Wishful Thinking Is Back in Fashion
Yesterday we came across a report by Credit Suisse (pdf) on China's economy that seems to have been sent out over the weekend. The report asserts in its sub-title that the 'hard landing risks are gone, but rebound weak' (sic).
If one looks closely at the nifty charts of various economic data provided in this report, one wonders which one of them actually suggested that there is a rebound underway. In fact, every single one of the indicators displayed seems to be right at a new low for the move – with the exception of retail sales and consumer price inflation (note here that rising final goods prices tend to artificially inflate retail sales numbers). So what gives? Most likely it is the recent recovery in share prices that is behind the currently widespread notion that there must be an economic rebound underway.
The Shanghai stock index has rebounded to its declining 200 day moving average after a relentless decline since its 2009 interim high – click chart for better resolution.
The rebound in stock prices was in our opinion driven by three major developments: the fact that the index had plunged so far below its 200 day moving average that a bounce was practically preordained in order to relieve oversold conditions, the temporary easing of the euro-land debt crisis following the ECB's LTRO injections which has led to 'risk asset' rallies all over the world, and finally the decision by the PBoC to lower reserve requirements for China's banks. Note here that this lowering of reserve requirements is a logical consequence of the faltering of China's trade surplus growth. Reserve requirements are the central bank's major 'sterilization' tool, otherwise the managed peg and the huge inflow of foreign exchange would lead to even more massive money supply and credit growth than it already tends to do.
We admittedly can't claim to know whether or not a 'hard landing', this is to say a major economic bust, can be avoided in China this time around. Neither does Credit Suisse know it, nor anyone else for that matter. It is after all always possible to create another artificial boom by loosening monetary and fiscal policy, as long as there is still wealth that can be diverted into bubble activities.
This qualification is extremely important: once too much wealth has been squandered by capital malinvestment (such as China's equivalent of pyramid building, namely the erection of empty apartment blocks and office towers or the building of high speed trains nobody is using and that seem unable to ever turn a profit, etc.), it no longer matters how much new money and credit is created. It is only possible to engender an artificial boom as long as the economy's pool of real funding is not exhausted and still growing.
It is not possible to ascertain beyond doubt if this is the case, as there is no way of doing a quantitative measurement that could tell us what the state of China's pool of real funding actually is.
From the CS report on China: credit growth continues to slow down - click chart for better resolution.
What never fails to astound us however is the touching faith everybody seems to put in the valor of the central planners of China's economy. To our mind, every iota of wealth that is actually created in China is created by the businesses that are as distant as possible from the central planning endeavors of the political leadership. A sizable portion of the wealth that these enterprises create is then squandered by the edicts of the political elite and the state controlled enterprises under its sway.
Entrepreneur Zong Qinghou, China's second richest man, evidently agrees with this assessment.
“Zong Qinghou, China’s second-richest man, called on the government to increase the role of private business in the economy and said the nation’s prospective next president agrees.
The 66-year-old self-made billionaire who is chairman of Hangzhou Wahaha Group Co (HWGZ). and a member of China’s legislature, said the nation should cut taxes and allow private investment in more industries. When Vice President Xi Jinpin “comes to power,” he will encourage the development of private enterprise, Zong said in a March 3 interview.
“The government has become a monopoly company that invests in everything,” Zong said before annual meetings of the National People’s Congress that start today. “The biggest hurdle facing China’s economy now is that the government’s income is too high and the people’s income is too low.”
Zong undoubtedly has it right and it is gratifying to see that some people in China have given some thought to the problem – especially when those people actually wield some influence. The article contains an interesting tidbit about the growth of Mr. Zong's company and what a rarefied position it inhabits in China's economy:
“Zong’s rise to wealth Wahaha, which means “laughing children” in mandarin Chinese, into a beverage maker that had 7 billion yuan of profit last year. The privately-held company may boost that to 10 billion yuan this year on sales of 85 billion yuan, Zong said. with a 140,000 yuan ($22,230) loan in 1987 when he and two retired teachers in the city of Hangzhou started their business by selling popsicle, soda and stationery. He built
Wahaha’s growth is rare in China, where the 12 biggest publicly traded companies by market capitalization are all state-owned. The government is the majority shareholder in the nation’s four largest banks, its three biggest oil companies and the largest producers of cars, computers, steel, washing machines and milk. Private investment continues to be limited in industries such as tobacco and banking.”
A positive development in this context is that Xi Jinping, the vice president and designated successor of Hu Jintao as president of the country and chairman of the Communist party (which is communist in name only), shares his convictions regarding the importance of growing private enterprise. This is apparently a result of the time he spent in Zheijiang, the province Wahaha and a number of other big private companies hail from.
