Hooray! China has Bottomed Out

Have we reached a bottom? A lot of analysts are pointing to the improvement in both measures of Chinese PMI to suggest that Chinese manufacturing may finally have reached a bottom, even though both PMI measures are still well below 50 and so indicate a contraction in manufacturing. More impressively the stock market has rebounded, with the SSE Composite bouncing off its January 13 close of 1863 to reach, as of yesterday 2108 (up 13.1%). Today it traded up another 2.0% in the morning before giving it all back, and more, during the afternoon to close down 0.5% for the day. Before the market turned Bloomberg today reported a very optimistic fund manager:

“Stocks continue to be lifted by speculation more stimulus measures are on the way,” said Michiya Tomita, a Hong Kong-based fund manager of Chinese stocks at Mitsubishi UFJ Asset Management Co., which oversees $61 billion. “There’s a growing perception that China’s economy will recover surprisingly fast.”

Surprisingly fast? I’ll take that bet. Aside from the normal excitement we all get from the right kinds of stimuli, part of the recent optimism seems to reflect the huge upsurge in bank lending I reported last week – with loans in January rising by RMB 1.3 trillion. Nearly one-quarter of that was provided just by ICBC. According to an article in today’s Bloomberg:

Industrial & Commercial Bank of China Ltd., the nation’s largest, said it offered 252.1 billion yuan ($36.9 billion) of new loans in January in response to the government’s stimulus plan to avert an economic slowdown. The bank lent 69.3 billion yuan to power grid, railway, roads, and hydroelectric power projects, and 135 billion yuan in discounted bills to small and medium-sized companies, the Beijing-based firm said in an e-mailed statement, without giving comparisons. New loans to individuals, including mortgages, amounted to 16 billion yuan.

China dropped lending quotas and unveiled a 4 trillion yuan stimulus package in November to maintain economic growth and counter the global financial crisis. Banks have responded by raising lending targets and focusing on railways, roads, power grids and other infrastructure projects with stable returns. Domestic banks offered a record 1.2 trillion yuan of new loans last month, representing almost a 50 percent gain from a year earlier, the China Securities Journal said yesterday.

ICBC aims to advance 530 billion yuan of new loans in 2009, about the same as last year, the 21st Century Business Herald reported today. The bank plans to complete 45 percent of the loan target in the first quarter. ICBC attracted 271.2 billion yuan of deposits in January, equivalent to a quarter of the total increase in 2008, according to today’s statement.

I have long argued that credit is a much better gauge of money supply in China than any of the monetary aggregates, so this explosion in bank lending should suggest at least that China is making the right moves from a monetary point of view – pumping liquidity into the system to avert a contraction in money supply that would exacerbate the contraction in demand. But I have three very serious problems with the optimism associated with the latest numbers on credit expansion.

First, this credit expansion is not all that it may seem. Aside from the fact that a lot of this new credit has consisted of an increase in bill discounting, in order to understand what is really happening to total credit in the Chinese economy we need much better data. There are persistent rumors that part of the increase in bank lending consisted of putting back on balance sheet loans that were taken off balance sheets in 2007 and 2008 when the PBoC was trying to constrain bank lending. It isn’t really new credit. We also don’t have a very good feel for what is happening in the informal banking sector, and in the past there was evidence that contraction and expansion in the informal banks counteracted what occurred in the formal banking sector.

What is more, there is clearly an increase in lending games aimed at making policymakers happy by showing fat loan books. One of my students just visited me today with an example that involved his father. I don’t want to get into too much detail, for obvious reasons, but the net effect of the transaction involving his father was that an entity was created to borrow money from a bank, the proceeds of which were deposited in a CD, which was then assigned in ownership to the real borrowing entity, which then used the CD as collateral for the “real” loan. Aside from the complications used probably to get around credit restrictions, one single loan was recorded as two loans plus a CD deposit. Apparently the lending bank knew about all the intermediate steps. Surprise, surprise! It turns out that if your career prospects depend on increasing the total amount of loans outstanding, with less focus on the quality or structure of the loans, in fact it isn’t hard to show very nice, fat loan book.

