According to Jonathan Anderson of Emerging Advisors Group, who is our favorite China economic analyst, his “base case” for China has shifted. Regular readers know that we have followed Mr. Anderson for many years, and that in our view he has been the most accurate economist on China over the long term. For four years, he had argued that the government would eventually act to rein in the meteoric growth of leverage in the Chinese financial system -- noting that while the adjustment would be difficult, the characteristics of the Chinese economy would likely permit the authorities to gradually deflate the bubble and still maintain a GDP growth rate of 2 to 3 percent in the process.
Mr. Anderson now thinks that current evidence suggests that the Chinese authorities do not have the political will for the necessary reforms. As a consequence, his “base case” is now that the growth of domestic credit will continue until the advent of a crisis.
However, we note his estimate of the timing of that crisis: he believes that stresses will not begin to appear for two or three years, and that the crisis itself is probably four or five years away.
Current economic trends, he notes, are quite positive. His own analysis suggests that GDP growth is in the 6 percent range or slightly below, not drastically different from the official 6.9 percent. Property sales are stable, housing prices stable, steel demand flat or slightly positive, and he sees progress in industrial and freight indicators -- in short, trends in the real economy show a better outlook than they did a year ago.
All of this is actually good news for the emergence of a China “stabilization trade” in 2016, which, if it emerges, could be significant for a shift in global market participants’ psychology in a more positive direction.
Nevertheless, the government has retreated from showing any signs that it intends to take the pain that would result from reining in overall domestic credit growth, which at 18.5 percent is three times nominal GDP growth. In the past calendar year, China added as much debt relative to GDP as it did during the post-crisis stimulus in 2009.
Source: Emerging Advisors Group
Overall debt levels are no longer mentioned in official communiqués. Growth targets remain predicated on big credit growth, and show no signs of the caution that would accompany a debt slowdown. 2014’s throttling back of credit creation by trust companies and other shadow banking sector entities was not used to decrease overall credit growth -- instead, on-balance-sheet bank credit growth expansion more than made up for the reduction. And although local government bond issuance was inaugurated, it didn’t prove to be a way to reduce the burden of dodgy local government finance vehicles (LGFVs) -- rather, those stayed on banks’ books, and the new bonds simply added to aggregate debt creation.
However, Anderson notes that stress signals are still far from a crisis point. He views the trend as negative, but notes (as we have reiterated in this letter time and again) that “[China’s] banking system is still a net creditor vis-à-vis the rest of the world, better than EM-wide level, and despite the recent bout of headline capital outflows the net surplus position has actually increased over the past 12 months.”
The direction is negative, but he believes a financial crisis is still years away. In the meantime, we also believe, the growing strength of the Chinese services sector will continue to make itself felt, and we expect to continue to see more encouraging data on e-commerce, travel, and other consumer-facing industries. Whether these and other positive trends in China penetrate the fear currently gripping global stock markets remains to be seen.
Investment implications: Our favorite China economic analyst, Jonathan Anderson, no longer expects the government to rein in credit creation, currently growing three times faster than nominal GDP. Instead, he expects domestic credit expansion to continue at a breakneck pace until it results in a Chinese financial crisis -- but not for another four or five years. In the meantime, the real industrial economy is showing signs of stabilization and looks stronger than it did in the first half of 2015. In addition, the consumer sector, including e-commerce and travel, continues to show robust growth. Fears of Chinese instability are part of the poor psychology of global markets at this juncture -- and we continue to believe those fears are overblown. When and if market participants absorb a more accurate analysis of Chinese trends and risks, it will help lift global markets from their doldrums.
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