When Americans and the Europeans come back from their summer holidays in September it seems quite possible that they will see history repeat itself.
It was of course from September 2014 onwards that commodities prices started to decline from their all-time record highs, largely because of a belated understanding that credit growth was slowing down in China. The collapse in prices then led to lower global economic growth.
To understand the basis for our argument, it is worth studying the work of Autonomous Research analyst Charlene Chu.
Chu estimates that lending in China jumped by 19% in 2016 over 2015. This year she expects a 13% increase over 2016.
THE REFORMERS BACK IN CONTROL
This would still be a big increase in lending, but you need to pump more and more air into any investment bubble in order to keep it inflated. Pump in less air and any bubble deflates, which was what happened from January 2014 until the end of 2015 during Beijing’s previous attempt to tackle excessive lending.
There have in total been four stop go phases of China’s credit bubble since 2008:
1. China increased lending by $10tr in 2009 when its nominal GDP was only $5tr. This contributed to a surge in oil and other commodities prices on stronger demand. This supported global growth.
2. Growth in lending slowed in 2014. This was one of the factors behind the decline in global oil prices from around September of that year. As we said, commodities prices in general slid on a slowdown in the Chinese economy. Lending was down by $4tr by 2015.
3. Last year, China once again took the controls off its financial system, resulting in a renewed surge in credit growth. And this again boosted commodities demand and pricing, along with the global economy.
4. We are now in the midst of phase four as China sharply reduces growth in lending.
Last year’s renewed credit boom was because the populist political faction, led by Prime Minister Li Keqiang, took control of the economy. But now President Xi Jinping and his princeling, or reformist, faction, have regained firm and perhaps permanent control of the economy. It is possible that the populists will lose even more influence during this autumn’s crucial 19th National Congress political meeting.
Chu worries that even though the rate at which credit is expanding is being slowed down, not enough is being done to deal with what she believes is a huge potential bad debt crisis. Her estimate of nonperforming loans is 25% of total lending compared with the official estimate of a bad-loan ratio of just 1.74%.
Recent signs of a major policy shift include:
■ China’s credit impulse declined by 17.5% year-on-year in Q1, according to William Sterling, chief investment officer at Trilogy Global Advisors. Credit impulses are a measure of new credit issued as a percentage of GDP, thus widely viewed as a more reliable measure of the strength of new lending than headline lending data.
■ Money supply growth is expected to have remained at a record low of 9.4% in July. In May, the growth of money supply fell to 9.6%, marking the first time the reading had dipped below 10% in 22 years.
■ Bond issuance by Local Government Financing Vehicles fell by 54% year-on-year in January-May 2017 because of new government restrictions on local government financing. These financing vehicles are highly speculative and carry significant financial risk.
■ A plethora of new restrictions in the housing sector led to new-home sales measured by floor space dropping by 46% year-on-year in July, the first-tier cities — Beijing, Shanghai, Guangzhou and Shenzhen. Prices were down by 23% in 16 key second-tier cities, including Hangzhou and Nanjing.
China’s chemicals and polymers markets have started to feel the impact of a slowdown in the growth of lending. Not only is credit becoming harder to obtain, but interest rates have also gone up.
This all runs counter to the conventional view that Beijing would do very little to rein-in the credit bubble ahead of the 19th National Congress meeting. The thinking was the government would want to keep the economy booming in order to create a stable social and political environment ahead of and during the congress.
But Beijing has been able to put its foot down on the lending brake because of the lag effect of last year’s credit boom. So much money is still flowing through the economy that GDP growth was an unexpectedly strong 6.9% in H1.
Exports and imports are also booming and the Caixin Purchasing Manager’s index bounced back in June and July, into firm expansionary territory.
The political calculation seems likely to have been that any pain the Chinese population would feel ahead of the autumn meeting would be soothed by the strength of H1 and possibly Q1-Q3, growth. This looks like it might well have been a correct calculation.
Globally, though, the impact of the China credit slowdown is likely to be more immediate and a lot more painful.
The China bubble could be on the verge of popping as the government restricts credit
John Kemp, in a 3 August Reuters article, says that world trade grew by 5% in the three months to May compared with the same period a year earlier.