“Private companies including Wahaha, Alibaba Group Holdings Ltd. and Zhejiang Geely Holdings Group Co. have fueled growth in the province. Zhejiang, which ranks fifth among China’s provinces and municipalities in per capita gross domestic product, has the smallest gap between rural and urban consumption of any region in China.
“Because he spent some time in Zhejiang, he believes private enterprise is the main direction of economic development,” Zong said of Xi. “I figure when Xi Jinping comes to power, he’ll encourage the development of private enterprise.”
Alas, this concerns the more distant future. It is a positive development worth mentioning, but it doesn't tell us anything about how the current economic slowdown will resolve. Unfortunately the 'soft landing' scenario seems to have become the consensus view. It is of course also what people want to hear. For instance, at the recent PDAC (prospectors and developers association) conference, Canada's Scotiabank chimed in as follows:
“China’s government should be able to engineer a “soft-landing” for its economy and that should support base metals prices as the country looks to make its economic growth more sustainable, an economist at a leading Canadian bank said Monday.
China’s gross domestic product is forecast to rise 8.6% in 2012 and 8.9% in 2013, compared to 9.2% in 2010, said Patricia Mohr, vice president and commodity market specialist at Scotiabank. She said Scotiabank has a large presence in China.
Mohr spoke at the PDAC2012 Prospectors & Developers Association of Canada’s annual convention, which runs through Wednesday in Toronto. China represents 42% of global demand for the four main base metals: copper, zinc, nickel and aluminum, so its decisions regarding how to direct its state-run economy are paramount to the outlook for these commodities, she said.
There are three reasons why China should be able to cool its economy without damaging its growth prospects, she said.
One, China is planning to expand its social housing program. The private sector housing market was behind much of the building development in China, but that market has fallen sharply. China’s plan to build more housing for lower-income citizens will offset the decline in private sector housing.
Second, a top Chinese banking regulator said recently that municipal governments, which have seen mounting debts, can roll over bank loans as long as projects are 60% complete. She said when that announcement came out, copper prices rose sharply, which underscores the importance the Asian nation has to the red metal.
Third, China’s National Development Reform Commission said government-led infrastructure projects will rise 15%-20% in 2012, which is a substantial gain over last year, she added.”
So to summarize everyone's case for a 'soft landing': the government will 'engineer' one. A you will see below, this is not surprisingly exactly what the government itself is saying. Even World Bank president Zoelick has said so. Seems it is easy as pie (if you google 'China, soft landing' you get 1,8 million hits).
China's external trade data: the last time a similar slump was seen was right after the 2008 financial crisis - click chart for better resolution.
Yesterday's release of for February was apparently 'better than expected' as it improved to 49.6 from January's 48.8 and was slightly above the 'flash' number released previously. Alas, it is still in contraction territory and as so often, the devil is in the details. As HSBC commented:
“Despite the marginal improvement in the headline PMI, led by quickening production and a recovery of hiring after the Chinese New Year, deteriorating external demand is adding more downside risks to growth in the absence of a strong comeback in domestic demand," Qu Hongbin, HSBC's chief economist for China, said in a statement. He added that he expects the central bank "to step up policy easing efforts as inflation pressures recede."
Stepped up central bank 'easing efforts' (we wonder why everybody insists to call the exercise an 'effort'. It mainly involves the pushing of a few buttons and the whipping up of a brief press release) are usually seen as a 'positive', but it should be remembered here that if everything were fine, the central bank would see no need to ease.
Nomura has taken a closer look at the innards of the PMI report and discovered that the steel sector – one of China's largest industrial sectors – is crumbling at a rather disconcerting pace. The steel industry's PMI fell to a mere 42.8 in February, indicating a severe slump. Normally February is one of the seasonally strongest months for China's steel sector, which makes this reading especially worrisome. As Nomura asks: 'Starting to look a bit too much like 2008?'
China's steel industry PMI crumbles to 42.8. Any further and we'll have to rename it the 'rust PMI' - click chart for better resolution.
The following chart illustrates the tendency of the month of February to normally produce especially strong numbers for the steel sector:
China's steel PMI, the February numbers over the past few years. The month normally produces an especially strong reading – this time it is the lowest February reading of the entire data series - click chart for better resolution.
By deducting finished inventories from new orders, Nomura has constructed a leading indicator for China's steel industry that seems to be saying that steel production will actually fall year-on-year in March. This is a rare event indeed. Perhaps some of those rich iron ore deposits in Australia will last longer than was hitherto expected.
