China's Credit Growth Is Freezing Up At The Worst Possible Time

Submitted by Gordon Johnson of Axiom Capital


China until recently euphoric credit growth, is rapidly grinding to a halt. As we published last week, and a key underpinning of our negative outlook on commodity prices through the remainder of 4Q17 and into 2018, the moderation in China’s credit seen more recently appears to be gaining momentum. The evidence? 

Well, we note that: (1) new yuan loans in October came in at CNY1.04tn (vs. expectations of CNY1.1tn, and CNY1.8tn in the prior month), with banks making up CNY663.2bn of this amount – which was below the Consensus estimate of CNY783bn for October, and down from CNY1.27tn the prior month (Exhibit 1), (2) shadow banking remains around one-third of total social financing (“TSF”), showing little signs of providing the “lift” to credit it has previously when bank debt issuance underperformed – Exhibit 2, (3) year-over-year growth of new yuan loans, on a three-month-rolling average, has slowed to just +7.5% in October (Exhibit 3), (3) Y/Y M2 growth in China hit a multi-decade low of +8.8% in October (Exhibit 4), (4) household loan growth (i.e., mortgages) continued its precipitous fall in October (Exhibit 5), (4) Y/Y corporate bond and government bond issuance continues to trend negative (Exhibit 6), all ultimately resonating in (5) broad credit growth that continues to moderate (Exhibit 7).

In short, we believe
China’s efforts to deleverage are, increasingly, bearing fruit. What this means, in our view, is that China’s economic indicators will continue to slow, weighing on bulk commodity prices, and ultimately industrials, metals, and mining stock prices.

Exhibit 1: China Total Social Financing (“TSF”) – New Yuan Loans

Source: Peoples' Bank of China (PBOC), Axiom Capital Research.

Exhibit 2: Shadow Banking as a % of Total Social Financing (“TSF”)

Source: Peoples' Bank of China (PBOC), Axiom Capital Research.

Exhibit 3: 3MMA China Total Social Financing (“TSF”) Loan Growth, Y/Y%

Source: Peoples' Bank of China (PBOC), Axiom Capital Research.

Exhibit 4: China M2 Money Growth, Y/Y% - Multi Decade Low (bearish)

Source: Peoples' Bank of China (PBOC), Axiom Capital Research.

Exhibit 5: 3MMA Household Loan Growth, Y/Y%

Source: Axiom Capital Research, Bloomberg, National Bureau of Statistics.

Exhibit 6: China Bond Issuance – Sharp Downturn in 2017


Exhibit 7: China Broad Credit Growth (TSF + Local Government Bond Issuance)

Source: Peoples' Bank of China (PBOC), Axiom Capital Research.

WHAT ABOUT THE ECONOMIC DATA? Well, as detailed in Exhibit 8 below, for the month of October, fixed asset investment at +7.3% Y/Y was the weakest since 12/31/99 (i.e., the height of the global financial crisis), followed by industrial production at +6.7%, which has remained subdued for some time, and finally retail sales at +10.0%, falling 30bps M/M (and completely erasing last month’s strength). Furthermore, as detailed in Exhibits 9-11 below, while crude steel output remains robust, both cement output and electricity output have slowed much more recently, suggesting structural weakness in underlying demand for steel at present (despite claims by China of impending cuts to output, when adjusting for 50mnt/year of induction furnace output that is now included in reported data, YTD 2017 crude steel output through October is ~712mnt vs. 714mnt for the same period in 2016 [this does NOT represent the major reduction in crude steel output that has driven speculators to predict a more balanced steel supply/demand backdrop in China, which has contributed to steel price strength this year]).

Exhibit 8: GDP Growth Internals - China (FAI, Industrial Production, & Retail Sales)

Source: National Bureau of Statistics, Axiom Capital Research.

Exhibit 9: China Monthly Steel Production by Year

Source: World Steel Association (WSA), National Bureau of Statistics (NBS), Axiom Capital Research.

Exhibit 10: China Cement Output

Source: National Bureau of Statistics, Axiom Capital Research.

Exhibit 11: Y/Y Growth in Electricity Production by Month

Source: National Bureau of Statistics, Axiom Capital Research.

WHAT ABOUT THE HOUSING DATA? By way of background, we remind our readers that China’s residential + commercial + office construction markets comprise the overwhelming majority of the country’s bulk metals consumption (i.e., >50% of steel consumption). Stated differently, analyzing trends in these key areas is crucial to having a view on where global bulk metals prices are headed.

That said, as detailed in Exhibit 12 below, Y/Y growth in China’s property sales of residential buildings was negative for the second consecutive month in October at -3.42% (a dynamic we haven’t seen since late 2014, or right ahead of the “great industrial stock panic” that saw a major sell-off across a number of the stocks we cover). Furthermore, China residential floor space under construction contracted to -3.6% Y/Y in October (or the lowest level since January) – Exhibit 13. Further, and among the most important metrics to measure when predicting future bulk metals pricing trends in China, and thus globally, YTD residential + commercial + office construction new start growth in China slowed to +5.6% Y/Y (or the lowest level since 4Q15) – Exhibit 14. Yet, on a monthly basis for October, residential + commercial + office construction new start growth actually turned negative (Exhibit 15).  

