The most common pushback from any China bull, industrial commodity bull, US equity market bull, or in fact any risk market in general "bull" is "won't the authorities just pull the trigger? Won't they just stimulate?" As UBS Commodities group notes, The debate is most advanced for China and for industrial commodities, where the weakness in the economy, and the sharp commodity price falls of recent weeks, has consensus looking for a stimulus driven bounce. UBS does not think so - the authorities in China and the US have become increasingly focused on structural issues - which, simply put, means they are less willing to act than before.
Via UBS Commodities & Mining,
Many investors are relying on what UBS calls "Bazooka theory" to protect them from any potential downside...
Over the past decade, China investors have used a couple of rules of thumb to trade domestic and commodity markets. When total social financing slips to 15% y/y, and when the Shanghai A Share Index falls towards 2000, expect a stimulus. We appear to be in that zone.
And as UBS notes, investors are right to be expectant as the macro data is not strong...
we don’t rely on the GDP data, where a client pointed out to us that, in 2013, no region in China reported lower GDP growth than the national average.
Instead, we rely on the three indicators highlighted by Li Keqiang a decade ago, when he was party secretary for Liaoning; electricity production, volume of rail freight and loan disbursements. We use our macro team’s total social financing series (Fig 3.) as a proxy for loan disbursements.
Clearly rail freight is weak. Electricity production is more robust, although it has lost a little momentum.
And we watch steel consumption and pricing. Carsten Riek, European steel analyst, pointed out in 'China's steel mills to limit global steel recovery', 25 March 2014, that China steel consumption is down 1.3% y/y. Carsten uses the worldsteel production data that UBS has used consistently in its global steel modelling (worldsteel rationalises sometimes conflicting data from CISA and the China steel council). We believe the fall reflects two key developments;
• An end of restocking
• Weak underlying demand.
So will the China authorities stimulate?
It is a key question. Stimulus may allow a solid, consensus like demand performance for the commodities across 2014. But without aggressive stimulus, commodity demand will likely fall well short of consensus – leading to larger surpluses and lower prices than consensus anticipates.
We always saw stimulus in the past when the Shanghai A Share Index fell towards 2000 and when renminbi loan growth decelerated below 15%.
The standard view on China is that the Party’s main aim is the continuation of power, and so it won’t tolerate a slowdown in growth below 7% (otherwise popular support for the party will fail). We agree that the main ambition of the party is to extend its rule. But we disagree that this means that GDP growth won’t be allowed to fall below 7%. We understand that Xi Jinping and Li Keqiang see structural reform as a more important target than short-term growth. Commentary following the China development forum earlier in March also indicated a consensus that there was considerable flexibility around growth targets.
We understand that this stems from the politbureau’s deep study of previous regimes; whether Russia from the 50’s to the 80s, or Japan and the Asian Tigers in the 80s and 90s. In each case, the lack of decisive reform after a period of deteriorating returns on capital led to malaise and, in Russia’s case, collapse. We suspect that the reinjection of liquidity into the system from July 2013, was in part to buy time to allow Li Keqiang and Xi Jinping push forward the deep and wide-ranging reform agenda that they delivered during the third plenum in November 2013.
Prior to the third plenum, Li Keqiang stated; ‘Pursuing reform in the face of vested interests is akin to stirring the soul’. Now something of the meaning may have been lost as it went through ‘Google Translate’, but in commodity strategy we see this as a clear shot across the boughs of the vested interests in state-owned enterprises (SoEs).
China’s political process is highly factional. The anti-reform factions have in the past pointed to slowing growth as a signal that reforms had gone too far, and used it to undermine the reformists’ political standing.
But we believe that Li Keqiang and Xi Jinping have orchestrated the reform process to quietly but fundamentally weaken the powerbase of these vested interests. The crackdown on corruption is the most clearcut reform. Some China watchers see it as a political masterstroke from Xi Jinping. The corruption probes have clipped the wings of key anti-reform politicians. And they act as a latent threat against anyone who might seek to stand in the way of reform in the future.
Beyond that, the tightening of net interest margins at the banks, electricity and coal price reform, and the controls on corporate and private property speculation all put pressure on vested interests. All enhance Xi Jinping’s and Li Keqiang’s power base.
Further evidence from the reform process to date indicates a persistent intention to push forward.
Xi Jinping’s decision to chair the shadow banking reform committee, normally chaired by the premier or a more junior official, seems a clear signal that Beijing intends to get shadow bank lending under control. The decision to allow the rmb to weaken from the start of the year, and to widen the rmb trading band is also suggests that the authorities intend to disincentivise China dollar borrowing, and hot money speculative inflows. The fact that the move came when underlying growth was lacklustre is testament to the current political will.