Nomura's leading indicator index seems to be saying that China's steel production is set to decline - click chart for better resolution.
Obviously the fate of China's steel industry is closely intertwined with that of the property bubble. Alas, there are also other major industrial users of steel that will likely lower their demand considerably. One is the ship building industry. Currently more than 2,600 new ships are being built in China's shipyards – ships that were ordered during the 2005-2007 shipping boom, but which no-one needs anymore, as there is already a huge glut of ships. One should expect a rash of order cancellations, many of which will be of an involuntary nature, as several more shipping companies are likely to bite the dust.
The Baltic Dry Index reflects both the decline in China's trade and the glut of new ships. At this point the glut of ships probably has the bigger influence on the BDI, but one shouldn't underestimate the slowdown in China's external trade - click chart for better resolution.
Another industry that may turn out to have less use for steel (and other raw materials) is China's car industry. As we learned yesterday, car sales in China have just slumped to their worst annual start in seven years.
“Automobile sales in China , the world’s biggest car market, may be having their worst start in seven years as a slowing economy and record gasoline prices keep consumers away from dealerships.
Deliveries of passenger autos, including sport-utility vehicles and light-goods vans, in the first two months of 2012 fell 3 percent from a year earlier, based on the median estimate of five analysts surveyed by Bloomberg. That would be the biggest drop since 2005, when they fell 8.9 percent, according to the China Association of Automobile Manufacturers , which will release industry data later this month.
Slumping deliveries in the world’s second-largest economy and Europe are undermining a revival in the U.S., where sales are rising at their fastest pace in four years. In China, which has fueled global growth in the past decade, foreign automakers from General Motors Co. (GM) to Volkswagen AG (VOW) are also facing tougher regulations as the government rolls out policies favoring domestic brands and clamps down on overcapacity.
“The days of China’s vehicle sales going through the roof are over,” said Huang Wenlong, a Hong Kong-based analyst with BOC International Holdings Ltd. “I don’t think the overall economic situation is that optimistic.”
Global carmakers are counting on a rebound in China to help drive earnings this year as auto demand in Europe is forecast to decline for a fifth straight year as the sovereign debt crisis unsettles consumers.
The hopes of global car makers may turn out to be misplaced. Last year growth in car sales in China slowed to 2.5%, which was the first time in 14 years that it trailed car sales growth in the US.
Color us slightly surprised at the staying power of the 'soft landing meme' (which we last discussed in November in 'Can The Planners Do It One More Time?') in view of all of the above.
Meanwhile, the National People’s Congress in Beijing provides an opportunity for the planners to lay out their upcoming policy moves. The markets certainly didn't like what prime minister Wen Jiabao had to say:
“China pared the nation’s economic growth target to 7.5 percent from an 8 percent goal in place since 2005, a signal that leaders are determined to cut reliance on exports and capital spending in favor of consumption.
Officials will also aim for inflation of about 4 percent this year, unchanged from the 2011 goal, according to a state- of-the-nation speech that Premier Wen Jiabao delivered to about 3,000 lawmakers at the annual meeting of the National People’s Congress in Beijing today.
Asian stocks fell as Wen, 69, said the nation needs to shift to a more sustainable and efficient economic model and achieve “higher-quality development over a longer period of time.”
What disappointed the markets was this 'official cut to the growth target' from the previous 8% goal to 7.5%. Now, we're not sure how exactly other market participants are interpreting such an announcement. From our point of view the Chinese government makes up a lot of economic data from whole cloth anyway, so an official cut to the 'growth target' very likely means that growth is slowing down much more than it expected it would. Cutting the 'target' is a good 'cover your behind' move, as it will make the economic downturn look as though it was 'planned' – even if it is the result of developments outside of anyone's control.
Mind, China's government may actually be taking a positive steps by lowering its growth target. Consider for instance this remark by an observer:
“The growth target indicates the lowest level that the government is comfortable with and is also a signal to local officials that they shouldn’t solely focus on the rate of expansion,” said Michael Buchanan , chief Asia-Pacific economist at Goldman Sachs Group Inc. in Hong Kong . “China’s trend growth rate is coming down but it’s still higher than this — more like around 9 percent.”
As it were, China's 'growth at any cost' policy has created nothing but trouble at the local level, where municipalities are now up to their eyebrows in debt, much of which will end up as NPL's on the balance sheets of the state-owned banks. The attempt to shift away from an investment-focused economic model to a more consumption oriented one has of course failed before. However, the new 'investment target' should probably worry all producers of raw materials that have benefited from China's boom:
“The growth target matched the median forecast of 15 economists surveyed by Bloomberg News last month. Twelve of 15 economists forecast a 4 percent inflation goal, while the median estimate of 13 respondents was for a budget deficit of 1 trillion yuan.
