China is not in Crisis, it is reforming

China is frequently presented as a source of crisis or instability for the global economy. We see little evidence of crisis in China. The picture that is apparent to us is one of imperfection, not one of peril.

At the heart of Chinese catastrophism is the assertion that loan growth in China has been “unsustainable” and China possesses an “economic model is based on debt rising at an ever-increasing rate”^[2].  There has indeed been a rapid increase in lending in the banking system and indebtedness more broadly in China since 2008. For loans outstanding exploded from 2008 to 2018, from 20 trillion RMB to 140 trillion RMB.

But you know what else grew a lot?

Deposits.

Deposits in the banking system also exploded, leaving a loan to deposit ratio of 77% at the end of 2018 (Australia’s banks have a loan to deposit ratio of about 112%^[3]). There are off-balance sheet liabilities outside of this, no question, but given the massive deposit base of the Chinese banks, there are about $6 trillion of deposits in excess of loans. That’s about 40% of GDP. There is A LOT of slack to absorb bad loans in off balance sheet activities^[4].

The principal reason for the massive deposit base of the Chinese banking system is that Chinese households save a lot. Indeed they are forced to. The erosion of the “Iron Rice Bowl” and the chains of the hukou system mean that Chinese households need to save for their retirement (this is changing at the margin^[5]), given stringent loan to value requirements Chinese home buyers need to save for large deposits, and migrant workers need to save for the education of their children and their healthcare needs^[6]. The result is household savings rates higher than any other country globally: Chinese households save approximately 35% of disposable income on average^[7]. And with an illiberal capital account, these savings largely get trapped in the banking system.

To give you a sense of the unfairness of the current situation under the hukou system, allow me to demonstrate by example. I was born in Perth, but grew up in Sydney after my dad moved the family for work. Our family would have had no free access to state education or healthcare if we had made an equivalent move in China, say from Datong to Shanghai. But local Shanghai residents, hukou holders, do have access to healthcare and educational services^[8]. Hence the need for savings on the part of the hundreds of millions of non-hukou holders.

China has generated a current account surplus for 25 years. It has little foreign currency debt^[9] as a result. Interestingly, 2018 has seen China’s current account surplus shrink and it posted a deficit in early 2018^[10]. This is exactly what one might expect from an economy moving from savings and investment to boost domestic consumption as a share of its economy.

China’s aggregate debt to GDP number is high for a developing country but pretty moderate for a developed country, at approximately 250% of GDP. Given its intermediate status as an emerging middle income country – this does not strike me as alarming. But that’s not just me, for a good framework for understanding China’s debt, please see the work of Yukon Huang – his book Cracking the China Conundrum, for instance^[11].

More alarming is the rate of change of total debt in China. Clearly – credit creation peaking at over 30% p.a. and exceeding 20% for years in an economy growing at ~10% real is too fast! This occurred from 2009 to 2011. But note that Chinese credit creation has been below 15% since 2012, and over much of the period since 2012 has been roughly in line with nominal GDP^[12]. Or stated another way, total debt to GDP in the Chinese economy has not meaningfully increased in years^[13]. This was China’s Quantitative Easing and Zero Interest Rate Policy and Negative Interest Rate Policy – but it was conducted via the banking system, rather than via central bank purchases of treasury securities^[14]. And it’s over.

However, one may well be sceptical – surely the explosion of credit continued in other areas outside of the banking system, amid shadow banks and other mysterious channels, and is somehow hidden from official statistics, this being China after all?

There is no evidence of this. Money supply growth in recent years of approximately 8% p.a. in official statistics has been lower than nominal GDP and this is backed up by M2 proxies such as one measured by investment bank CICC^[15]. And there’s little evidence of a general boom in asset prices of the sort one would expect in an economy replete with Minsky-style Ponzi financing – credit does not simply disappear from an economy, it manifests itself in asset price or general price inflation^[16]. Chinese consumer price inflation has averaged approximately 2% in recent years^[17]. So let’s look at asset prices in China.

