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Thursday, February 12, 2009

China - The Begining Of The End, Or The End Of The Beginnining?

by Edward Hugh: Barcelona

Is China about to lead the charge out of the current slump, or is the Chinese economy about to succumb to it? This appears to be one of the most interesting and most hotly debated questions of the moment. On the one hand the latest manufacturers PurchasingManufacturers Index seemed to suggest the contraction in China's economy slowed in January, while other data, in particular producer price inflation, loan growth, employment figures and movements in external trade seem to give a rather different impression.

External Trade Drops Sharply

China’s exports fell at the fastest rate in almost 13 years in January while imports fell completely off the cliff, plunging at the record rate of 43.1% year on year, indicating that the contraction in the world’s third-biggest economy may well be gathering rather than losing pace. Exports were down by 17.5 percent from January 2008.

Due to the massive fall in imports China's trade surplus remained high - at $39.11 billion it was the second largest on record - and this is almost guaranteed to add to tensions as global leaders seek to avoid a return to protectionism. China’s economic slowdown has already cost the jobs of 20 million migrant workers and the economy is now almost certainly contracting, rather than, as some argue, simply slowing.

Exports to the European Union fell 17.4 percent, while those to the U.S. were down 9.8 percent. Shipments of electronics goods dropped 21 percent. Steel slid 32.5 percent and toys declined 14.7 percent, although the numbers are possibly exacerbated by the week-long Lunar New Year holiday, which took place in January this year as opposed to February last year.

Chinese government researchers have already begun to advocate weakening the yuan against the dollar to support exports, and according to a report from the Ministry of Finance’s research institute published earlier this month China should “actively guide” the yuan to about 6.93 to the dollar to aid growth and boost employment, although there is no indication at this point that such a recommendation will be acted on.

It is very hard to know what is the actual present condition of the Chinese economy, since while it grew by 6.8 percent from a year earlier in the fourth quarter of last year - following a 9 percent in Q3 - this data point doesn't actually tell us too much about the current rate of expansion/contraction, and since things are changing very quickly this is quite important. The same goes for the official industrial output numbers which tell us output was up at a 5.7 percent annual rate in December, down from 17.4 percent a year earlier, but don't tell us what happened between November and December.

China Compared With The Other Asian Exporters

Some commentators are arguing that the drop in Chinese exports is not that severe if we compare it with the decline in other Asian countries, suggesting in effect that China is less export dependent than some of its neighbours.

“While the recent export slowdown has been alarming, China’s export slump has not been as severe as in some neighboring countries with a greater reliance on high-tech exports,” said Jing Ulrich, head of China equities with JPMorgan in Hong Kong. Taiwan’s exports fell a record 44 percent in January.

But this view seems to me to be misleading, and possibly ill-founded. According to a recent research report from DBS, two things stand out in the latest data. First, China’s exports to the US have obviously fallen considerably. In fact, they have fallen by around 9% since October (USD terms, sa, 3mma). Exports to Europe have also fallen by a similar amount. But Asia’s exports to China have fallen by four times more - or 37%. If China were simply passing along weak demand from the US and Europe to its neighbors, the drop in Asia’s exports to China ought to be roughly proportionate. So obviously they’re not.

DBS suggest that there is thus a huge disconnect between the fall in global demand for China’s exports and China’s demand for Asian exports.

Secondly , China’s demand for Asian exports starts to drop sharply in August, fully three months before China’s exports themselves begin to drop. A number of interpretations are possible at this point. One possibility is that the decline in other parts of Asia reflected a decline in new orders which only later hits China (in which case we should expect China's exports to take much stronger hits in February and March). Another is that China was the “leader”, not the“follower”, with much of the Asian exports being directed to fuelling China's internal investment boom. There is a third possibility here, and that is since China is very energy dependent, a significant share in the imports drop is a reflection of the fall in energy prices, since oil did, conveniently, peak in July 2008.

Possibly there is some truth in all these arguments, but, in terms of quantities and in terms of timing, there does seem to be something “autonomous”going on with Chinese demand. And if its not simply about the drop in demand from the US, what is it about?

Could the end of the Olympics bubble have something to do with the disconnect, and with the subsequent bust in Asian exports? It certainly seems to be more than a coincidence that China’s imports from Asia rise sharply in the run-up tothe August Olympics and then fall sharply immediately thereafter.

Price Changes Hit Deflation Territory

Prices in China have now started to fall, with producer prices dropping in January by 3.3 percent -the most in almost seven years. Consumer prices rose 1 percent in January from a year earlier, after gaining 1.2 percent in December, but these are year on year numbers, and the recent decline in month on month prices changes, despite a surge in food prices as we entered the Lunar New Year celebrations, have generally moved into negative territory.

