China hits the brakes

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From restrictions in lending to measures in the housing sector, the government is trying to slow China’s economy

It could still go either way. The Chinese government may still decide to prolong the 2016 credit bubble, but as this article went to press there were signs that economic reforms were once again being accelerated:

The growth in total social financing (the total of lending from China’s state-owned banks and its private lenders) was sharply down in January-February 2017 over the same two months of last year.

We have also seen a flurry of new measures to take the heat out of China’s boiling-hot property sector. These include raising down payments on second homes to 60% from 50% of their value in many cities in China. The Beijing government has also closed a loophole where couples were getting divorced in order to be able to each benefit from the lower down payments that apply to a first-home purchase.

The Caixin/Markit China manufacturing purchasing managers’ index (PMI) fell to 51.2 in March from 51.7 in February, indicating a slower expansion of activity.

The PMI has in the past been a very reliable reading of credit, manufacturing and commodity-price cycles (they are all the same thing) in China. Hence, it swung into positive territory last year as the credit bubble was re-inflated and is now moderating again.

The official government manufacturing PMI pointed to a pick-up in activity in March. But the official PMI focuses on the big state-owned companies that tend to enjoy access to easy finance for longer than smaller, private companies when credit conditions tighten. The Caixin/Markit PMI measures the smaller, private companies.

The thing is that we have been here before:

• China increased lending by $10trn in 2009 when its nominal GDP was only $5trn. This was a desperate scramble to stimulate local demand in order to compensate for export-focused jobs that were at risk as a result of the Global Financial Crisis. “Go out and lend for the sake of lending and don’t worry about the long-term supply and demand fundamentals of the projects you lend to,” was in effect the instruction from Beijing to the state-owned banks. This led to overcapacity across many industrial sectors and a major real-estate bubble.

• It also resulted in the growth of the shadow banking sector. This involves highly speculative and complex, and so very risky, lending practices.

• Growth in lending then slowed down in 2014, which was one of the factors behind the decline in global oil prices from around September of that year onwards. Commodities prices in general slid on a slowdown in the Chinese economy.

• And last year, China again took the shackles off their financial system. Credit growth climbed higher again.

As we’ve discussed before in previous China Monthly articles, this up and down nature of credit growth has been the result of shifting political influence between the “Populists” and the “Princelings”.

The Populists, led by China’s Prime Minister Li Keqiang, prefer delaying reforms for the sake of shoring-up short term growth. But the Princelings, who can trace their lineage back to the founding fathers of the Chinese Communist Party – hence their name – want to press ahead with weaning the Chinese economy off the wrong kind of lending. This group is led by Xi Jinping, China’s President.

Evidence of the wrong kind of lending includes oversupplied industrial sectors, including some chemicals and polymers, and a real-estate sector where rising prices in China’s first and second-tier cities in particular is creating growing public resentment.

Then of course there is the bad debt issue. Ratings agency Fitch warns that capital shortfalls to meet China’s debt are at 11-20% of GDP, with the potential for this to increase to 33% in the worst-case scenario by the end of 2018. In Britain and the US, the direct costs of bank rescues reached approximately 8% of each country’s GDP after the Global Financial Crisis

And the other problem is that lower growth since 2008 has made it harder for China to grow its way out of debt.

Li appears to have regained control of the levers of the economy in 2016, hence the re-inflation of the credit bubble. Now it seems that Xi has taken control again – hence, indications during the early months of this year that the lending bubble is yet again being deflated.

EFFECT ON PETROCHEMICALS

There was a big surge in polyethylene (PE), polypropylene (PP), styrene, mono-ethylene glycol, acetone, and phenol exports to China in January-February – maybe on the assumption that the credit growth we saw in 2016 would continue throughout this year.

But markets suffered a severe bout of indigestion in March as unsold cargoes piled up in bonded warehouses. Some consignments of PE and PP even had to be re-exported to other locations in Asia because traders failed to find end-users in China.

This was one of the factors behind flat or declining prices in March, when many market participants had expected higher pricing as we are in the midst of the Asian turnaround season. Between March-June, plants in Asia come off-line for maintenance work.

And in iron ore, inventories of iron ore at 46 Chinese ports reached 132.45m tonnes on March 24 – the highest since data started to be tracked in 2004, according to a 31 March Reuters report.

This would be enough to make 12,960 replicas of the Eiffel Tower. A third of the stocks belonged to traders. Domestic production of iron ore was also up by 15.3% year-on-year in January-February.

“I wouldn’t say the mood out there is negative, but is certainly cautious when I had expected it to be bullish,” said a Hong Kong-based aromatics trader.

“There is a perception that the Chinese government is determined to slow the economy down a little and this has dampened petrochemicals demand. Too many cargoes were shipped to China in January-February on the basis that there would no slowdown,” he added.

In PE and PP, the data shows that China’s imports surged in January-February at the same time as domestic production also saw substantial increases.

On a net basis (imports minus exports), PE imports rose by 38% on a year-on-year basis to around 1.9m tonnes, according to China Customs data. Meanwhile, ICIS China estimates that domestic production rose by 11% to approximately 2.7m tonnes during January-February.

It is the same story in PP. Net PP imports were up by no less than 50% to around 900,000 tonnes and local output was 15% higher at 3.1m tonnes.

TOO EARLY FOR CONCLUSIONS

Two months of data clearly don’t make a long-term trend. By the time you read this article, we could see the results of China reining-in the growth of credit.

But as we shall discuss in next month’s issue, repeatedly kicking the can down the road – delaying dealing with debt problems – is an ever-more risky strategy.

At some point China will have to deal with an economic growth model that has become too heavily reliant on lending to real estate and to oversupplied manufacturing sectors. And when the reckoning with these economic imbalances does take place, as our article next month shall also examine, the consequences for the global economy will be profound.

In short here, a strong argument can be made that much of the global economic recovery that we’ve seen since around the middle of last year is the result of China’s decision to allow lending to climb out of control again.

Take this momentum away, whether it is this year, next year or even later and the question that will then need to be asked will be this: How strong is the global economy without very loose Chinese lending conditions?

A strong argument can be made that much of the global economic recovery that we’ve seen … is the result of China’s decision to allow lending to climb out of control again