I would like to invite you to play a guessing game. Please guess which country saw the highest real property price appreciation out of China, Belgium, the USA, Australia and New Zealand, from 1999 to the last available observation point in early 2017^[18]. Note that the period encompasses the birth of the national market in residential property in China in 1999, until the imposition of property tax, resale and lending restrictions directed at property investment activity in 2017. Try to guess where China sits, versus developed world peers? The answer is right in the middle. Real property prices in Belgium have performed roughly in line with Chinese property prices of the last twenty years – with Australia and New Zealand property prices WAY in excess of this level and the USA well below.

Further, when comparing Chinese property prices with various countries in the emerging world we find that Chinese property prices have performed far less strongly than in India or Brazil over ten years (our data set is shorter for emerging markets). Over the last ten years, real property prices in China have performed in line with Singapore.

China has had a huge property boom. That seems natural in a place that had no property market 20 years ago. On our analysis, something like 100 million dwellings have been built in China since 1999. Please search for yourself what pre-1999 housing in China looks like. It’s not good. So, there has been a construction boom, driven by newly available modern housing, plus growing incomes. But we just don’t have anything like the excesses or fragility implied by most breathless reporting of Chinese property prices.

More broadly, China does not seem to be in the grip of an asset price bubble. Actually, quite the reverse – equity prices have gone nowhere for over ten years. This is an immature market, dominated by retail investors, with low levels of institutional ownership and little international participation. There are wild swings, with stasis for long periods, followed by wild booms, followed by crashes, albeit to higher lows^[19].

China has gone from hosting among the most expensive equity markets in the world, to among the cheapest^[20]. The S&P 500 has outperformed the Shanghai Composite by 200% over ten years^[21]!

This has none of the hallmarks of a bubble. This looks much more like a bubble that has burst. So are we sliding into depression, marked by debt deflation in the mould of the USA in the 1930s…?

It does not look like it, based on the Li Keqiang Index – a composite of lending growth, power generation growth and the growth in rail freight movements expressed as an index. It is named for Li Keqiang, China’s Current Premier, who cited these measures as far better measure of China’s economy than “man-made” GDP numbers^[22].  Based on this measure, we are at slightly below the average levels of growth witnessed over the last 15 years and well above the recent trough in 2015^[23]. This does not look like a collapse. Indeed it looks more like the recovery from a protracted industrial recession in the wake of a crash.

So – China has an excess savings and debt problem, with debt having increased dramatically, likely leading to misallocation, but leaving debt no higher than most industrialised economies and with massively higher savings rates and somewhat faster growth rates. There is little evidence of an asset price bubble in comparison with other developed & developing nations and finally, industrial activity, while moderating, does not appear anything more than in a mild downturn. So what gives!?

Well, Xi Jinping’s vision for China is a significant break from previous administrations. To give you a sense of how significant, it’s worth setting out some scaffolding for understanding the Chinese economy.

The place to start for this is 1978 and the accession to power of Deng Xiaoping, following the inauspicious years in power of Hua Guofeng who succeeded Mao upon his death in 1976^[24].

The earthy, profane, pragmatic Deng is one of the most important human beings to have lived in the 20^th century. He established the fundamental underpinnings of China’s hybrid market-socialist economy, achieving the following:

• The establishment of special economic zones which became the foundation of China’s export-led development model;

• The de-collectivisation of farm land;                                                                                       

• The allowance of private ownership of farm land;

• The establishment of a de-centralised model of economic development with provincial level governments competing for capital and party officials competing for advancement on the basis of largely economic measures; and

• Support for private enterprise in his iconic Southern Tour.^[25]

It is no exaggeration to say that thanks to Deng, modern China emerged. He was also responsible for repression and death, notably in the crushing of the Tiananmen demonstrations of 1989. We are not dealing with perfection, I remind you.