Officials are targeting money-supply growth of 14 percent, according to the report, in line with the median forecast of 15 analysts for the rise in M2, the broadest measure. China has a goal of increasing fixed-asset investment by 16 percent this year, the National Development and Reform Commission said in a report. That’s below the 18 percent median estimate of 12 economists.”
Alas, once again this new 'target' only seems to validate retroactively what is in fact already happening – growth in fixed asset investment is slowing down considerably, with the decline accelerating sharply since the middle of last year:
A three month moving average of China's fixed asset investment growth - click chart for better resolution.
And how are these changes to be achieved? By micro-managing the economy – curbing output in some industries, raising it in others. For instance, Wen inter alia “the government will promote strategic emerging industries, but emphasizes that it will also “put an end to blind expansion in industries such as solar energy and wind power” (of course solar and wind power industries everywhere on the planet are highly reliant on government subsidies anyway, but it is noteworthy that whatever subsidies these sectors stand to lose will go toward subsidizing other sectors). As Ludwig von Mises noted in connection with subsidies and protection granted to so-called 'infant industries' (in 'Human Action'):
“The truth is that the establishment of an infant industry is advantageous from the economic point of view only if the superiority of the new location is so momentous that it outweighs the disadvantages resulting from the abandonment of nonconvertible and nontransferable capital goods invested in the older established plants. If this is the case, the new plants will be able to compete successfully with the old ones without any aid given by the government. If it is not the case, the protection granted to them is wasteful, even if it is only temporary and enables the new industry to hold its own at a later period.”
Wen that 'capacity in car manufacturing is to be curbed' and production of 'new energy vehicles' subsidized. China's version of the Chevy Volt seems to be on its way.
China will control the increase in auto manufacturing capacity and encourage mergers and reorganizations in the industry, according to a work report that Premier Wen Jiabao delivered at the nation’s legislature.
The government will promote new-energy vehicles and encourage the scrapping of old vehicles to reduce pollution, according to a separate report today by the National Development and Reform Commission, the country’s top economic planner.
“The auto industry is among four industries listed in the government report where increases in capacity should be curbed. The other three are steelmaking, shipbuilding and cement production. “
Readers will notice that the industries the output of which is to be 'curbed' are precisely the industries that are already under great pressure from the end of the housing boom and the depression in shipping. Once again, this seems to merely retroactively acknowledge the fact that growth is likely to turn negative in these industries no matter what.
Undaunted Faith in Central Economic Planning
The central planning mindset of China's government is best exemplified by this article written by Li Keqiang, a member of the Political Bureau of the Central Committee of the Communist Party of China and Vice Premier of the State Council. A few snips follow below, the first one on how the party is supposed to 'plan and control prices' (no kidding):
“To tackle problems concerning resource environment, we must accelerate the decommissioning of outdated production capacity, curb the overheated growth of industries which rely on high energy consumption and high emissions, and exercise rational control over total energy consumption. However, in order to address the core issues, we must focus on reforming our systems and mechanisms. We should deepen the reform of the prices for resource products, and ensure that the relationship between the prices of coal, electricity, gasoline, gas, water, mineral products and other resources are correctly managed, along with ensuring that such prices accurately reflect the relationship between supply and demand, the scarcity of the resources and the cost of environmental damage. A good example of such management lies in the trial implementation of tiered pricing for household electricity, which puts equal emphasis on fairness and efficiency and promotes energy conservation and environmental protection. We must do the same with regard to the price reform of other resources. We should accelerate studies examining how such a system can be applied to water, natural gas and other products. In order for services to meet people' basic demands, we should keep sensible controls on prices.”
This whole emphasis on the 'rational management of resources and their prices' could be taken from any of the many pamphlets written by the defenders of socialist central planning over the past century in their ultimately vain attempt to disprove the economic calculation problem Ludwig von Mises first identified and discussed in the early 1920's. Whatever should this planning be good for? If they really want prices and resource allocation to be as rational as possible – the avowed goal of all these planning exercises as Li himself says – then they must leave prices and resource allocation to the free market.
To be sure, amidst the sea of platitudes Li's paean to the joys of central economic planning largely represents, there is also a little bit of lip service given to market oriented reforms. This is found in a single paragraph discussing the role of enterprises in the economic system, which Li says should be strengthened by promoting private investment and competition, all of which of course must be 'properly channeled' by the government (we would have thought better of it if he had talked about the people behind the enterprises, i.e., entrepreneurs. Enterprises are not entities with a volition of their own. The people running them are who counts).
