INSIGHT: China's recovery is held in the rebalance

22 April 2013 12:27  [Source: ICIS news]

By John Richardson

PERTH (ICIS)--Perhaps the only surprise about last week’s announcement that China’s first-quarter 2013 GDP growth was a relatively subdued 7.7%, should have been that most economists were surprised.

China’s new president Xi Jinping, and its new prime minister Li Keqiang, have given plenty of indications that the economy would be rebalanced at rapid speed.

The focus is on the quality rather than the quantity of growth, which was made clear during last month’s National People’s Congress – China’s annual parliamentary meeting.

An improved quality of growth means less expenditure on new industrial capacity and infrastructure.

For many years, capital investment has been the easy way for provincial governments to hit GDP (gross domestic product) targets.

This has led to overcapacity in many industries. For instance, Chen Letian, an economist at Rising Securities in Beijing, estimated that the average factory capacity utilisation rate in China was just 57% in 2012.

Overcapacity is a problem across several petrochemicals. Polyvinyl chloride (PVC) is one of the most prominent examples. Operating rates were just 55% in 2012, according to ICIS.

Methanol, too, is affected by oversupply with butadiene facing a surge in capacity during 2012, which could leave the market very long. 

China is also anecdotally littered with bridges and roads to nowhere, barely used public buildings and underutilised regional airports.

When the economic multiplier effect of investing in new buildings has run out, one approach of local governments has been to blow-up perfectly public facilities, such as exhibition centres, so construction work can resume.

Blowing-up perfectly good public buildings has, of course, come at a huge environmental cost, as has building an excessive number of factories.  Margins are obviously squeezed because many industries are so heavily oversupplied. This has led to high emissions levels and the use of cheap, highly-polluting technologies, in an effort to reduce costs.

China’s new leaders, in frequent public statements, have recognised the need to better protect the environment.  

For instance, Li, in his first speech as prime minister, said on 17 March the news media and the public should hold him accountable if the government failed to clean up China’s contaminated water and food supply.

“Poverty and backwardness in the midst of clear waters and verdant mountains is no good,” he said, “nor is it [good] to have prosperity and wealth while the environment deteriorates.”

Highly-polluting chemicals plants are thus being shut down, according to an Indian aromatics trader who recently visited China.

Regulations making it tougher to buy new autos continue to be introduced. Last week, for example, Guangzhou became the fourth city in China to place a cap on auto sales because of worsening pollution.

Beijing is one of the other cities. In January, its air pollution was 40 times above the World Health Organisation maximum safe limit.

And, obviously, with so many industries blighted by overcapacity, China can ill afford to add yet more output for economic, as well as environmental, reasons.

One very good economic reason is that the old growth model is producing diminishing returns, which is hardly surprising given that manufacturing operating rates are below 60%.

"In China, it's often the case that the numbers themselves are a source of confusion, if not outright disbelief. But sometimes the numbers also speak for themselves. And one in particular is telling: credit intensity," wrote the Financial Times in a 15 April Beyondbrics blog post.

"This measures the amount of credit needed to generate growth, and it has risen rapidly in the past six months to near its highest level. In other words, when it comes to GDP, China is getting less bang from its credit buck."

“Here’s a chart (courtesy of HSBC’s Fred Neumann) plotting total social financing against GDP. The rising line indicates that China hasn’t needed this much credit to generate growth since late 2009.”

(Total social financing represents total lending, from both the shadow banking system and formal loans from the state-owned banks. The increase in shadow banking has raised major concerns over the last year because the sector is highly diverse and lightly regulated. Shadow banking comprises private finance companies and off-balance-sheet lending by the state-owned banks via, for example, wealth-management products).

How much credit needed RMB of GDP

One theory is that because lending in China jumped by 58% in the first quarter of this year over the same period in 2012, GDP growth will be a lot stronger in the second half of 2013.

But government officials and financial analysts have warned that the out-of-control credit growth in the first quarter was largely used to refinance existing debt and further inflate the property bubble.

And the surge in credit, and with it bad debts, threatens a financial sector crisis that could put US sub-prime in the shade.

Fitch Ratings, in response to this growing risk, cut China's sovereign credit rate to A+ AA- on 9 April. This was the first time that an international ratings agency had cut China’s sovereign rating since 1999.

"Credit has grown significantly faster than GDP since 2009. China experienced the second-fastest expansion of credit in real terms, behind only Qatar, between end-2009 and end-June 2012," wrote Fitch when it made its announcement.

"The stock of bank credit to the private sector was worth 135.7% of GDP at end-2012, the third-highest of any Fitch-rated emerging market,” Fitch added.

The ratings agency believes total credit in the economy, including various forms of shadow banking activity, may have reached 198% of GDP at end-2012, up from 125% at end-2008.

Hence, much tougher measures to rein-in credit growth and reduce property prices seem likely.

Last week’s “shock” first-quarter GDP number, along with the release of disappointing US employment, retail sales and consumer confidence data, led to a sharp correction in oil prices and equity markets.

“There seems to be a growing feeling that oil and financial markets have already priced-in a recovery that has yet to happen in the real economy,” the precious metals analyst added.

But in chemicals markets in China, evidence of a faltering real economy has been evident for several months.

For example:

*Polyethylene (PE) markets have failed to stage a widely-expected post-Chinese New Year rebound. Asian prices fell by a further $10-45/tonne for the week ending 19 April on concerns over new PE capacity, lower crude and the weak macro-economic data, said ICIS.

*China’s purified terephthalic acid (PTA) prices had staged a comeback during the first two weeks in April but during the week ending 19 April, they fell by $27-29/tonne, added ICIS (see chart below). Around 14m tonnes/year of Asian PTA capacity has reportedly been idled because of poor margins, one- fourth of the region’s total capacity.

Terephthalic acid spot

*Buying sentiment in China’s olefins and aromatics markets remains weak on concerns over tougher government action to deal with excessive credit growth and the property bubble. Inventories are high. For instance, in the second week of April, benzene stocks in eastern coastal China had reached 90,000 tonnes, said ICIS. This compared with 30,000 tonnes last year.

*China’s export market for products made from acrylonitrile butadiene styrene (ABS) is in a deep trough. As a result, Chinese manufacturers have reportedly cut back on orders for ABS by as much as 30%. There even reports of small volumes of Chinese ABS being exported to Europe at prices up to $500/tonne below European material, added ICIS.

The big question is: How much more will China’s GDP growth decline while economic rebalancing takes place?

“More than ever I am convinced that if China is to rebalance its economy towards a more sustainable growth mode – and rebalance it must if it is to avoid a financial crisis - its GDP growth rate will drop sharply,” wrote Michael Pettis in an 11 April post on his blog, China Financial Markets.

China’s average annual growth would be unlikely to exceed 3-4% over the next decade, said Pettis, who is a finance professor at Peking University’s Guanghua School of Management. 

“My forecast is still an outlier, but over the past six months even the optimists no longer see it as unthinkable,” he added.

Additional reporting by Chow Bee Lin, Becky Zhang and Matt Tudball.

By: John Richardson
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