Why A Soft-Landing Is Bad For China

Counter-cyclical measures cannot solve structural problems. If the market is counting on monetary easing or fiscal stimulus to lift the Chinese economy out of the current slump, we believe they will be disappointed (as we have discussed a number of times recently). Without major structural reforms, we believe, like Credit Suisse, that China will be growing around 7-8% in the coming years, rather than the coming quarters.



Via Credit Suisse: China, The New Norm For Growth

The core problem is the sudden disappearance of investment interest from the private sector. Local governments and the NDRC have announced significant infrastructure investment plans. However, we think that their funding remains unresolved and that government-funded infrastructure investment is not a substitute for private investments in the long run.

Anything but short-term funding is not being borrowed currently...


On the structural front, we believe China needs to open its service sector to private capital, cut corporate tax and break the monopolies in the banking and utility sectors. Unlike much of the manufacturing sector, many parts of the service sector, such as healthcare, education, environmental protection and asset management, are profitable and have room for efficiency gains.


The market, it would appear, is factoring in a global growth slowdown (which will be quickly recovered from thanks to Central Bank largesse). As Credit Suisse notes, though, in the case of China as a growth engine via stimulus, the market is not quite prepared for a prolonged slowdown and its repercussions on corporate cash flows. To us, what ultimately matters is not how far economic growth will fall, but how long it will fall. Credit Suisse's base case scenario is that consumption can prevent the economy from a hard landing. Yet, any strong rebound is unlikely without the re-engagement of private investment. GDP growth has been stuck in a range of 7-8.5%, in our view.

To economists, this is good news because it represents a soft landing. From a corporate perspective, this is unfavorable news as the debt accumulated during the boom time may start to have negative repercussions. Merely two years ago, in a negative real interest rate environment, excessive borrowing was good as bank credit was ‘free money’ to take home. Companies in China also have a tradition of doing cross-guarantees. But when the business environment deteriorates, pricing power diminishes and account receivables surge, the debt chain tends to break down at the weakest link. Anecdotally, account receivables appear to be rising quickly.

For global commodity and machinery producers, this would mean that demand from China will not rebound soon. In fact, there may be more risk on the downside than the upside. Furthermore, as the economy becomes more dependent on consumption instead of housing and infrastructure investments, the propensity for capital goods usage is likely to decline. When capital intensive industries are consolidating, power demand may decline more than GDP growth would imply.


A key question now is whether the leaders in Beijing will be willing to bite the bullet and undertake more structural reforms. We do see some signs of willingness, in areas like the social safety net, subsidized housing and interest rate deregulation, but these tend to be less controversial than others. Whether a breakthrough can be executed still remains to be seen. We suspect there could be a strong preference for gradualism, at least.

Traditionally, China has bitten the bullet when its economy has been cornered, which was the case for both relaunching the special economic zones and joining the WTO. The most likely catalyst to force the government’s hand, in our view, would be a plunge in the property sector. This scenario is unlikely to happen in the coming six months, but is more likely in the next six years, in our view. Until the structural issues have been addressed, we expect mediocre growth to be the new norm in China.


Bottom Line - It's The Cash-Glow Stupid and a soft-landing does not provide the cover for the exponential credit extension that occurred in the past to be contonued. Combined with lower FAI, there is not much hope for a 'rebound' in Chinese growth, and there is pain to come for the over-levered as govt funding is not is not in a hurry to be deployed... they need major structural reform (and that involves COST!).