Market outlook: No hiding from the truth on China’s economy

China’s leaders are being very frank about the scale of the economic challenges. This means lower growth in 2015

Lending by China’s banks is being restricted Copyright: Rex Features

China’s leaders are being incredibly open at the scale of the economic problems that they confront.

In late November, the government told the world – via a report from one its research bodies – that:

■ No less than $6.8 trillion of investments made since 2009 have been “ineffective”.

■ In 2009 and 2013 alone, “ineffective investment” came to nearly half the total invested in the Chinese economy during those two years.

■ The crisis has deepened since the launch of a huge economic stimulus package in late 2008. In 2009, yuan (CNY) 7.9 trillion (€1.05 trillion, $1.28 trillion) of spending was completely wasted. By last year, this had risen to CNY13.2 trillion.

Some people think that such numbers do not matter because of the scale of China’s financial reserves.

But the country’s total liabilities now stand at $24 trillion, up by $15 trillion since 2008, according to James Gruber, a Melbourne Australia-based financial journalist and former fund manager.

This blows a very large hole in the argument that all that China has to do to deal with its financial crisis is to tap into its large foreign reserves. These are said to total approximately only $3.9 trillion.

“The government’s admission of the scale of what we have to deal with first of all surprised me quite a lot. I hadn’t expected such openness,” said a Shanghai-based aromatics trader.

“But when I thought about it over a glass of wine, which always helps my thinking, I realised that the statement was consistent with what our leaders have been saying since last November. In short, their message has been that the days of easy growth are over and from now on, it is going to be very difficult.”

He expects a lot more economic pain next year as GDP growth further decelerates.

“This expectation is widespread and so has left many us in the chemicals trading community very risk averse,” he added.

BANKS LEND MORE CAREFULLY
“Yes, there will be short-term opportunities to make money as chemicals markets bottom out and temporarily recover in 2015 – and we all need to be ready for that. But I don’t see any sustained upswing.”

This is in line with the November 2014 China Visit report by UK-based metals consultant and macroeconomist Simon Hunt.

“Banks are becoming parsimonious in their lending activities with credit lines focusing on large companies in each sector of activity, by calling in loans without notice and in other cases by not renewing loans,” wrote Hunt.

“They want to hoard cash for the expected worse times ahead. Many of our industrial friends are worried about 2015 and foresee worse times ahead,” he added.

This year’s economic about-turn in China hasn’t obviously just involved consistently strong words; it has also involved a radical change in economic policies.

The biggest policy shift, which began in January, has been a sharp reduction in lending growth, said Paul Hodges, chairman of the UK-based chemicals consultancy, International e-Chem.

“Official bank lending was up just 6% in January-October 2014 versus the same period last year,” he said.

“But in the case of shadow banking, it fell by 30% in January-October, with most of the decline occurring over the last few months.”

Official bank lending is credit issued by the state-owned banks, whereas shadow banking comes via “off-balance sheet” products sold by these banks – and via loans from privately-run banks and finance companies.

To put these numbers into context, it is important to go back to February of this year and another landmark statement made by Beijing – again through a government-run research body.

The research organisation said that total credit creation (official and shadow lending together) would have to increase on a year-on-year basis by 12% if the economy was going to grow at the same rate in 2014 as it did in 2013.

The comments were given an extra official stamp of approval as they were made through an 11 February article in the China Daily – a state-run newspaper.

Clearly, 2014 total ending growth is not going to be anything like 12%, and so this gives you a rough measure of the scale of the slowdown taking place in China.

“I can only see it getting worse in 2015 as the government further deleverages the economy. I am particularly worried about steeper declines in real estate investment and real estate prices and what this means for metals demand,” said a Hong Kong-based iron ore and steel analyst.

Reducing the growth in lending is just one of many reforms taking place in China at the moment.

Another crucial reform set to take place in 2015 is writing off the bad debts of local governments, while also reforming how they finance themselves.

Local authorities will no longer be able to obtain land from rural residents at very low prices and then sell it on to real estate and industrial developers at inflated prices.

But as these reforms take place, the last thing that China needs is local authorities defaulting on their borrowings, according to a 24 November Reuters story .

This was one of the reasons why lending rates were cut for the first time in two years in late November.

THE $64,000 QUESTION
Another reason for the rate cut was to reduce the financing costs of struggling companies, said China’s central bank – the People’s Bank of China – when it announced the rate cut.

As the lending rate was reduced, banks were given the freedom to set deposit rates at 20% above benchmark borrowing costs.

Previously, they were only allowed to set deposit rates at 10% above the cost of lending.

Although this might not have an immediate big effect on deposit rates, this is seen an important step towards liberalisation of the financial sector.

“Financial repression” in China has involved low savings rates. Low savings rates have enabled the banks to funnel lots of cheap loans to companies – mainly big, well-connected state-owned companies.

Due diligence has often been very bad on these loans, which is a major factor behind today’s bad-debt crisis.

In the future, though, the greater flexibility given to banks in setting deposit rates should force them to compete for customers by offering higher rates. This will, hopefully, make them more discerning about who they lend money to.

Beijing has also announced plans for a trial deposit insurance scheme in 2015.

This, in effect, says to lenders: You will eventually be on your own and can and will be allowed to go bust if you continue to make bad loans. The implicit guarantee – that the government will always come to your rescue – is going to disappear.

The long-term opportunities in China remain nothing short of fantastic. For example, Hunt added in his November China Visit report that “the service sector is booming and contributes more to GDP now than does manufacturing”.

On-line shopping was booming and employed manly millions of people, with Alibaba alone employing some 27 million directly or indirectly, he added.

And he wrote that the on-line shopping sector was expected to grow by 40% or more.

But the $64,000 question remains: How long will it take consumption-led growth to fully replace the growth lost by the collapse in investment-led growth?

“Five years, perhaps even more, I think,” added the Shanghai-based aromatics trader.