Deng’s aphorisms reveal much of the man and his thinking about the world:

‘On economic matters, relaxed controls; for political matters, tight controls.’^[26]
‘It doesn’t matter if the cat is black or yellow, as long as it can catch mice, it is a good cat.’^[27]
‘Cross the river by feeling for stones.’^[28]

In short, the design of China’s economy in the Deng Xiaoping model is far from monolithic. The 34 provincial level governments and lower levels of administration, which control 70-80% of government spending in China, each compete with each other, with Party officials promoted in a vaguely meritocratic fashion, or perhaps seeking at least not to disqualify themselves from advancement^[29]. Infrastructure, like motherhood or democracy, sounds like an unadulterated positive. Dinny McMahon, who wrote an excellent survey of the Chinese economy and the challenges it faces, frames this differently. Instead of infrastructure, think of “public works” – this may convey some of the waste and self-aggrandisement that occurs on the public purse.

That said, successful ideas or methods generated at lower levels of government are implemented elsewhere. Advancement for Party officials relies on success across multiple jurisdictions. In short – this is a competitive, decentralised system, albeit administered from a strong centre^[30].

China’s hybrid system of market signals, plus state ownership of assets, plus the transference of usage rights of state owned assets, incentivises productivity and corruption. As long as production outcomes are being met, with applicable safety, environmental and other guidelines met, the state tolerates the capture of rents by agents in the system. In return, China has enjoyed a massive boom in productive capacity for a generation^[31].

However, at higher levels of capital stock to GDP, this system is inappropriate. China needs better – not just more activity. And herein lies the need for reform.

And then along comes Xi Jinping. Apparently Xi was selected as a ‘safe pair of hands’, a centrist candidate spanning the middle ground between liberal reformers and Maoist, old guard hold outs^[32]. So much for that.

The first moves of the administration – the corruption crackdown (including a suspended death sentence of the apparently loathsome wife of Bo Xilai^[33]) and an emphasis on “beautiful China” and the “Chinese dream” were pure populism^[34]. This is a populist leader, happy to tread on the toes of elites, who purged the Party early and established a centralisation of power not seen since Mao – in formal terms (it’s arguable that Deng had much more power than Xi, and did not need the titles to prove it^[35]). So, perhaps this is just a megalomaniac bent upon the acquisition of power without scruples. Or maybe something else is going on.

While the overwhelming impression one gets when talking to China strategists is one of disappointment in the Xi administration’s reform efforts, there has been a great deal of reform activity undertaken. A couple of these reforms in particular ought to be stressed. The first is the huge success of industry consolidation and capacity closure in Chinese heavy industry. China has done this sort of thing before – for instance before accession the WTO^[36]. But nonetheless, the implementation of swingeing cuts to capacity in industrial stalwart industries such as steel (150mtpa capacity cut) and coal (800mtpa capacity closed)^[37], while eliminating credit provision to zombie firms has been impressive. Consider the price recovery of aluminium, copper, steel and coal since 2015, to name but a few examples of commodity prices that foretold of deflation from 2011 to 2015, but have since recovered markedly. The world dodged a bullet in the form of deflationary capacity growth funded by Chinese policy banks.
 

 
It ought to be noted that rather than opening the spigots of the banking system to lend to heavy industry, as has occurred in the past – notably in the response to the GFC when the banking system was the core of a 4 trillion yuan stimulus^[39] – the government is targeting monetary stimulus and fiscal stimulus via liquidity injections and effective tax cuts. This is a far more market-based series of stimulus measures than has been seen previously in China. There has latterly been some increase in the approval of infrastructure projects, with US$160bn in December 2018, but this is a remains small compared to the 4 trillion yuan (approximately US$635bn) of the post-GFC stimulus.

While lending growth and money supply growth have been muted in recent years in China, one area of the economy has seen a huge leap in credit availability – Chinese households. As credit availability was curtailed to heavy industry and local governments, credit to households exploded. China’s household debt-to-GDP ratio increased from 18% in 2008 to 49% at the end of 2017^[40]. And note – this has been an area of focus for Chinese regulators in the last year or so, with peer to peer lending, trust structures and other non-formal lending channels coming under particular scrutiny^[41].

