As even the most casual observers are no doubt aware, China’s transition from investment to consumption-led growth is one of the major reasons why global demand and trade remain stuck in low gear seven years after the crisis. Indeed, the massive overbuild that occurred in the lead-up to 2008 was a direct result of the pervasive (and exceptionally naive) assumption that Chinese demand and the double-digit GDP growth that stood behind it would persist in perpetuity.
This assumption was foolhardy even if we pretend the crisis did not occur. That is, investment-led growth simply cannot last forever. Not even in China, where rapid urbanization and an unprecedented infrastructure build-out once seemed to suggest that the bid for raw materials would remain essentially limitless for the foreseeable future.
Make no mistake, the timing of China’s transition is inopportune. If ever the world economy could use a shot in the arm it’s now. We now know that central bank stimulus isn’t immune to the law of diminishing returns, and indeed, it’s not entirely clear that QE’s supposed aggregate demand transmission mechanism (the fabled “wealth effect”) ever really existed in the first place.
In short, the world needs real stimulus (i.e. demand that isn’t driven by printing press money), but China’s move away from the smokestack and towards consumption and services may mean a true recovery is impossible. As Credit Suisse noted last week, "typically a move from investment to consumption-led growth leads to a halving of the growth rate."
So where are we now?
At this juncture, the question doesn’t seem to be so much about whether the Chinese economy can re-accelerate and reclaim the breakneck growth of the past.
Or at least not by depending on investment and a re-flation of the property bubble.
The hope now is that the oversupply and overcapacity have largely been absorbed and that investment demand doesn’t slump further.
For UBS, the outlook is not good in that regard. In fact, the bank believes China’s property "adjustment" is only "half way through." In the excerpts below, take particular note not only of the color the bank provides on everything mentioned above (i.e. raw materials demand, FAI, and the read-through for imports and the global economy in general), but also of the color on the implications for consumption (vehicle sales, etc), asset performance in the financial sector, and fiscal strains for local governments (which, you're reminded, are currently executing a critical refi effort that will eventually total some CNY20 trillion).
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Bubble trouble: halfway through?
Back in May 2014, we pointed out that China was starting to undergo a structural property downturn which was not driven by policy tightening – as has happened in the past – but characterized by general oversupply and faltering investment demand. While the underlying "final user" demand from urbanization and upgrading has been stable, new housing supply had until 2013 been expanding rapidly, increasingly exceeding final-user demand (Figure 1). At the same time, investment demand, which previously filled in this gap, had been eroded by a sharp increase in real interest rates, stagnating or falling property prices, the rise of alternative onshore and offshore investment channels, and changing RMB exchange rate expectations. We thought this shift in the supply/demand balance and large inventory overhang would lead to a multi-year property downshift starting in 2014, dragging down with it industrial and mining production and investment and GDP growth, with serious ramifications for China's financial sector and commodity-related sectors, and prompting policy easing to mitigate and offset the downturn.
The property downturn has been the key factor behind weaker investment and industrial activity. Given the extensive linkages between China's property and industrial sectors, the downshift in property construction has brought increasing headwinds to the latter, affecting mining and heavy industries such as metals, construction materials, and construction machinery the most (Figure 3-4). Deteriorating production in energy-intensive heavy industry has also weighed down power generation, which has slowed and stagnated since early 2014. Weak industrial sales consequently aggravated excess capacity situation, depressing investment in the industrial sector and seen manufacturing investment slow from 18.5% in 2013 to 13.5% in 2014, and further to 9.7%y/y in H1 2015.
Softened property activity has also weighed on consumption and fiscal conditions. The drop in property sales and prices across most cities had led to a negative wealth effect, compounded by a slower pace of wage and household income growth caused by weaker overall economic growth. This has affected sales of not only household durable goods, but also autos, whose sales volume slowed from 13.9% in 2013 to 6.8% in 2014, and further to 1.5%y/y in H1 2015. Meanwhile, fiscal conditions, especially at the local government level, have deteriorated in line with falling land sales and property-related tax revenue. This has significantly constrained local governments' spending capacity, especially on fixed investment. In the first half of 2015, local government land sales revenue plummeted by a sharp 38%y/y.
As we anticipated, the property downturn has seen China's trade surplus increase and exchange rate remain stable, counter to some market concern. Given the importance of China's property sector as the final demand for global commodities, the former's downturn has led to weaker imports and much lower prices of some commodities (Figure 5). In addition, the property downturn has depressed China's overall domestic investment (Figure 6), which has also dampened its imports of investment goods in general. As a result, China's imports dropped, causing its trade surplus to rise from USD 259 billion in 2013 to 382 billion in 2014 despite a weak export performance. The rise in China's trade surplus helped to support the exchange rate, as did the government's consideration for RMB internationalization. The government's desire to stabilize exchange rate expectations have also helped underpin RMB exchange rate, despite increased capital outflows in H2 2014 and early 2015.
Not surprisingly, non-performing loans in China's banking system rose, though only modestly considering its large property-related exposure. Banks' risk exposure comes not only from loans to developers and housing mortgage, but also from loans collateralized by property and land, fast expanding shadow banking credit, and loans to other industries and LGFVs that are closely related to property. By Q1 this year, banking system NPL ratio had climbed further from 1.25% at end 2014 to 1.39% (Figure 7). Indeed, CBRC highlighted property as a key source of risk. We think the property downturn has likely led to a greater worsening in asset quality in many related sectors. The modest increase in China's official NPL ratio and the lack of major credit events in its shadow banking sector partly reflect policy efforts to contain financial risks, by for example, allowing banks to roll over loans, pushing through local government debt swaps, and having local governments arranging bailouts or loan renegotiations. In addition, monetary easing has resulted in lower money market rates and allowed for the expansion of more formal bank lending, which has helped to bring some off-balance sheet credit back onto banks' balance sheet.
Although sales have improved notably in recent months, judging from the destocking process especially in tier 3 and 4 cities, we believe that the adjustment in China's property construction is only halfway through.
Despite expected the sales improvement, the ongoing downshift in property construction will continue to undercut China's demand for commodities, raw materials and machinery, weigh on property as well as mining and industrial investment, and be a drag for overall GDP growth in 2016. We expect real estate FAI to slow further to about 2% in 2016, dragging down overall FAI investment to 10% despite the assumed further policy support for infrastructure investment.
Continued downward adjustments in property construction will have wider ramifications for corporate and local government finances, and banks' asset quality. Revenue and cash flows in sectors which supply to property construction will become increasingly strained. Local governments will have to reduce their reliance on property related tax and land sales revenue. Banks' asset quality is likely to deteriorate further, both from their direct exposure to the property sector, and indirectly to other affected corporate sectors.
As the largest emerging economy in the world and having contributed about one third to global GDP growth since 2010, China's property downturn is inevitably affecting almost every market. The most direct and important channel through which this impact spreads is trade linkages, given China's role as the top exporter and second largest importer in the world. China's property construction slowdown so far has clearly hit commodity exporters the hardest and they will face further headwinds in the next couple of years until China's property construction activity stabilizes. Many economies in Asia have also felt the pain from China's downturn as their exposure to China's domestic demand had grown considerably in recent years. As China's property construction continues to slow this year and in 2016, China's imports of capital goods from countries like Korea will likely drag their growth further.