Overnight the People’s Daily published an interview with “anonymous authorities” on the topic of China's economy. It’s a very important article as the “anonymous authorities” is considered to be Mr. Liu He, who is the economy brain of President Xi Jinping. The interview sends strong signals that China policy will shift from its aggressive easing in Q1 to a conservative position which focus on structural reforms.
People’s Daily also published the “anonymous authorities” interviews in May 2015 and Jan 2016, which led to the subsequent collapse in the China A share market, because Mr. Liu (and President Xi’s camp) has been promoting structure reforms and risk controls. For a credit driven China economy and the associated highly leveraged equities/commodities/properties markets, these’re the bad news. The A share market and China domestic commodities market had a big fall last night. Many overseas investors may think last night’s chaos is driven by the weak April import/export data announced during the weekend. I can tell you that it’s not. The local Chinese take the “anonymous authorities” article seriously and his opinion will have much deeper impact for China in the coming quarters.
Shanghai composite index performance after the “anonymous authorities” articles
In general, the interview denied the “demand driven” stimulus policy adopted by China in Q1. Like other governments in the world, the CCP party and Chinese government have different sub-parties internally holding different views of the economy. They believe their own claims are the best for China and advocate their ideas when the reality cling to them. For example, when the economy is really bad, the pro-growth camp will have upper hands and is able to push for their demand driven policies. That’s why we see China swings between structural reform and demand stimulus in the last two years. China pumped $1tn credit in Q1 to stop the falling knife, and this really cross the line of structural reform camp, so that’s why we see the article comes out right now. As the Politburo economy meeting just finished in the end of April, I believe the article delivers the consensus message agreed in the meeting.
I translate the key message of the interview below and add my comment in blue color.
1. China’s economy will run as a L shape, not a U shape or V shape. L shape is a long process, but not just a one or two years’ period.
It’s the first time the government outlines a clear picture of what the economy will look like, and that’s their core judgement. Some China analysts have been calling for U shape after couple key indicators picked up in Q1, but apparently, the government see the current challenges are difficult and will last much longer. If there’s no recovery for China and the recession will go longer, it means those high financial leverage China plays such as some commodities producers will go to zero, as time is the biggest enemy for them. Remember the US coal industry? Almost the whole industry file chapter 11 after four years’ coal price downturn.
However, Chinese government is still too optimistic about the shape. Chinese investors make fun of the L shape statement as it technically can be drawn in four forms as below:
I will agree with the first one
2. In general, the economy meets our expectation currently, but the structural problems are not resolved yet and new issues come out beyond our expectations. We still use the old methods (refers to investment and leverage driven GDP) to stabilize the economy, which brings pressure to fiscal balance and raise the risk of economy. We see risks in the area of lack of private investments, property bubbles, overcapacity, local government loan, equity market, currency market, credit market and illegal fund raising. So, it’s hard to simply say we have a good start in 2016. However, China economy is resilient, and has great potential and sufficient buffer room. Even we do not stimulate, the GDP growth will not have a free fall.
The “anonymous authorities” are not happy about investment and leverage driven GDP and don’t think it’s sustainable. Specifically, he points out nine risk areas which need to address, and he mention “property bubble” in this interview for the first time ever. It shows that the government has clear understanding of the risk areas and will try to curb them down, so that’s why he tries to hold back the stimulus which will make the issue worse. In the coming quarters, the credit boom will be kept controlled and not allowed to flow aggressively into these areas. I agree that his measurement will benefit China in the long run, but I don’t share the same confidence of economy bottoming.
3. We need to use both supply side and demand side policies to boost macro economy, but the focus should be different at various stage. Right now, supply side reform is the major problem and should be our top priority. Investment expansion is a supplemental policy and we cannot rely on it.
Again, clear message, the crazy credit and investment in Q1 is not appropriate. Going forward, government focus will return back to supply side reform. Therefore, Q1 is the peak for investment demand, we will see it slow down in the next couple quarters. Bad news for commodities.
4. High leverage will bring higher risks. If we cannot control leverage well, it will heighten systematic financial risk, lead to negative GDP growth and swallow normal people’s saving. We cannot rely on high leverage to boost GDP. Compared to slower GDP, the risk of high leverage is more damaging, so we should put more focus on control of leverage. The worst outcome is trying promote GDP with more leverage.
High leverage is the Viagra for a commodity driven economy. The article points out the risk and admit that stabilizing economy (adding leverage) and controlling risk (deleveraging) are conflicting policies. After evaluating the pros and cons, the government choose deleveraging.
5. For equities market, FX market and properties market, we should respect the market force and not simply put them as means to maintain GDP growth. For RMB, we should build a flexible floating mechanism based on market supply and demand (interestingly, he does not mention “targeting a basket of currencies” as PBOC did). For properties, we should push the destocking through urbanization but not through allowing the residence to add leverage.
That’s very important discussion for the three major asset classes in China. If you still remember, the Chinese government was trying to use the equity market to raise money and lower the debt burden of Chinese companies. Now it abandoned this idea and focus on the stabilization of equity market through the market forces themselves. Unless there’s another market collapse like that happened in last June, the government will not push money into the equity market again. Anyway, it already put so much money there.
The message of RMB is very interesting as it did not mention “targeting a basket of currencies” as PBOC did. Actually, RMB has been depreciating to “a basket of currencies” but stabilizing with USD as the dollar is weakening to Euro and Yen. This is the perfect outcome for PBOC as “a basket of currencies” represents the merchandise trading flow while the USD represents the capital flow. If we believe there’s a “Shanghai Accord” which aims to kill the dollar, then we can understand why the Chinese government does not mention “targeting a basket of currencies” anymore, as the RMB will continue to depreciate with those currencies with a weakening dollar.
The comment of properties market means the destocking process will be much longer and it definitely will hurt the new housing start number. In Q1, we saw some crazy buying from residences as they got leverage again. The sale result make the developers believe the mania will continue and that’s why they decide to build more properties and turn around the declining housing start trend. But now, as the government will curb leverage from the residences, I believe the property sales will cool down and the inventory liquidation cycle will be much longer. The government tries to destock properties inventory through urbanization, which means relying on the residence moving from village to cities. That will be a long process even those “new urban” can afford the properties price.
In general, the article’s main thesis is that China needs to put structural reform on top of investment driven stimulus and control the risk from high leverage. Say good bye to the aggressive easing in Q1 and China will enter couple quarters’ “reform” period, until the government cannot stand with the pain and has to use “investment driven stimulus” again.