By John Richardson
THERE was a lot of unhelpful and distracting noise surrounding the release of China’s official year-on-year H1 GDP growth that came in at an unexpectedly strong 6.9%.
Equally misleading was the pick-up in June total social financing (TSF). This was taken as an indication that China is backing away from its efforts to rein-in its credit bubble.
Add this to the unexpectedly strong export and import figures for H1 and you might mistakenly reach the conclusion that China’s GDP growth definitely isn’t going to slow down in the second half of this year and into 2018.
Why this would be wrong is because of the lag effect of what is, in fact, a major pull-back in lending growth. It will take one more quarter or longer before this reduction in new credit starts to be reflected in both the official GDP numbers and independent growth estimates. A deeper dive into the lending data, below the level of the headline TSF figures, tells the real story.
And instead of backing away from tackling its credit bubble, China looks set to continue with the lending clampdown. This is evident from recent regulatory changes and the strong language in the state-owned press about the need to get rid of bad lending practices.
I also believe that the big surge in exports and imports in H1 was largely the result of global deflation in 2014-2015 being replaced by mild reflation in 2016.
It is all about China’s credit cycles. The global deflation we saw in 2014-2015 was because of China’s previous attempt to tackle excessive and risky leverage. We were back to reflation in 2016 – with a carry-over effect into the first half of this year – because of China’s decision to once again relax lending conditions.
This return to reflation forced Western purchasing managers to stock-up on Chinese finished-goods exports in an attempt to beat future cost increases.
Chinese manufacturers had to thus import more raw materials to both meet this better export demand and hedge against higher input costs. This helps explain the big surge in polyethylene and polypropylene imports in January-May of this year.
Now, though, we are back to the future as real lending conditions once again become more difficult. This will reduce the support given to Chinese GDP growth from stronger exports as growth prospects in the West dim on a return to deflation.
And in turn, of course, China might need to import less raw materials, including petrochemicals, as its economy cools. This would obviously be bad news for the countries and companies which export to China.
Diving deeper into the credit numbers
TSF, which is a broad measure of credit and liquidity in the economy, rose to 1.78 trillion yuan ($262.22 billion) in June from 1.06 trillion yuan in May, according to a Reuters report on Chinese central bank data. For the first half of the year as a whole growth in TSF remained strong on a year-on-year basis,
But what matters more than these headlines numbers is what is referred to by economists as the “credit impulse”. This is a term coined by Michael Briggs in 2008, who at that time was an economist with Deutsche Bank.
What credit impulse means is the change in new credit issue as a percentage of GDP. Briggs argued that private sector demand in most countries correlated very closely with the credit impulse, rather than with the total stock of credit. Declines and increases in the total stock of credit is reflected in statistics such as China’s headline TSF numbers.
China’s credit impulse declined by no less than 17.5% year-on-year in Q1, according to William Sterling, chief investment officer at Trilogy Global Advisors (see the above chart showing the link between China’s credit impulse and GDP).
“By our measure, the magnitude of this negative credit impulse has only been matched or exceeded a few times: in 1994, 2004-05 and 2010,” wrote Sterling in this FT Beyondbrics blog post.
But he added that in those previous periods the negative credit impulse came against the backdrop of very robust growth in nominal GDP – 37% 1994 and 18% in both 2004 and 2010.
However, China’s nominal GDP grew by a relatively small 11.8% in Q 2017 versus the same period last year. This suggests that the impact of the credit slowdown could be greater on this occasion than in the past.
As everyone knows, a big driver of China’s stronger GDP growth in 2016 and H1 2017 has been a booming real-estate market. But Fitch Ratings believes that a weaker credit impulse, combined with the tightening of home purchase restriction,s will reduce the growth in home sales during the second half of this year.
A further dive into China’s lending data shows that there has been a sharp decline in financing available via China’s shadow banking sector, according to fellow blogger Paul Hodges, in his latest PH report. It peaked a three-month rolling average of 157bn in January this year, but then fell to an average $23bn in Q2.
Why these numbers matter is that shadow or private lending is highly speculative, and so highly risky and is thus the target of the government’s economic reforms. The boom in shadow lending also helps to explain the big pick-up in GDP growth in 2016 and in H1 2017.
China accelerates regulatory reform
Underlining my earlier analysis, Sterling also wrote in the same blog post: “The most important global policymaker nobody has ever heard of is Guo Shuqing, the recently appointed chief of the China Banking Regulatory Commission.
“With the implicit support of President Xi Jinping, Mr Guo has issued a flurry of new regulations aimed at tackling corruption and speculation, including a requirement that banks account for previously lightly regulated wealth management products, in line with capital adequacy regulations.”
Earlier this month, during its annual National Financial Work Conference, Beijing also announced the establishment of a new cabinet-level committee to better coordinate China’s financial regulators and tackle systemic financial risk.
And as Paul Hodges also points out in his latest PH report, the conference was this year presided over by President Xi Jinping, whereas normally the meeting is run by the less senior premier or prime minister.
You should also take note of the very strong language in this editorial in the state-run newspaper, The Global Times:
Admittedly, there are worries about the impact of supervisory tightening on the country’s financial innovation, notably in the world of fintech, considering that rapid innovation in the financial sector is seen intertwining with the rise of shadow credit that plagues the Chinese economy. But that should by no means be an excuse for further shadow lending indulgence.
These could easily turn into a nightmare for the Chinese economy if allowed to run their course without hindrance. China can hardly make great breakthroughs in economic reforms if it fails to tame rampant debt.
There shouldn’t be any doubt that stability comes before innovation if something has to be sacrificed. Market watchers are gratified to see the country is moving in this direction, with the newly announced financial stability commission expected to address the issue of regulatory arbitrage, which has been blamed in part for shadow credit growth. The commission’s responsibilities include making financial reform plans, coordinating financial policies to enable regulatory synergy, drafting rules to fill regulatory gaps, and holding officials accountable for inadequate regulation.
What happens next – implications for China and the global economy
I maintain my view that China will be fine. It will only see a slight moderation in growth over the next few quarters – and of course this moderation will occur from a very high base.
The question of when the slowdown starts to take effect is, as indicated earlier on, hard to nail down exactly. We could see an effect as early as the third quarter of this year or as late as 2018.
How long will it last? Sterling wrote that since 1995, the average duration of credit impulses in China has been four-and-a-half quarters.
Globally, the implications are likely to be far greater than in China itself. As I also mentioned at the beginning of this post, China was essentially exporting deflation to the rest of the global economy during its last credit slowdown in 2014-2015. This turned to exports of reflation in 2016 and now we are set to return to deflation.
Combine this with disappointment over President Trump’s stalled policy initiatives (tax reform and infrastructure spending), and global growth prospects could well dim over the next few months.
The IMF might thus have to think again about its global GDP growth forecasts. In its latest update, it has kept its April forecasts unchanged at 3.5% growth this year and 3.6% in 2018. This on the basis that stronger growth in China and the EU will compensate for the negative impact of US policy failures and weakness in the UK economy resulting from the build-up to Brexit.
The next question on the exam paper is what lower global growth – possibly even a recession – would mean for the petrochemicals industry. This will be the subject of my post on Friday, as I take another look at polyethylene.