In particular, food prices are usually higher during the Chinese new year celebrations and for that reason consumer prices were probably higher than usual in January. Despite inflation declining less than expected in January, there are signs that inflationary pressure is easing fast and it is likely that China will enter deflationary territory in the coming months. Inflation excluding food in January plunged from 0.6% year on year to -0.6% (see chart below).

The residential component showed an unexpected large drop from 1.1% year on year to minus 2.3%. Besides food - which is running just below 5% year on year - all the other major components are now in negative territory.

“Inflation could have been close to zero or worse if not for the Chinese New Year, because vegetable prices and grain prices went up,” said Wang Tao, China economist at UBS AG in Beijing.
McDonalds, the world’s largest fast-food chain, said last week that it was cutting the prices on some of its meals in China by as much as one-third to attract customers to its 1,050 restaurants across the country.

So my feeling is that we have now entered a deflationary period in China, of longer or shorter duration depending on whether or now the authorities are successful in turning the economy around. The rate of price deflation, and in particular in producer prices, will certainly give us one convenient indicator of the rate of contraction. Further, the inflation slowdown will put additional pressure on the central bank to cut interest rates, since the key one-year lending rates still stands at 5.31 percent - following a total of 2.16 percentage points in reductions at the end of 2008 following the collapse of Lehman Brothers. The central bank has not yet cut rates so far this year, despite the fact that with inflation now around zero, and the economy more than likely contracting, those 5 percentage points represent very tight monetary conditions. Of course, and looked at from another perspective, any further loosening in interest rates may well not be all that positive for the yuan.

Mind What You Say

During the lunar new year festival Chinese people send traditional greetings to each other, such as "Caiyuan gungun" (May prosperity come rolling to you) or "Xinxiang shicheng" (May you achieve all your desires). This year, festive well-wishers have had to be careful which salutations they choose. “Caiyuan gungun” has been virtually banned because it sounds exactly the same as the phrase meaning “laid off and discarded”. “Xinxiang shicheng” is also out of favour because it sounds suspiciously like the Chinese for “40 per cent pay cut”.

Giant Credit Surge In January

The Chinese government has now abandoned quotas for new credit growth and has urged state-owned commercial banks to offer finance for the Rmb 4,000bn ($586bn) fiscal spending plan which is due to run over the next two years. As a result there are now plenty of signs of monetary losening, among which is the fact that new loans rose at a record pace in January while the money supply expanded at the fastest pace in more than a year. Banks extended Rmb 1,620 bn of new local-currency loans and M2 climbed 18.8 percent from a year earlier. The new lending was equivalent in size to 40 percent of the proposed stimulus spending.

“Explosive lending growth is unsustainable and will likely decelerate,” said Ha Jiming, Hong Kong-based chief economist at China International Corp. “China may face increased risks going forward if the lending upsurge is coupled with declining loan quality and loosened lending terms.”
The biggest proportion of new lending, 39 percent, was through discounted bills, which could be though of as supplying working capital, rather than funding investment. Medium and long-term corporate loans accounted for 32 percent.

Also of note, consumer credit grew by 121bn in January, and this was almost evenly divided between short and long term credit. These together accounted for just 7% of total credit growth. The level of consumer credit growth was the largest in just over a year, but it was not far above the levels prevailing in 2007. Consumer demand in the holiday month should have been particularly strong in relation to the rest ofthe year, so this rather mediocre result suggest a weakness in the underlying dynamic of consumption growth that could become more apparent as the year progresses.

China Is At The Start, Not The Finish, Of The Slowdown

At this point in time it would seem highly premature to start speculating that China's economy may be turning the corner. Many have read the lates CLSA PMI survey, which showed the output index rose in January to 39.7 from 38.6 (which had been a record low) in December, as signs of turning the corner. New orders were even up to 39.9 from 37, while the export orders component rose to 36.3 from 33.6. So the situation was better in January than December, but it is SO important to remember that these sub-components all indicate ongoing contraction, and it is very, very early to start saying that all this has "bottomed".

The collapse of China’s export engine has obviously hit the most vulnerable first, and the Chinese authorities estimate that 20m of an estimated 130m rural migrant workers in China's industrial sector have lost their jobs and returned to home towns and villages. The implied 15.3 per cent unemployment rate among migrants is not captured in official jobless numbers, which measure only urban workers who register as unemployed. That official number rose to 8.86m people, or 4.2 per cent of the urban workforce, in December, but many specialists say this number vastly underestimates the true scale of the problem.

And in this environment it is hard to see the "big switch" to a consumption driven economy moving slowly, if indeed it moves at all.