China economic slowdown - hard or soft?

This is written by Chris Woods.

Recessions are man-made. Or rather central bank induced. See the way BOJ applied the brakes to Japan's economy in 1989. So will the continued tightening by China's central bank lead to a mild recession (soft landing) or a prolonged slowdown (hard landing).

Analysts at Fitch who first drew attention to the fact that broad credit growth in China was much stronger last year than indicated by a focus on the narrow renminbi bank lending data. This argument was, importantly, confirmed earlier this year when the PBOC published its new “social financing” data series, which includes bank loans, entrusted loans, trust loans, bank acceptances, corporate bond issuance and non-financial sector equity financing. This indicated that, based on this broader credit measure, total credit growth was even greater in 2010 than in 2009, the year of the post-Lehman bust command-economy surge in bank lending to local governments' infrastructure projects. Thus, total social financing volume was Rmb14.27tn in 2010, compared with Rmb14.1tn in 2009.

What is interesting about this latest Fitch report is that the authors argue that broader credit has not slowed as much this year as suggested by both the bank lending and social financing data. In an attempt to measure better broader credit growth, Fitch has come up with its own so-called “adjusted total social financing (TSF)” index. This indicates four main areas that Fitch argues are not properly counted in the official social financing data; namely letters of credit, credit from domestic trust companies, credit extended by other non-bank financial institutions and credit extended from Hong Kong banks.

Thus, despite the ongoing credit tightening in China, as reflected in daily loan-deposit ratio targets on individual banks, Fitch estimates that, based on its adjusted TSF, total financing is expected to exceed Rmb18tn in 2011, or 38% of GDP. True, this rate of growth is down from the average of 42% of GDP in 2009 and 2010. But it is still well above the pre-2008 average growth in broader credit of 22% of GDP. It is also important to highlight that Fitch estimates that more than 55% of the new financing is expected to come from areas outside bank lending, since the formal banking system is clearly experiencing much tighter conditions as reflected in those daily loan-deposit ratio targets. If the Fitch methodology is correct, the overall credit to GDP is now becoming worryingly large both in terms of its absolute size and in terms of the scale of the ramp up in the past three years. Thus, Fitch estimates that the ratio of total stock of credit to GDP is on course to reach 185% of GDP by the end of this year, up from just 124% of GDP at the end of 2007. This sort of rapid ramp up in credit to GDP (up 61ppts) is often a prelude to an over investment-led banking crisis, as Fitch also highlights by quoting relative historical comparisons, be it Japan between 1985-1990 (credit/GDP up 45ppts), Korea from 1994-1999 (up 47ppts) or America and Britain from 2002-2007 (up 41ppts and 50ppts respectively).

All these mean a big flashing yellow light (though not a red yet) is the current signal for the China macro story. First, it means the authorities may have to stay tighter for longer to rein in the broader credit growth with the resulting damage that may do to economic activity. That a credit squeeze is already on is clear from the latest China Reality Research (CRR) survey of SMEs (SME Quarterly – Credit crunch bites, 15 July 2011). Thus, the share of SMEs finding it harder to access bank loans compared with a year ago soared to 74% in 2Q11 from 52% in 1Q11, with 80% of them facing higher financing costs in the quarter (see Figure 2). It is also clear from very high black market lending rates. Thus, the latest CRR monthly survey on China’s informal financing market reported that the annualised underground lending rate in Wenzhou, a centre of China’s informal lending business, rose to 66% in June, a new record high since this particular data series began in March 2006 (see Figure 3 and CRR research Banking – Underground lending, 4 July 2011). There is also the technical issue of whether the relevant authorities, such as the CBRC, have the means to rein in what could be termed China’s shadow banking system.

Still the China story is more nuanced than the China bears often take into account. This is because of the political and social context and the related command-economy banking system. This means China can take the credit-to-GDP ratio to higher levels than would be the case somewhere else. Still key “pillars” of the system need to remain in place; most particularly healthy deposit growth and continued control over the capital account. For now deposit growth remains healthy at 17.6%YoY. As for the capital account, the risk to watch out for is whether the offshore renminbi market creates leakages which cause a potential loss of control for the authorities. SO watch out for potential leakages as well as the authorities’ efforts to rein in broader credit growth need to be watched. Indeed the two are connected in a certain respect, as reflected in Hong Kong banks’ surge in claims on the mainland in recent years. Thus, Hong Kong banks’ total claims on the mainland have quadrupled over the past two years from HK$407bn in April 2009 to HK$1.8tn at the end of April 2011, according to the Hong Kong Monetary Authority

For now the mainland authorities appear to be relatively relaxed about all this because the prevailing concern has been “hot money” inflows into China. Hence, the decision at the end of last year to allow exporters to keep their overseas revenues offshore. Under the program, qualified Chinese exporters can hold up to five overseas accounts and are free to decide on the length of time they keep income offshore. Hence, also the continued relaxed official attitude to the ongoing boom in Macau. Thus, Macau gaming revenue was up 52.4%YoY in June.

Still all this could change in a heartbeat if there is sudden evidence of an outflow. In this respect it is also important to understand that China’s capital account has become increasingly porous in recent years, in the sense that it has been seemingly easy for the rich and connected to get their money out. This raises the issue of what is the concentration of ownership of household deposits. The data is not available. But the more concentrated the ownership the bigger the potential risk. On this point, household deposits account for 42% of total bank deposits in China. Clearly it would be a surprise if household deposits are not quite concentrated in China. On this point a clue to the concentration of wealth in China, and the growing trend of sending money offshore, was provided by a recent survey carried out by the consultancy firm Bain & Company and China Merchants Bank. They found that the investible wealth of Chinese individuals was Rmb62tn, and that the number of Chinese with more than Rmb10m in investible assets have nearly doubled since the onset of global recession in 2008 to 585,000 this year. The report also found that rich Chinese have doubled the share of their portfolios invested overseas from 10% in 2009 to 20% this year.

All of the above serve to alert investors to the obvious systemic risks that are the consequences of the mainland’s command economy structure. It is also the case that the higher the base in terms of the level of money supply or credit to GDP, the harder the challenge for the authorities both to maintain control and politically acceptable growth rates. In this respect the best analogue for the Chinese economy is the same as it was for the Japanese economy in the late 1980s. That is the bicycle economy. The question is how long the rider can stay on the bicycle. For now, it is safe to assumes that the rider can stay on the bicycle. But that is an assumption that will have to be stress tested regularly. The positive point is that the Chinese authorities are much more aware of the over-investment risk than the Japanese were in the late 1980s. Indeed the Japanese bureaucracy did not even understand there was such a risk. But the negative point is that the China system story is much more starkly binary in the sense that if the economy collapses so, likely, will also the political system.