3 threats to China’s second half economic recovery16 July, 2012, 13:48. Posted by Zarathustra
Even though there is very few evidence that the Chinese economy has hit the bottom and will recover in the second half, we noticed that a consensus that the economy will certainly recover in the second half has emerged on the back of stimulus hope.
There is little doubt that there will be more stimulus, and a lot of “fine-tuning” has been done in hope to stimulate growth, especially investment. So far, however, the so-called “fine-tuning” is nothing like the RMB4 trillion we saw back in 2009 for obvious reason, and we believe more dramatic measures will only be possible when things are getting really bad (and those dramatic measures such as a RMB8 trillion stimulus are not going to solve the problems within the economy, although it will boost growth in short-term).
On top of the fact that we find no clear signals that point us to a second half recovery (except blind faith and hope), we can identify at least a few threats that could undermine the story of a second half recovery.
1. Bad loans are surging as shadow banking mess spreads
|By Daderot (Own work) [Public domain], via Wikimedia Commons|
We were early in looking at the shadow banking system back in last year, and we have recently noted that because of the intricate linkages between the informal and the formal banking system, the risk of contagion where increasing credit risks feeding back into the formal banking system is on the rise.
Recently, non-performing loans in Wenzhou’s banking system has been rising for 12 consecutive months to a new record high thanks to its vibrant shadow banking sector. Companies that were forced to borrow in the informal banking sector at high costs of borrowing have been finding themselves in huge trouble since last year as the economy slows and business conditions deteriorated. We have also highlighted the mini credit crunch in Zhejiang caused by complex network of companies guaranteeing loans for each other, which dragged more than 600 companies into the crisis, and the increasing risks in the trusts industry.
Instead of being isolated cases unique to Wenzhou or Zhejiang, we believe this reflects a broader systemic issue in the banking system. We believe that companies will continue to be forced out of businesses or deleverages.
Very dramatic measures on the part of the central bank and the government to force banks into lending more money or rolling over debts will be required to hide bad loans and to maintain high credit growth that supports a very high growth in money supply in hope that everything will be fine in a few years down the road. We do realise that there has been something done on this front, but we believe the on-going force of deleveraging and debt deflation might prevail for the time being, and that will undermine both consumption and investment in the short-run.
2. Capital flow is not favourable for monetary condition
We noted in our guide to Chinese monetary policy that favourable external balances in the past contributed to high liquidity within the Chinese banking sector. High current account and capital account surplus necessitated the central bank to create money to stop Chinese Yuan from appreciating too quickly, thus creating excess liquidity.
That has changed, both because China is not so much a export-driven economy, and because capital flow is no longer providing positive impact on liquidity. Although we do not have good means to distinguish flows from different sources, the current situation as far as capital flow is concerned is not favourable to monetary condition. In fact, it tightens monetary condition as outflow could eventually necessitate selling of foreign reserve assets and purchase of Chinese Yuan by the central bank, “absorbing” liquidity from the banking sector. This trend will limit the effectiveness of monetary easing.
3. Europe, one big question mark
Much of Europe is already in deep recession. Our view is that the Euro Crisis is primarily about the flawed design of monetary system, and we increasingly believe that economically viable solutions are also politically impossible. Thus we believe there will only be short-term reliefs from time to time, but not an end to the crisis, at least in the foreseeable future.
As such, there is, to our mind, no reason to believe that external demand can recover in the short-run that could help the Chinese economy. We are also facing some potentially apocalyptic scenario where the Euro area breaks up, and that will probably trigger a financial crisis that ripple through the entire world. Deleveraging in Europe (and to a lesser extent this time round, the US), will pose further challenges to the Chinese economy as liquidity might disappear (even though the closed capital account could shield China a bit).
Even growth recovers greatly, a note of caution
While it is possible for the government to boost growth by throwing more money into the economy in the short-run, we believe that the money required to do the job this time round will be a horrendously high number which may even be bigger than the last major stimulus. Even if growth recovers strongly in the second half, we believe due to massive overcapacity already in the economy, further investment will reduce return on capital across the economy such that it will destroy corporate profits going forward. Thus we do not think we would be very enthusiastic for the long-term future of the economy even if the government announced a RMB10 trillion fiscal stimulus package, although it will probably feel very excited in the short-term.