Rudi's View | Sep 28 2011
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck, Editor FNArena
Earlier this year commodities analysts observed China's monthly manufacturing index was noticeably at a lower level than usual. This, some analysts suggested, proved the government in Beijing had a firm control on overall financing and economic activities inside the Middle Kingdom and government policies had now all but flattened the usual seasonal patterns that had characterised Chinese data and demand in the years prior to 2011.
I found this a strange reasoning in May this year and I still find it strange today.
When I looked at the same charts my initial thoughts were China's gradual tightening is slowing down the economy, not the government is flattening out seasonal patterns. My view has been vindicated since with this month's HSBC Flash PMI for China indicating the manufacturing sector remains in mild contraction for the third consecutive month.
This does not mean the Chinese economy is headed for a hard landing. Personally, I believe financial media are too much focused on potential extremities -hard landing or not- while stockbrokers and market commentators allow themselves to be sucked in. The real message that is emanating from Chinese data is the same message that still applies today: China is transforming towards a gradually lower gear of growth. Whether investors like it or not, this will have consequences elsewhere.
Firstly, let's have a look at China's main growth engine in years past as this will instantly show why too much talk about a pending hard landing for China is just that; too much talk. With economies in Europe, the US and elsewhere faltering post the Lehman collapse, the Chinese authorities used local banks and the current account surplus to solidify economic growth by ramping up infrastructure projects worth trillions of dollars. Not all funds were wisely spent as witnessed by the YouTube revelations about Chinese ghost cities, but the policy did protect China from joining Europe and the US into the financial abyss and in fact, it has helped Greater China and the rest of the world in successfully dealing with the US deflationary fall-out.
The policy is not a perpetual medicine, however. It is in the same breath the reason why many an economist feels at least a little uncomfortable with China's economy becoming the hope for many others elsewhere, including in Australia. China is not unique. Not so long ago Japan and Korea went through a similar phase, and before that it was Germany. One hundred years ago the US went through a similar growth phase. What makes China unique today is the uncomfortably high reliance of the economy on ongoing strong investment spending. This is why the likes of hedge fund investor Jim Chanos have been talking about the next crash waiting to happen.
In 2010 China was, against the odds, still growing at double-digit speed. Look at the details behind the reported GDP data and one sees an ever declining contribution of Chinese households and growing importance of infrastructure spending to sustain economic growth. Last year the investment-to-GDP ratio for the country reached 48.5%. This, economists point out, marked a new milestone for no other country in the history of mankind has ever shown a similar ratio. Japan and Korea, during their own fast growth phases, had ratios of 40%. China's is practically half of its (high) GDP growth.
Already a few negative consequences have come to the surface. Local government debt in China doubled between 2008-10 to reach RMB10.7tn, lifting total government debt to circa 45% of GDP (there's eternal discussion about these estimates and data with some economists putting the numbers at much higher levels, but let's stick with these for now). Also predictably, Chinese banks are starting to see a rise in doubtful and non-performing loans (another heavily discussed topic). Equally important, and equally non-surprising, the return on all these investments is in gradual decline.
The latter effectively makes the current policy of economic stimulus unsustainable. Earlier this month, China specialists at Citi concluded: "It becomes increasingly clear that aggregate demand created by low-yielding investment would increase government debt and banks’ NPLs, and cannot support sustainable growth".
We all know the solution. Chinese growth has to switch from infrastructure spending to local demand from households and businesses. This is already happening, at slow pace, as the Chinese authorities know full well their current policy cannot be relied upon in perpetuity. Assuming the transformation goes smoothly, which is no sinecure with downward pressures on China's exports to Europe and to the US, economists the world around are virtually united in their prediction this will ultimately result in a Chinese economy growing at 5-6% per annum, instead of the 10-14% we have seen in years past.
China also has the additional problem that favourable dynamics from demographics have started to reverse. Labour costs are firmly on the rise. One way to deal with this challenge is through increased productivity and Chinese manufacturers are already embracing robotics and modern technologies, as well as through the development of a local services industry. The latter will become an important tool in developing internal demand, but economists also believe more services will equal lower trend growth as it is much easier to improve productivity in manufacturing than it is in services.
There is more than just a fair chance that what we are experiencing right now is the early stage of what will be a significant transformation for tomorrow's economic super power. The problem is, we cannot know for certain because the world's attention is firmly focused on Europe either imploding, or spiraling into recession, or both. Meanwhile, the jury is still out whether the US will remain in low growth mode, or whether the world's largest economy will experience its own recession (pulled down by Europe?) in 2012. And China? Well, as I stated in the opening sentences of today's story, China's growth is slowing down at a time when the existing policy of massive infrastructure investments are becoming less and less attractive, with inflation at elevated levels and labour costs on the rise.
For commodities, the main threat does not come from the inevitable transformation of China's internal growth dynamics, but from liquidity tightening measures by Chinese authorities and the People's Bank of China. As pointed out by many a China observer, these tightening measures are impacting particularly hard on small and medium sized companies in the country, and many have been forced to seek alternative routes to access cash as Chinese banks, on directive from Beijing, reined in their lending. Many of these alternative funding routes have a direct link to commodities, supporting my personal view that apparent commodities demand from China is partly fueled by "financial" demand. It remains anyone's guess as to how large exactly this financial demand is in the bigger scheme of things.
Anecdotal evidence suggests that at the very least there is potential for unforeseen mayhem were commodity prices to continue to weaken. The reason is the widespread practice amongst Chinese SMEs to acquire physical commodities and then arrange "inventory financing" through Chinese banks, which effectively gives them access to fresh cash. It doesn't take a genius to figure out that these types of financing deals come unstuck when the value of the underlying collateral -say a tonne of copper- decreases in value. Already, some analysts have started to become quite uncomfortable about this. After all, copper is down close to 30% from its peak earlier this year and it would appear the red metal was the crowd's favourite when setting up these deals.
For good measure: nobody knows exactly how big of a threat this "inventory financing" is or how important it can become, neither can we find out how far commodity prices have to fall to trigger a negative spiral from China. The only insights we have today are anecdotal, speculation or pure guesswork. But don't be surprised if we start reading more about this in weeks or months ahead.
(This story was originally written on Monday, 26th September 2011. It was mailed out on the day to paying subscribers of FNArena).
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