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Why China’s Manufacturing Sector Is Not Contracting

International | Oct 21 2015

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By Greg Peel

A Purchasing Managers’ Index (PMI) is a survey conducted within a particular economic sector to determine whether that sector is growing or contracting. There are three main PMIs published each month in Australia, for the manufacturing, services and construction sectors.

Japan, the eurozone and UK all publish manufacturing and services PMIs, as do many other countries, while in the US, each month there are two publications for each PMI, one by the Institute for Supply Management (ISM) which is most closely followed, but also by Markit, which publishes Japan’s and other countries’ PMIs.

In China, there are also two sets of PMIs published each month: one by independent survey conductor Markit (sponsored by Caixin) and one by the Chinese government. China’s PMIs are officially split into manufacturing and “non-manufacturing”, although in the latter case we can substitute “services”.

The two Chinese surveys are not quite “apples to apples” because Caixin’s sample set is more heavily weighted towards small and medium enterprises and away from large state-owned organisations that dominate the government’s official PMI.

A PMI is a “second derivative” measurement. It does not measure growth but the pace of growth. Thus while a PMI index is published in theory on a scale from zero to 100, mathematically zero or 100 are impossible. A measurement of 50 is considered the “neutral” level at which point growth is zero. A number above 50 implies expansion and a number below 50 implies contraction.

While zero and 100 are impossible, numbers above 70 are simply unrealistic and never seen. No industry can grow that fast. On the downside, numbers in the 30s or less are similarly very rare, although we have seen such results for the likes of Greece, for example, in recent years.

For the bigger economies, numbers implying contraction are usually contained to the 40s and expansion to the 50s, although it’s not that unusual to see a brief stint in the low 60s.

PMI releases typically appear from the first business day of the new month (or the first of month, weekend or not, in the Chinese government’s case). More recently, the Caixins and Markits of the world have taken to publishing “flash” estimates of PMI results one week ahead of the end of the month, at which point the month’s trend is becoming clear.

PMIs are considered important indicators because they offer close correlation to actual economic growth, as measured by GDP. And that’s why, particularly in recent years, they have become such potential market movers. We recall that what had been to that point a stock market pullback to August became a full-blown correction later in the month, triggered by a flash manufacturing PMI from Caixin that indicated Chinese contraction.

The Chinese government followed up at the beginning of September with an August manufacturing PMI of 49.7. Confirmation, it seemed, that China’s economy was indeed slowing and that the world should be afraid. Very afraid.

But the world, says Morgans, has got it very wrong.

The world is assuming that like every other PMI measurement on the planet, a 50 reading for Beijing’s manufacturing and services PMIs implies zero growth. Hence 49.7 implies contraction. In fact, the Chinese National Bureau of Statistics has set the neutral point to match the government’s target GDP growth rate. The zero point is therefore based on 7% growth.

Converting that into the PMI scale, Beijing’s August manufacturing PMI reading of 49.7, a number just under 50, implies a growth rate of just under 7.0%, indeed 6.9%. On Monday we learned China’s GDP grew in the September quarter at a rate of 6.9%.

Yes, this is the slowest rate of growth for China since the GFC, but sufficiently consistent with Beijing’s target rate. Where the world is getting it wrong, Morgans implies, is in believing that if the Chinese manufacturing PMI remains under 50 then it is continuing to contract. September’s result was 49.8. But in actual fact it just means the sector is not growing as fast as the target GDP growth rate suggests.

Prior to issuing its Fourth Quarter Investment Strategy, Morgans had not yet seen China’s September GDP numbers. But the analysts have broken down the previous June quarter results.

China’s GDP grew at an annual rate of 7.0% in the quarter. On a segmental basis, the manufacturing sector grew at 6.0%. The service sector grew at 8.5%. Within that sector, finance grew at a solid 19.2%.

Clearly there is a close correlation with China’s manufacturing sector GDP contribution and the manufacturing PMI. There is also a close correlation with monthly industrial production numbers. In August Chinese industrial production grew at an annual rate of 6.1%. Within that particular number, state-owned enterprises saw a slower rate of growth but private sector enterprises grew by 10.3%.

This suggests, Morgans believes, that Beijing is looking to increase productivity by supporting private sector growth ahead of state-owned enterprises. The government is trying to transition the economy away from being export driven to being driven by domestic consumption. This requires an increase in disposable income, Morgans notes. In the June quarter disposable income grew by 9.0%.

“It may be that the recovery in domestic demand and domestic consumption that the Chinese government wants to achieve is just now beginning to occur,” says Morgans.

And it just may be that every time global markets panic over a Chinese PMI result under 50, they are drawing the wrong conclusion.

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