“Trade growth came close to a standstill in the first quarter of 2016 but has been accelerating gradually since then, especially from the fourth quarter onwards,” he wrote.
He is correct to link this recovery to the rebound in commodities demand and prices that has replenished the coffers of countries heavily dependent on commodities for their economic growth. And he is also right to argue that better world trade in general is the result of the rebound in commodities.
What has driven the commodities rebound? It is of course China.
Take iron ore as just one of many examples. In 2016, its iron ore imports rose by 7.5% over 2015 to 1.024bn, according to the China Customs department data. This was an all-time record high.
The new China boom has also benefited the west. A return to mild reflationary conditions has forced purchasing managers up and down on all the manufacturing chains in Europe and the US to buy raw materials ahead of their immediate needs. They have been trying to hedge against further price rises.
At times like this it feels like demand is actually strong as no company has complete visibility all the way to the end of their particular manufacturing chain or chains. They never know to what extent final consumer demand has improved because of better economic fundamental, versus the final consumers also responding to stronger inflationary signals.
The US is in a political crisis as it faces longer-term lower growth because of its ageing populations.
The EU has rebounded slightly, but you have to question whether this is largely the result of Germany’s success in export markets. And China is a major export destination for Germany. The EU also confronts the drain on demand caused by an ageing population.
As for the UK, it faces both an ageing population and the economic damage resulting from Brexit. The remaining EU countries will also be hurt to a lesser extent by Brexit.
Stronger economic growth in the west could thus be largely due mild reflation – and that mild reflation has been down to the latest Chinese credit bubble’s impact on commodities demand and pricing.
Hence, the argument that history could repeat itself as September arrives. Later in this quarter, the effect of China’s slowdown in lending growth may start to feed through to significantly lower commodities demand and pricing.
IT SEEMS likely that China’s economy will only undergo a moderate slowdown during the rest of this year and into 2018.
And any such slowdown would come from a very solid base of strong GDP growth in H1 this year. In the first half over the same period in 2016, China’s economy expanded by 6.9%. This was better than many economists had expected.
Therefore, it seems unlikely that there will be a sudden collapse in China’s chemicals and polymers growth, which is of course tied to the rate at which GDP expands.
Take polypropylene (PP) as an example where the ICIS Consulting base case is for real demand to rise by 7.8% in 2017 over 2016. This would leave real demand by the end of this year at around 26m tonnes. And by 2020, we expect a market of around 31m tonnes. Real demand is demand adjusted for inventory distortions.
Let’s for arguments sake reduce this growth to exactly 6% on a cooling-off in the overall economy.
A fall to 6% real growth would be way below the apparent demand growth seen in the first of this year of 10.3% over H1 2016, and so seems overly pessimistic.
Apparent demand growth is net imports (imports minus exports) plus local production which hasn’t been adjusted for inventory distortions.
But let’s say the market did only grow by 6%.
This would still leave real consumption by the end of this year at over 25m tonnes, around 450,000 tonnes less than if 8% growth does happen.
This quite small difference reflects that percentage changes are now coming from a much bigger base of demand in China than was the case a decade ago. In the case of PP again, real consumption was just 9.2m tonnes in 2006, but last year it had grown to 24m tonnes.
But the problem for the global chemicals business is just how reliant it has become on Chinese growth.
Sticking with PP as an example, China’s percentage share of total global real demand was at 23%. In 2016 it was 35%, and we forecast this to increase to 36% by the end of this year.
The same applies to the global economy in general, as William Sterling, chief investment officer at Trilogy Global Advisors, very well illustrated in an 18 July post in Beyondbrics, the Financial Times blog.
“China’s impact on the world economy is significant. Over the past five years its nominal GDP has expanded by $3.7tr, an amount that exceeds the GDP of Germany,” he wrote.
“In contrast, the entire global economy has expanded its nominal GDP by only $2.2tr,” Sterling added.
The old cliche was that if the US economy caught a cold then the global economy was at risk of a severe dose of flu. Now it seems it is the case that if the Chinese economy develops a minor chill, then the rest of the world will be hit by the flu.