One of the readers of this blog, yesterday gave another very interesting example of what might be included in this new lending. He says:

As for the sudden surge in lending, this looks to me to be an accounting exercise, clearing or otherwise funding non-bank debts piled up by SOEs. Many large SOEs (not central ones, regional/local ones, though the central ones win no prize themselves) are behind on paying wages, suppliers etc, and the stimulus provided by this lending surge is really just to ease the log-jam of triangular debts. This implies that there will not be much “bang” for all of this lending.

Second, exploding credit may provide a fillip to growth in the short term, but if it leads to a future increase in bad loans, it will have exactly the opposite effect in the near future. As I discuss in my previous blog entry, this represents a big bet on the duration of the slowdown.

Third, the biggest problem has to do with how much credit expansion will make a difference. Andrew Batson at the Wall Street Journal (sorry, I don’t have the link) makes this point when he discusses the “string of dire profit warnings has signaled a rapid deterioration in the financial health of Chinese companies.” His relevant paragraphs:

Corporate investment is hugely important to China’s economy, where capital spending accounts for more than 40% of annual output, one of the highest ratios in the world. The profit decline will have major effects across the economy as companies have less money to buy new equipment or expand their businesses.

…Economists have long warned that Chinese companies’ heavy reliance on retained profits would tend to exaggerate swings in the nation’s investment cycle. Official statistics show that 63% of investment in China last year was financed by what are called “internally generated” funds, which include retained profits. That’s up from just below 50% a decade ago.

Basically Chinese corporate profitability in China is dropping sharply, and nearly everyone expects the trend to continue over the rest of 2009. If nearly two-thirds of investment in China was funded by retained earnings, a sharp drop in profitability should result in an equally sharp drop in investment funded by retained earnings. I don’t know the magnitude, but I would guess that a very large increase in real bank lending aimed at real investment, far more than has been reported, would be needed just to make up for the decline in investment out of retained earnings. This, by the way, is an argument that has also been made by my friend Sam Baker at TNR.

For these three reasons (and a few others), I am not as impressed as many others are by the recent expansion in credit. I acknowledge, of course, that I may be hemming myself in intellectually because my very strong belief that China will be forced one way or the other to make a necessary but difficult adjustment from export orientation to growth based on domestic consumption, and so I am blind to the good news, but for now I am sticking with my belief.

Aside from doubting the beneficial impact of credit expansion a larger part of the reason for my continued skepticism is that I am much more impressed by the expectations of hordes of workers returning to work after the Spring Festival and not finding jobs. Today’s South China Morning Post starts off an article today:

One of the world’s leading luxury furniture makers has folded in Shenzhen amid the economic crisis, leaving more than 2,000 unpaid workers blocking traffic in protest until the local government paid more than 10 million yuan (HK$11.3 million) in back wages. DeCoro, the Shenzhen-based Italian sofa manufacturer employing nearly 3,000 people, had gone into liquidation with all assets seized by a local court in Longgang district, the National Business Daily reported.

Less anecdotal is another article, also in today’s edition:

Guangdong authorities are expecting millions of unemployed migrant workers to pour into the province in search of work, despite official warnings that the prospects are slim. Provincial labour authorities say 10.25 million migrant workers left for the Lunar New Year holiday, and of the 9.7 million expected to return soon, about 20 per cent would find it extremely difficult to find work.