Li Keqiang’s speech in March, which indicated a willingness to allow corporate defaults (albeit not to allow the spread of contagion), is also a strong message on reform.
But of all the measures to date, Beijing’s decision to allow bond yields to rise over the past six months without significant policy interference is the policy action that shows greatest intent.
As UBS goes to note, China’s policy of financial repression has created substantial distortions. As the chart below shows the process has been virtuous for years but has major risks of reversing in a vicious manner...
China has paid negative real rates on savings for much of the last decade.
In China, this induced consumers to raise savings (left hand arrows in Figure 8). That’s because consumers had to build a nest-egg for their retirement, in the absence of sufficient grandchildren to look after them in old age (because of the one child policy) or a decent social safety net. But lower real rates reduce the size of that nest egg, compared to their target. That induced consumers to save more, and as a result, consumer spending fell from an emerging market average rate of 45% of GDP in 1995, to an all-time/all country low of 40% in 2002. It currently stands at 35%.
We suspect that corruption and easy money may have induced asset reflation, in as much as it has skewed China’s income inequality to one of the highest in the world, and also had a significant effect of raising savings rates (all things equal, societies with more skewed income distributions save more – see ‘23 things they don't tell you about capitalism’ by Cambridge professor Ha-Joon Chang).
At the same time the second and third set of arrows in Figure 8 showed the distortions this creates; inducing excessive property speculation and excessive fixed capital formation. This in turn causes diminishing returns on capital, and the potential for bad loans to develop.
For much of the last thirty years, the massive productivity boost from migration (500m people saw their productivity up 13x as they moved from working the land to working in factories), as well as the demographic benefit of a growing workforce, more than outweighed the negatives from the misallocation of capital. But all this changed with the extraordinary lending and capex boom from 2009-11. It was a period that saw lending and fixed capital formation double – an event unprecedented in emerging market history.
Raising bond yields threatens to reverse this process. It helps the consumer, who can save less. But it hurts property speculation and it hurts fixed capital formation. The fact the authorities have allowed this to take place without intervention is a profoundly important move; as the higher real rates will dampen property activity and fixed capital formation. That in turn depresses activity, and undermines pricing power in China’s heavy industry.
We have seen this in the weak China data highlighted earlier, and the combination of rising wages and falling prices suffered by the coal, steel, cement and other heavy industries. The danger here is that the process pressures profits, and reveals bad loans.
The authorities’ willingness to engineer and then tolerate these developments appears to be a strong signal that Li Keqiang and Xi Jinping are serious about reform.
This discussion leads UBS to believe there two conclusions that last night's mini-railway-focused stimulus seems to confirm...
- The China authorities intend to hold to the reform agenda.
- Any stimulus will be moderate and directed.
Tao Wang, UBS China economist believes that it is too early to roll out stimulus, but that the authorities may push a directed ‘mini-stimulus’ if conditions remain weak into 2Q14 (see China Focus: '2014 GDP Growth Forecast Cut to 7.5% on a Weaker Start', 13 March 2014). Any stimulus would be small and directed into key areas;
• Building the social safety net.
• Environmental projects.
• Social housing, hospitals, schools, water treatment, urban public transport.
The monetary authorities will intervene to prevent a banking crisis through providing liquidity to large and small banks to smooth over solvency concerns. Tao highlights possible reserve requirement or loan/deposit ratio cuts in the face of a default-driven credit squeeze. But neither she nor we anticipate an aggressive credit expansion aimed at boosting private property speculation, heavy industry expansion or non-directed local government infrastructure spending.
Finance minister Zhou Guangyou’s comments on 23rd March that there will not be any ‘Big Stimulus’ from Beijing in 2014, and that the focus on quality of growth means no ‘shotgun stimulus program’ appear to be consistent with this view.
This in turn means that the base case is that growth will likely moderate over the next three years, and that commodity intensity will fall. It is entirely likely that we will see years where China commodity demand growth is zero or negative.
There are lessons here from Japan...
That suggests barely any growth in offtake for iron ore and copper in 2014. This is a much more conservative outcome than the 6-7% copper growth and 4% iron ore demand growth that consensus or our bottom-up team are looking for. We would also highlight that the Chinese authorities’ decision to reform does not rule out the potential for a harder landing. In commodity strategy we maintain the view that the probability of this type is even greater than consensus believes. Credit growth is now much less effective in driving GDP growth than in the 2000s. This was the same red flag that warned of an impending deterioration in Japan in the ‘90s.
This analysis makes us more cautious than our economists and our bottom-up commodity analysts. UBS China economist Tao Wang is looking for a moderate acceleration in activity in 2Q14. Our bottom-up commodity team also anticipates a seasonal bounce, before conditions deteriorate later this year