As reported last night, China pleasantly surprised watchers when it reported its latest data dump, including a stronger than expected 6.7% Q2 GDP print and unchanged from the previous quarter, which beat across the board with the exception. The reason for the beat: a buoyant property market and government stimulus boosted demand for factory output. On the other hand, fixed-asset investment, traditionally the biggest driver of Chinese growth, and which includes both infrastructure and manufacturing investment, grew at only 9%, its slowest pace since 2000 in the first six months and down from 9.6 per cent in the year to May.
“The most important data point in today’s release is private investment, which accounts for 62 per cent of total investment but continues to see zero growth in June.” Larry Hu, China economist at Macquarie Securities. “Whether private investment can turn round in the coming months is the key to the Chinese economy in the second half.”
Breaking down the GDP components, we find that investment contributed only 2.5% points to GDP growth in the first half, down from 2.9% last year, while the consumption contribution rose from 4.2% to 4.9%. This, of course, is a number which can not be indenepdently verified from the traditionally opaque and data-fudging National Bureau of Statistics.
To be sure, as Capital Economics said last night, China GDP should be taken with a grain of salt given the political nature of the data and pressure to meet official 6.5%-7.0% growth target. China’s economy probably only expanded 4.5% in 2Q rather than official figure of 6.7%.
More worrying was that net exports subtracted 0.7%, in yet another confirmation that global trade continues to deteriorate.
Also troubling: China’s industrial economy continues to suffer from rampant overcapacity and deflation. Mining grew 0.1% in the first half, while electricity, heat and water production grew 2.6%. Facing a bleak demand outlook, privately owned manufacturers have cut spending on new factories, contributing to the sharp slowdown in fixed investment. But a surge in infrastructure investment by state-owned enterprises has taken up the slack, supporting demand for commodities such as steel, copper and cement
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In any case, the take home message, as per the market's euphoric reaction, is that China's economy has stopped contracting, if only for the time being. However, as Bloomberg reports, the stabilization comes at a cost, a big one. Instead of tackling a debt pile estimated by Rabobank at a gargantuan 3.5x of the economy’s size, policy makers are only making it worse with a renewed credit binge.
"The amount of cash Beijing is shoveling into the economy is stunning," said Andrew Collier, an independent analyst in Hong Kong and former president of Bank of China International USA. "Given high fixed-asset investment among state-owned enterprises, it’s likely most of it is being consumed by the inefficient state sector. This is more bad news for structural reform. "
Our favorite metric of Chinese credit creation, Total Social Financia, the biggest credit creation aggregate, rose 1.63 trillion yuan ($244 billion) in June, topping all 29 analyst forecasts in a Bloomberg survey. That means last month alone saw new credit exceed the 2015 GDP of Chile, Ireland, or Vietnam.
Where is this unprecedented credit deluge going? Sadly, not in productive sectors. Quite the opposite. Instead of funding expansion and hiring among private companies, much of the lending is going into state-owned enterprises, many of which are unprofitable and only kept alive to avoid wide-scale job losses. A reluctance by private companies to invest suggests they aren’t buying into the recovery story, and even worse may be being squeezed out by a bloated and inefficient state sector.
One thing is clear: any promises of reform by China are now dead and buried. As Bloomberg adds, "the credit expansion is at odds with the policy platform President Xi Jinping and Premier Li Keqiang have been articulating. The duo have promised to transform the economic model that has driven China for more than three decades by rebalancing away from manufacturing and investment and towards services and consumption through slashing overcapacity and clearing the way for private enterprise. So far, the evidence suggests that’s progressing slowly at best."
Actually, so far the evidence suggests precisely the opposite.
"The stabilization in growth has come at a cost, as China’s structural and leverage problems become more severe," said Bloomberg Intelligence economists Tom Orlik and Fielding Chen. "Credit data for June show expansion in lending continuing to accelerate ahead of growth in the real economy. The reform and deleveraging can is being kicked further down an increasingly bumpy road."
In a morbid case of irony, China itself warned about the risks of rampant credit growth. In May, state media cited an unnamed official warning that excessive debt was China’s “original sin” and the country can’t borrow its way to long-term economic health.
As we reported a month ago, Goldman Sachs said in a report that China’s debt increase is among the highest in recent history when comparing the magnitude and pace of the increase in China’s debt-to-GDP ratio to those of other countries. The longer reforms are put off, the greater the risks down the road, said Eswar Prasad, a former chief of the International Monetary Fund’s China division and now a professor at Cornell University in Ithaca, New York.
"While there are signs that the Chinese economy has gotten through a particularly rough patch, long-term growth prospects have hardly improved as risks continue to build up and reform momentum has slipped," Prasad said.
Then there’s the risk of an exogenous shock stemming from a slowdown in big trading partners or from a natural disaster. Weeks of torrential rain across central and southern China have caused the country’s worst flooding since 1998.
Above all, the next six months will be critical for getting the private sector to invest if the economy is to find its feet and cut off the drip of cheap, government supplied credit, said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong. "In the near term they’ve won a battle," Hu said. "But the war is still going on over whether China can find new growth drivers."
And while China's mountain of debt seems ever shakier, for now the take home message is that China has dodged a bullet, and markets have reacted accordingly. What they ignore is that, as Kyle Bass said two weeks ago, the coming Chinese financial crisis will shake the world. But that's a bridge the no-longer forward looking market will cross when it reaches it. And after all, why worry: that's what central bankers are for.