While much of the recent commentary targeting China has centered on its response to Trump's trade war and the sharp devaluation of the Yuan, many have argued that the real focus should be China's decelerating economy. Commenting on this paradox, Credit Suisse said in a recent note that "consensus has been far too complacent on China" for a country that in PPP terms is already the biggest economy in the world and has accounted for an average of 36% of annual global GDP growth over the past five years.
However, the Swiss bank adds, recent weeks have seen the flow of investor questions pick up significantly:
Given its importance, we find it surprising that, until just the last week or two, clients have not been asking us about China this year. Indeed in our June client survey, there was only a very low proportion of respondents believing China was the key macro risk, as we show in Figure 3 below.
And judging by Credit Suisse's bearish outlook, it's about time clients started asking questions: after all the bank's view is that there is clear risk that GDP growth undershoots the Credit Suisse house view of 6.5% GDP in 2018 and 6.2% in 2019 "given the weakness of demand proxies and total social lending. China has started to rebalance away from credit and investment led growth, but this process has a lot further to run, and rebalancing is likely to come at the expense of growth momentum."
As a result, CS strategist Andrew Garthwaite writes that the "risks are still to the downside" for China's economy, for the following six reasons:
1. Credit tightening
Credit has been steadily tightening in China with total social credit growth at historical lows. Credit momentum tends to lead IP by five months, and is pointing to a sharp slowdown in the latter, as shown in Figure 4 below.
The slowdown is especially salient in areas that rely heavily on credit. Already, total FAI growth is close to its lowest level in more than 10 years and the subsector of FAI that is most reliant on credit growth, i.e. infrastructure FAI growth, has slowed from c.20% in early 2017 to only 1.4%.
2. Demand growth is slowing
If one proxies total demand growth based on retail sales, exports and FAI, it is now the slowest it has been for nearly 20 years, as Credit Suisse shows in the chart below (which shows both the weighted average and the simple average of these inputs). Export growth was the bright spot, but here too growth has now rolled over together with global PMI new orders, as shown in Figure 7 below.
3. Supply has not slowed
Interestingly, Garthwaite notes that the proxies on the output side of the economy, i.e. manufacturing PMIs or the bank's proprietary indicator of 16 different industrial proxies, show no meaningful slowdown in supply. And this stability (measured on an output basis) has supported the headline growth numbers. It may also be storing up problems for H2, however, if output growth is outpacing demand.
The question then becomes why credit growth and demand are slowing, but supply is not when we look at GDP or PMI (with the official PMI new orders series 1.5 points above its 5 year average, and the Markit PMI series 1.2 points above its 5 year average). There appear to be two possible explanations:
- There is an inventory build
While, in theory, stable output growth and slowing demand growth should imply an inventory build, the data does not bear this out. Neither PMI new orders vs inventories nor the growth rate of finished goods on NBS data are sending concerning signals, as shown in the charts below.
- There is more to demand growth than proxies show
Proxies on aggregate demand include consumption (retail sales), investment (FAI) and exports, but it is possible these underestimate aggregate demand strength.
One particular area that might not have been properly captured in previous statistics is service consumption. The retail sales number in China captures primarily goods sales and catering services, but does not capture service consumption in areas such as tourism, education and recreation. The problem is that, although service PMI new orders have remained relatively stable, they are not particularly high relative to manufacturing PMIs.
Real estate accounts for 24% of total urban FAI in China. The property market, while it only accounts for 13% of GDP, has a disproportionately large influence on the economy as half of household wealth is accounted for by housing, around 60% of banks' collateral and 23% of local government revenue is property-related.
Housing starts have been stronger than expected, with the government keen to develop a rental housing sector. The problem is that there are signs that land purchases, which lead housing starts, are now slowing. Property transactions are pointing to a significant slowdown in housing starts, as shown in the Figure 14 below. CS' Chinese property analyst believes that housing starts will decline by 5% in 2019 and slow to 4% Y/Y for full year 2018 (versus 7% currently).
Also note that housing turnover is consistent with property price appreciation slowing to zero, and the recent underperformance of property stocks would also suggest that housing activity is likely to slow.
5. The equity market is pointing to a slowdown in the Chinese economy
Both MSCI China and Shanghai A tend to correlate well with China PMI manufacturing new orders. Both of these equity indices point to a sharp slowdown in China PMIs to a level below 50.
6. Structural issues persist
There are three structural issues that have been problematic:
- The investment share of GDP is still higher than any economy has ever experienced (at 43%). While we acknowledge the shift to a consumption-driven economy has started, we note that moving from investment to consumer-led growth has historically seen the growth rate of an economy nearly halve.
- Leverage: The increase in private sector debt is one of the largest in history, comparable to those in Spain and Thailand before their debt crisis. Private sector credit to GDP ratio is now 209% of GDP, 13 p.p. above its trend, according to BIS.
- Some symptoms of a real estate bubble. Real estate valuations, in terms of the mortgage rates versus rental yields or the house price to wage ratio, appear to be excessive. Housing as a proportion of GDP is not that far off the levels seen in Spain and Ireland at their peak (12.4% in Spain if we look at construction and real estate activities and 11.3% of GDP in Ireland compared to 13% of GDP in China).
- Demographics: The labor force is shrinking, with the job offer to applications ratio at an all-time high, suggesting wage inflation may be a key consideration soon if not already.
Then, after listing a handful of positive offsets, Credit Suisse lays out its conclusion:
Ultimately, we continue to believe that a hard landing in China can be avoided unless the following catalysts occur:
(1) House prices fall by more than c30% (which would create negative equity);
(2) Deflation returns as a result of excess capacity (that would push up real rates to abnormally high levels);
(3) The loan to deposit ratio rises above 100%;
(4) China ends up with a sizeable current account deficit and net foreign debt (this would then limit China’s policy flexibility).
If Trump wants to win the trade/currency war with China, he should focus on the 4 points above and do everything in his power to destabilize the country and its markets. China will undoubtedly be doing the same.