External events conspired to see that China’s reforms and credit restraint resulted in China being excessively tight in terms of both monetary and fiscal policy in 2018. Chinese authorities maintained relatively tight policy through the first half of 2018: for instance significant efforts to lower the Shanghai Interbank Offered Rate, or Shibor, via liquidity injections were not apparent until June 2018^[42]. As such, it would appear that the Chinese did not take the threat of a global slowdown in trade seriously – and to be fair they were not alone!

The thing about a trade war between the world’s two largest economies is that it affects everyone, in a world where trade equates to 70% of GDP^[43] and supply lines are incredibly complex. Many firms have thousands or tens of thousands of suppliers. When you try to bludgeon the great entrepôt economy of the world – you affect everyone. Clearly the threat of tariffs has affected China – their export PMIs have sagged from slightly positive to pretty clearly negative. But German export PMIs have suffered far more, falling from low 60s to low 40s, while export confidence has softened markedly in the US also, albeit remaining in mild expansion territory^[44]. Trade wars affect everyone.

To understand why, imagine you have to run supply lines for a firm in Hamburg, Seattle or Guangzhou and you don’t know what rate of tariff will apply to what product in two months’ time. If you believe tariffs will rise, you should order ahead of them and build inventories. If you think they’ll fall, you should run inventories down. This is a staggering level of uncertainty weighing on supply lines globally.

Now imagine being the CFO of the same firm – should you abandon current, highly efficient supply lines in China and invest in capacity in Vietnam, Cambodia or Bangladesh? You don’t know if tariffs are permanent or a bargaining chip which will disappear soon, making long term investment decisions difficult as well.

And we really must understand what is meant by taxing exports out of China. I wrote earlier this was an entrepôt economy, by which I meant that China takes stuff in, it assembles it or modifies it, and then it spits that stuff back out. As a result, net exports are a mere 6% of Chinese GDP^[45] – while total trade exposure (imports plus exports) is 38% of GDP^[46]. What this means is that taxing Chinese exports means taxing global supply lines.

Take for example the iPhone. We have pretty good data for the iPhone 7. This cost about US$240 to make in China and was exported at cost to the US or wherever it ended up, to be sold for US$700 or so. Of the $240 that would be subject to a tariff – only US$9 per phone is value that originates in China^[47].

$9…out of $240.

This is a very high margin product with a very complicated supply chain, so it’s not representative of all of the trade imbalance between the US and China. But it demonstrates a point by example. This is what I mean when I write when you tax the exports of the world’s great entrepôt economy, you are taxing global supply lines. Not China (well, not solely China at any rate!)

But, the tariffs have worked! Many seem to think this. I think a better interpretation is that tariffs have clubbed global growth, impinged on US corporates’ profits and/or forced US consumers to pay more for products in order to harm an economy that has not grown exports to GDP for years. This is madness.  

But, in true Trumpian fashion, there’s an element of luck and a grain of truth here. The tariffs and overall trade impact have hit China at an awkward moment. As I mentioned previously – Chinese authorities maintained relatively tight monetary and unsupportive fiscal policies throughout most of 2018, then had to play catch-up when it became clear that destructive and scatter-gun tariffs were actually going to happen.

I want to be careful to avoid the image of Chinese monetary authorities lurching from tight to loose to tight policy like so many drunken sailors. Rather, I’d like to leave you with an alternative image…one of an enormous ship, cumbersome and moving with great momentum. Nearly a decade ago, this ship was on a dramatically different course, in response to collapsing global demand. For the last five years and more, this ship has been cutting a far more sustainable course, of gradual monetary and fiscal tightening. But at times the ship will over-correct, and when it does it must be steered gradually back on course. China ended up over-tightening in 2018 and its tiller has shifted back to loosening now.

The reason all of this matters is that cyclical, industrial assets are remarkably cheap – globally, not just in China. It used to be tough to find a single-digit PE stock. Today you can buy Samsung for about 9x earnings ex cash; BMW for about the value of its cash and financing business and paying you a 5% dividend to hold it; or Micron on 7x earnings and on a 13% free cashflow yield^[48]. These things are about as cheap as they have ever been. So it matters if the world’s largest economy measured in purchasing power parity is not in crisis and is now stimulating.

It may matter a lot.