with high execution risk, AB warns, although the analysts do agree ongoing urbanisation is a reason the sector is unlikely to collapse.

The market simply needs time to absorb the surplus of buildings, market participants believe, and a correction of 18-24 months is anticipated. Sales are expected to remain flat in 2015 but construction is expected to begin rebounding from the low base reached in 2014.

One concern the AB analysts had from across the economy in general was a desire for companies to grow in scale for the simple purpose of rendering them “too big to fail” in the government’s eyes, thus ensuring a bail-out if necessary. This is a dangerous attitude and perhaps Beijing needs to let one or two high-profile corporations to go to the wall to signal the government will not tolerate poorly managed businesses, AB suggests.

All in all, AB expects the prospect of a long-landing scenario for China to begin playing out over the next 12-18 months. The analysts anticipate defaults in stressed commodity-related industries such as steel, where China’s banks are reducing their exposure. The banks themselves should remain in reasonable shape given the flexibility provided by the government’s targeted liquidity measures.

Infrastructure spending should accelerate from next year once the initial shock of the anti-corruption campaign subsides, while the property sector will muddle through its challenges.

All of the above is nevertheless predicated, AB warns, on the Chinese government continuing with its reform agenda and restrained targeted support for economic growth. The analysts believe continuation is highly likely.

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