Those silly enough to believe that China's economy has "recovered" should at least been given some pause by this week's events. For China surprised the market with moves to reduce liquidity in the banking system and curb the property market. Clearly, the government is worried about the re-appearance of bubbles due to excessive credit growth. And they should be worried because it's obvious that the bubbles which caused China's slowdown never went away. In fact, they've gotten worse from government stimulus designed to prevent a hard economic landing. These government actions have made the chances of an imminent China crash more likely.
Double, double toil and trouble
Just when the world had bought into a Chinese economic recovery, along comes the government throwing proverbial spanners in the works. Actually, they're more like grenages.
According to Bloomberg, China's central bank has drained Rmb910 billion (US$145 billion) from the banking system this week, a record high weekly net drain. Reducing liquidity after Chinese New Year is normal, as is increasing liquidity prior to this holiday. But the extent of the liquidity reduction dwarfed the Rmb 662 billion added before the New Year. To put this in some context, the People's Bank of China has now drained a net Rmb548 billion from the banking system this year. This compares with a net injection of Rmb1.44 trillion last year.
On top of this news came calls from outgoing Chinese Premier Wen Jiabao for local governments to impose home price restrictions and "decisively" curb housing market speculation. He described house price gains as "excessively fast" and also ordered major municipalities to publish annual price control targets. It's obvious that the government is concerned with three things:
- Local governments are again turning to fixed asset investment, particularly property sales, to boost their revenue and GDP. The problem is that local governments own the land so they're incentivised to sell that land to get revenues. These governments are already heavily in debt and this is exacerbating the issue.
- Property sales have led to increased bank lending, as January figures attest too. This is not what the government wants given total credit to GDP is already high, at 190% according to Fitch.
- More broadly, the property bubble has never really deflated. As economist Andy Xie points out, NBS data shows 10.6 billion square metres of property was under construction at the end of last year, half in residential and the other half in office/commercial. If you put market prices on this inventory, it equates to 1.5x Chinese GDP. Quite the bubble.
Why the noose is tightening
The vast majority of economists will tell you that the government's actions are prudent and will ensure that the economic recovery remains on track. They'll site all kinds of data to show that a recovery is on the cards. After all, GDP increased 7.9% in the fourth quarter of 2012, compared with the 7.4% in the third quarter. Exports in January grew 25% from a year earlier, while imports surged 29%. New lending from banks in January more than doubled from December. Total social lending - a broad measure of liquidity in the economy - increased to Rmb2.5 trillion in January, from Rmb1.63 trillion in December. Impressive stats indeed.
But I'd suggest that economists who take this data at face value are either extraordinarily lazy, ignorant of basic economics or both. Here are three initial quibbles:
- Anyone taking GDP growth as a sign of economic health needs to be seriously questioned. GDP growth in developed world economies before the 2008 crisis was supposedly showing healthy economies when they were anything but.
- Anyone taking GDP growth in China as a sign of economic health needs more serious help. The GDP figures can't get more rubbery, as highlighted by recent reports suggesting the real GDP growth for China was closer to 5.5% in 2012, rather than the 7.8% recorded.
- I was one of the first to question the export data out of China late last year and the latest data makes me more sceptical. Exports from China to its largest partner, Europe, are sharply recovering, really? Given the deterioration in European economies, it's more than a little hard to believe.
So the extent of the economic recovery as indicated by the data needs to be questioned. More importantly though, a simpler, broader question needs to be asked: what has driven this seeming recovery? And it's here that the answer should concern eveyone.
For China is repeating the same mistakes that it made post the financial crisis. Back then, the government unveiled an enormous Rmb4 trillion (US$640 billion) package to ward off an economic slump after developed market economies crashed. They primarily stimulated the economy via infrastructure and property-related investment, fuelled almost exclusively by debt. It seemingly saved the day as China's economy roared back into life.
But then the hangover began in 2011. The investment garnered little if any returns in industries which were already suffering from over-capacity. Property prices started levelling off after a decade of super-charged returns, as it became obvious that demand couldn't meet the endless supply. And bad debts at banks undoubtedly skyrocketed, but have remained hidden to this day.
An investment-driven, debt-fuelled binge had seemingly come to an end. Even the government had privately told investors and stockbrokers that this binge was a mistake.
I, for one, believed them. Six months ago, I thought an economic soft landing was likely as the government wouldn't repeat the mistakes of 2009-2010. But that assumption was wrong.
As the economic downturn gathered steam in the second quarter of last year, the government turned to the easiest way it knew how to boost economic activity: fixed asset investment funded by debt. The central government officially unveiled a Rmb1 trillion (US$160 billion) infrastructure package in September last year. Unofficially, local governments launched a similar package totalling up to Rmb13 trillion (US$2.1 trillion).
How much of this money has been spent isn't clear. But infrastructure spend and property investment figures suggest much of it has been put to work. And total credit financing figures, as mentioned above for January, are showing a sharp increase from the first half of last year. The unique thing this time around is that the debt financing is being done less via traditional banks but non-banks. In 2012, total credit financing grew 20%, with trust loans up 80%, FX loans up 27% and bond financing increasing 45%.
Credit Suisse estimates that the so-called shadow banking system now totals Rmb22.8 trillion or 44% of GDP, making it the second largest asset class in China!
All of this means that an economy that was unbalanced and fragile before 2012, has become more so thanks to the governments actions. The options to maintain the investment-led, credit boom are narrowing, and fast. As hedge fund titan Jim Chanos said of China: "They're on a treadmill to hell". Meaning, they either try to keep the bubbles going to maintain economic growth or they don't and risk an immediate economic crash.
Can China prevent a crash?
Now, the same economists who proclaim a Chinese economic recovery will also suggest that a hard landing isn't possible because China has the money to throw at any problems. They'll point to considerable savings, at 53% of GDP, and US$3.3 trillion in foreign exchange reserves.
There are several large holes in this argument. China's foreign exchange reserves cannot be swiftly used to help prevent an economic crisis. The majority of these reserves are tied up in U.S. government bonds. If China decided to sell just 10% of these bonds to throw at its own economy, it would have severe consequences. U.S. interest rates would spike, the U.S. economy would tank, closely followed by economies around the world. China's export-reliant economy would also be impacted. In other words, the forex reserves argument is largely an illusion.
That's not too mention that China's forex reserves have crawled to a stand-still: they're not growing anymore. If these reserves start to decline, it would mean China would need to start selling renminbi to maintain its currency peg. This would be deflationary.
The savings argument has some more merit. But anyone that has money in China and can get it out, is doing just that at present. The Chinese have few good options as deposit rates are negligible, they don't trust the stock market given its woeful performance since 2007 and property has become a less reliable investment too.
The other question that needs to be asked is: firepower for what? How can the money be productively used to both prevent a crash and re-orientate the economy to a more sustainable path. The likely answer is that it can't be: the bubbles have gone on for too long and are too large.
The best solution for China is to reduce its reliance on investment and promote the services sector. Doing this quickly though would mean plummeting economic growth. Doing it slowly would the bubbles of today could get larger and more problematic.
Sell China stocks
In October last year, I suggested that it was time to buy Chinese stocks. It was a short-term trade based on the extreme negative sentiment then towards both China and its stocks. It was not based on an improving economy, but the fact that a lot of the negativity had been baked into share prices.
I was about five weeks early in picking a bottom to the market, but since then there have been some nice gains. Now though is the time to get much more cautious and sell out of China stocks. And also think carefully about the wider ramifications of a potential China hard landing, in terms of countries and sectors most impacted (think Australia, Canada, industrial metals etc).
This post was originally published at Asia Confidential: http://asiaconf.com