Alas, there can be no doubt that Li is utterly convinced that the ultimate well-spring of wealth creation is the government. Consider for instance the following paragraphs:
“Adhering to the policies set out by the central government, we should further strengthen and improve management with a focus in a firm and proper manner. The government should fine tune the economy timely and appropriately in light of situation and deal effectively with the relationship between speed, structure and price. It should also place emphasis on addressing the outstanding conflicts and problems which stem from economic growth. This can be done by playing an active, leading role in terms of guidance and planning, ensuring that fiscal, credit and industrial policies are unified, striving to meet the economic growth target and making headway in shifting the economic growth mode and economic structure. We must also ensure that conditions are conducive to deepening the strategy of boosting domestic demand in the course of reform and opening-up.”
While maintaining a reasonable level of investment, the government should concentrate on streamlining its investment portfolio and enhancing the quality and efficiency of investments. A more effective relationship should be forged between investment and consumption. The government should play a more effective role in directing investment, and should also continue to increase assistance to rural initiatives, water conservation projects, less-developed areas, public initiatives, scientific and technological innovation, energy-saving and emission-cutting projects, and public infrastructure such as railways and highways. All of these will release the potential for domestic demand and allow for greater growth.”
Most of the article consists of platitudes in a similar vein. Needless to say, it is indeed desirable if an economy displays a proper balance between saving, investment and consumption. This is best achieved by an unhampered free market economy based on a stable monetary system (i.e., a market based one). No central planning organization can possibly improve on it, no matter how capable the planners.
Li also seems convinced that economic growth is 'contradictory to stable prices', an error that puts him on a par with the central planners at the Western central banks, who regularly spout exactly the same nonsense.
“Economic growth should be kept on condition that overall price level is basically stable, overall economic equilibrium is achieved and the economic structure is streamlined. In the meantime, the price stability we are to maintain should be coupled with stable and relatively rapid economic and social development. However, economic growth is usually contradictory to stable prices. It is relatively easier to achieve economic growth regardless of inflation or maintain stable prices at the expense of economic growth than to achieve both at the same time. The current mixture of excessive global liquidity and grim market outlook, together with ample money stock in the domestic market provides a real challenge to the task of simultaneously maintaining stable growth and stable prices.”
To keep this as simple as possible: consider what 'economic growth' actually means. When we say that growth has occurred, it means that more goods and services have been produced. Why should prices rise when more goods and services have been produced than previously? As a matter of fact, economic growth usually results in a decline of the prices of goods and services, ceteris paribus the inevitable outcome of an increase in supply.
Consider as an example the prices of flat-screen TVs. About ten to fifteen years ago, a flat screen TV cost a small fortune. Only rich people could actually afford one. Today they are a mass product and have become accessible to just about everyone. Obviously the production of flat screen TVs has somehow managed to grow without raising the prices of said products. The same principle can be applied to the economy as a whole – to repeat, economic growth does not 'raise the price level'. Obviously what leads to rising prices must be something else. Could it be the vast money supply growth in China (and elsewhere)? Why, yes, it could.
Whether or not there will be a so-called 'soft landing' (really, a re-acceleration of the inflationary boom) or not in China remains to be seen. There is a good chance that the government's efforts to curb the property bubble and rising prices have set a more severe downturn into motion than the government has bargained for. It may prove very difficult to stop it from playing out.
A 'hard landing' – this is to say a harsh economic bust – remains therefore a distinct possibility. Much of the talk about 'lowering official growth targets' seems to be a belated acknowledgment of the fact that the economic downturn that is already in train is already more forceful than was previously expected.
There are some signs that the handover to the new political leadership will lead to a renewed focus on giving private enterprise more room to flourish. However, the focus on central economic planning and price controls has by no means gone away (as always, the jobs of the planners hinge on the theory that central economic planning is actually sensible).
Western observers should be very careful in putting their faith in the presumed omnipotence of the planners. They won't be able to stop an economic contraction from unfolding if too much scarce capital has in fact been consumed during the extreme credit boom that preceded the downturn that has recently begun. A 'hard landing' in China is definitely not 'priced in' in the so-called 'risk asset' markets, i.e., stocks and commodities. It remains a potential source for a big negative surprise in the course of this year. Conversely, if the planners manage to revive the boom, this could give risk assets a boost. Alas, given the widespread 'soft landing' consensus, we would urge the utmost caution.
China's outgoing chief planner, Wen Jiabao.
(Photo credit: Imago)
Charts by: StockCharts, Crédit suisse, Nomura
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