But the biggest problem I have is that anyone taking a global view, and not just a very local view, cannot fail to be impressed by how bad the numbers out there are. For one thing, US GDP contracted by 3.8% in the fourth quarter of 2008. Normally that would be a horrible piece of news, but most analysts were pleasantly surprised because they expected something closer to 5.5%. Does that suggest that the US, too, is bottoming out? No, because apparently what saved the US from a much larger contraction was heavy orders from factories, including foreign factories, based on a surge of optimism during the summer. According to an article in Monday’s Wall Street Journal (I don’t have the link because I read it in the plane, but for those interested the article is titled “US Economy Dives as Goods Pile Up”):

While the fall wasn’t as steep as expected – most forecasts had GDP falling by 5% to 6% — output was boosted somewhat by a rise in inventories of goods that were produced but not sold in the fourth quarter. Excluding the inventory adjustment, GDP fell at a 5.1% rate, which economists say more accurately reflects the nation’s weakness.

Rising inventories, in other words, accounted for the better-than-expected US economy in the fourth quarter of 2008. But now those inventories have to be sold. That means however bad we expect US demand to be in the next few months, US companies will buy even less because they have excess inventory that needs to be run down. The unexpectedly good results for the last quarter will cause an unexpectedly bad result this quarter (not unexpected, of course, but you know what I mean).

And there is more. The US savings rate dropped to below zero in 2005 and 2006 but since then has been rising as Americans are forced to pay down debt and save more. Savings rose to nearly 3% of disposable income in the fourth quarter, from 1.2% in the previous quarter, according to the same article. But 3% is not enough. My guess is that this represents less than a third of the total adjustment that needs to be made. Remember that every dollar the US saves is a dollar that doesn’t go towards consumption.

Here is another way of looking at the same data. David Pilling has a very sober piece in yesterday’s Financial Times in which he argues that “China should raise wages to stimulate demand.” Of course he is right and of course they should (at least this is what I have been arguing for a while), even though it seems completely counterintuitive. Most analysts both in and out of China are arguing that China should try to increase the competitiveness of its manufacturers and the profitability of its businesses, and in this light raising workers’ wages seems stupid, but in fact I would argue that this is the best medium-term strategy to minimize the cost of the downturn to China. I will argue this more fully another day, but I do want to extract two paragraphs from Pilling’s article:

To see why, look at US personal consumption, which hovered around 67 per cent of gross domestic product in the last quarter of the 20th century. That was already high by the standards of the previous 25 years. But from 2000 to 2008, it shot up again to an unprecedented 72 per cent. That trend has now gone into painful reverse. As Stephen Roach, chairman of Morgan Stanley Asia, notes wryly: “We are already all the way down to 71 per cent.” In other words, it will be a very long time before Americans are again filling up their shopping carts.

…In 1980, 65 per cent of output of developing Asia was accounted for by consumption. Today it is about 47 per cent. The main reaction to the Asia crisis of 1997-98, when economies’ vulnerability to financial flows was exposed, was to build up exports. In doing so, Asia has swapped one kind of dependence for another.

US consumption dropped from 72% “all the way down” to 71%. Of course Stephen Roach is joking. US consumption has to decline by a lot more than that, and it will. Any attempt to understand China’s economy without situating it firmly within the global context, and especially within the contraction in global demand (remember as a major trade-surplus country China needs foreign demand to absorb its huge overcapacity) will not get the picture right.

By the way, on a related note, the US “Buy America” plan, which has been both widely criticized and widely replicated – explicitly or implicitly – by a lot of countries including China, is an example of how things are likely to turn when it comes to trade prospects. The good news, I think, is that those of us who worry about an explosion of protectionism are getting so alarmed that there may be a concerted fight to ward it off.

One other piece of mild good news, China yesterday increased the tax rebate for textiles. According to an article in today’s People’s Daily:

China will increase the tax rebate rate for textile and garment exports from 14 percent to 15 percent, an executive meeting of the State Council (Cabinet) announced Wednesday. The move would reduce exporters’ costs and support the textile industry, the Council said.

Increasing the tax rebate is actually a bad thing, in my opinion, since it seeks to improve the trade “competitiveness” of Chinese textiles and so increase China’s ability to export overcapacity, but the increase was much less than the industry expected. Thank god for small favors.

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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