Market Outlook: China Monthly

The first quarter of this year appeared to show the anti-reformers gaining advantage through a renewed increase in lending. Imaginechina/Rex/Shutterstock

Confused? One certainly should be by China’s latest economic about-turn, as confusion is the only intellectually honest reaction.

It seemed clear in 2014 and 2015 that China had dedicated itself to very painful economic reforms. These reforms promised a fantastic new economic growth model, based on services and consumption. But, in the interim, this guaranteed several years of much-lower GDP growth.

As President Xi Jinping put it at the launch of the critical 3rd Plenum central government meeting in November 2013, during which the blueprint for these reforms were laid out: “The good meat is all gone; all that is left are hard bones to chew.”

The chewing of hard bones began from early 2014 through the main tool of economic reform – a reduction in credit growth.

Reduced availability of lending meant that fewer people were able to build apartments that nobody wanted to buy. And similarly, there were fewer worthless factories added to what was already severe overcapacity across many industrial sectors. These sectors include many chemicals and polymers.

As the availability of credit fell, so did real GDP growth, which declined to the low single digits because of the loss of the “economic multiplier” effect of all this construction.

There was also a negative wealth effect as the property bubble deflated.

Late entrants into the bubble were left angrily nursing big losses, while those who got in and out at the right time were no longer making as much money.

There was another harmful impact from slower lending growth: Heavily indebted companies were unable to borrow more money as easily to service existing debt. Lots of smaller companies went out of business.

Throughout 2014 and 2015, there was tension between the reformers and the anti-
reformers. But during these two years, the reformers had the upper hand.

The first quarter of this year appeared to show the anti-reformers gaining advantage through a renewed increase in lending.

It is worth remembering that it was excessive credit creation during the 2009-2014 economic stimulus programme that has been behind reforms.

Those against economic reforms seem to want to “kick the can down the road” – that is to say, delay economic rebalancing in order to shore up short-term growth.

LAW OF DIMINISHING RETURNS

How much new lending are we talking about? Numbers vary, but all the estimates take your breath away.

Societe Generale, for example, said that total lending in China increased by 58% in the first quarter of 2016 compared with the first quarter of 2015, according to an 15 April Financial Times Alphaville blog post.

This has led to improved sentiment in all chemicals and polymers markets, thanks to a mild uptick in Q1 GDP growth.

But a major concern is that despite the big new surge in lending, some economic indicators remain anaemic. Take as an example the latest Caixin manufacturing and non-manufacturing purchasing managers’ indices, which were both down in April.

What we are dealing with here is a case of the law of diminishing returns. Chinese government data show that:

■ In 2007, $1 of credit added 83 cents to GDP growth.

■ By 2013, $1 was only adding 17 cents.

■ And it was thought that in 2014 each dollar of new borrowing would only have added 10 cents to growth.

It is reasonable to assume that if more oversupply were added in sectors such as real estate, steel and cement, then economic growth would actually be reduced.

This is exactly what seems to happening, with reports that even more cement factories are under construction, thanks to the new credit binge.

Real estate prices are also on the rise again, with credit once again flowing into lots of speculative activities in general.

President Xi is said to remain firmly in the camp of the reformers. Indeed, it is his determination and vision that seems to be largely driving the efforts to remake China’s economy.

OVERCAPACITY VS CONSUMER BOOM

It is hard to see this latest rise in credit as anything but a backward step – especially when the existing unaffordability of real estate in some of China’s bigger cities is considered.

One Chinese chemicals industry contact recently estimated that an average apartment in Shanghai costs 33 times an average annual salary. This compares with roughly seven times an average salary to buy the same type of home in Perth – one of the most expensive property markets in Australia.

There is also the potential further increase in bad debts. The existing level of non-performing loans is already a major cause for concern.

One school of thought sees only two outcomes if China continues to keep the credit tap turned firmly on.

The first outcome is a major financial crisis, when all the bad debt is eventually dealt with by the government.

Or it could be that “extend and pretend” continues for a very long time, in much the same way as has happened in Japan.

Rather than being forced to write-off bad debts, Chinese banks might be allowed to continue supporting loss-making companies. Some analysts fear that this could lead to a long period of sub-standard growth because of lack of new investment flowing to healthier parts of the economy.

POSITIVE INDICATORS

Way too pessimistic? Perhaps, because there are some very positive economic indicators.

These include surging internet sales. The potential for further online sales growth remains nothing short of enormous, which could be of huge benefit to polymers demand.

Overall retail sales are also extremely healthy, as retail markets such as local cinema ticket sales and foreign travel continue to boom.

Linear low-density polyethylene (LLDE) is one polymer in particular that could benefit because of its heavy use in the packaging of durable and non-durable consumer goods.

In the graph below, we provide the latest ICIS Consulting estimates for LLDPE growth which may be revised upwards. The same graph also shows a healthy gap between local demand and local capacity, which would thus leave a lot of room for imports.

However, the big question that remains to be answered is, will these new sources of growth be sufficient enough in the near term to fully compensate for the growth that is being lost as a result of oversupply in old industries, such as steel and cement?

On the surface, if we look specifically at the way GDP growth is measured today in China, the answer to this question seems to be a very clear “No”.

Surely, if these alternative sources of growth were really that strong, then there would have been no slowdown in GDP growth at all in 2014 and 2015, when credit supply was reduced?

And given the scale of year’s renewed credit binge, why have we not seen a much stronger rebound in GDP?

“Ah, yes, but the issue here is how GDP growth is compiled in China,” some of the China bulls will argue.

“The expansion of services and consumption is not adequately being taken into account because we still place too much emphasis on measures such as the rise in electricity consumption and freight volumes. These types of measures mainly reflect the health of the old economy,” they would add.

However, the honest and sensible answer to all of this should be, “I do not have a clue.”

What chemical companies must therefore do is build a series of rigorous, carefully thought-out scenarios for China.

They have to then revisit these scenario with a frequency and intensity that was not necessary just a few years ago.