Exhibit 12: China Property Sales of Residential Buildings, Y/Y%

Source: Bloomberg.

Exhibit 13: China Residential Floor Space Under Construction

Note: The NBS does not report January data, we assume January = February ÷ 2.
Source: National Bureau of Statistics (NBS), Axiom Capital Research.

Exhibit 14:  China Residential + Commercial + Office Construction Starts

Source: National Bureau of Statistics, Axiom Capital Research.

Exhibit 15: Monthly Construction Starts (Residential + Commercial + Office)

Source: National Bureau of Statistics, Axiom Capital Research.

WHAT ABOUT THE COST OF DEBT? According to our checks, at the 19th Party Congress a few weeks back (i.e., China’s once-in-every-five-year leadership transition), China’s top policymakers reiterated their efforts to contain excessive risk-taking in the financial system beyond 2017. More specifically, as detailed here, China leadership pointed to a continuation of efforts aimed at limiting debt, with hints of more regulation targeted at the interbank and wealth management product (“WMP”) arenas. And, as would be expected, on the back of these comments, the yield on three-year AAA notes in China (Exhibit 16) – the most common grading for Chinese corporate debt – spiked higher, now up 36bps over just the past 3 weeks (AND 16bps SINCE WE PUBLISHED OUR NOTE LAST WEEK ON MONDAY); stated differently, since the beginning of October, the cost of AAA-rated corporate debt in China increased 45bps, or the highest level in over 3 years.

In short, while we see an outright cash shortage as unlikely, with waning bond issuance (Exhibit 6) weighing on credit availability in China – following acute support in 2015 and 2016, incremental bond issuance in China has become a headwind to credit growth – we feel the “smart money” should be betting on a continued slowing in China’s economy over the near-term (although, based on discussions with a number of our clients recently, this is not Consensus thinking at present). This will likely invite

Exhibit 16: China AAA Corporate Bond Yield – Moving Higher Since Congress Meeting

Source: Bloomberg.

SO WHAT? Interestingly, in our discussions with investors over the past several weeks, the response we get to slowing Chinese data is simply… “so what, stocks don’t fall, and China growth will be strong next year”. While, in general, we acknowledge this sentiment is widespread, we notice a number of troubling trends that bear watching (as noted above). In short, to the question posed in the title of this note: “Should Commodity Bulls be Worried”, we believe the answer is yes.  

Why should the bulls worry? Well, with economic growth slowing in China, the question is will it continue into 2018, and will it lead to bulk commodity prices deflating? In short, due mainly, we believe, to slower overall credit growth vs. prior bubbles (i.e., 2009, 2013, and 2016), a material slowdown in economic growth or asset values in China’s market is inevitable – barring another massive ramp-up in credit issuance (which doesn’t appear to be “in the cards” near-term) – it’s simply math.

Stated differently, mathematically explaining why slowing credit growth in China is a big deal, we note that if an economy is 50 and credit is 100, and the economy grows 10%/year, while credit grows 30%/year:

  • At the end of year 1, the economy is 55 and credit is 130. Total demand is 55 + 30 (i.e., new credit created) = 85;
  • At the end of year 2, the economy is 60.5 and credit is 169. Total demand is 60.5 + 39 = 99.5, up 17.1%;
  • At the end of year 3, the economy is 66.6 and credit is 219.7. Total demand is 66.6 + 50.7 = 117.3, up 17.8%;
  • At the end of year 4, the economy is 73.2 and credit is 285.6. Total demand is 73.2 + 65.9 = 139.1, up 18.6%.

However, similar to what we’ve seen recently in China, if credit growth were to slow from 30% in years 1-4 in the hypothetical example above to 15% in year 5, at the end of year 5 the economy would be 88.6 and credit would sit at 328.5. That’s total demand of 80.5 + 42.8 (i.e., the change in credit), or 123.4, representing a -11.3% fall Y/Y in total demand. Thus, as detailed in Exhibit 7 above, where China’s credit growth has slowed from +20% Y/Y as of 6/30/13 to +12.2% Y/Y as of 10/31/17, we see a material weakening in China’s total demand as fated – we feel the inevitable reckoning here this year was delayed by pre-19th Party Congress distortions, which effectively “outlawed” select economic indicators from falling, as well as certain companies from reporting bad results, in an successful effort by President Xi to consolidate his power (via both government mandate and fiscal/monetary stimulus) – link.

With our checks suggesting a number of investors are long select large-cap metals, mining, and industrial stocks because, to quote a few “even though we don’t like the valuations at these levels, there’s nowhere else to go, and we can’t be in cash”, as the weakness in China spreads to other emerging markets, and ultimately the US, we see a potentially sharp sell-off/revaluation lower as likely. Caveat emptor.