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Takeaway: We don't think the recent strength in the Chinese equity market is sustainable, as China’s second-half growth outlook appears dicey at best.

This note was originally published May 17, 2013 at 12:26 in Macro

SUMMARY BULLETS:

  • On positive headlines largely surrounding economic and financial system reform(s), speculative capital continues to flow into the Chinese economy. According to PBOC data, growth in Chinese banks’ accumulated purchases of forex accelerated to +6.9% year-on-year (YoY) from +5.5% prior (+1.1% month-on-month). The issuance of new RMB in this process is a tailwind for money supply in the Chinese economy.  
  • On these increased inflows of “hot money” the Shanghai COmposite closed up +1.6% WoW on good volume into a bullish TRADE/TREND/TAIL setup, so there is little-to-no sense in fighting the tide here – especially given the positive outlook for China's consumer economy (real wage growth accelerated +30bps in 2012 to +9.3% YoY for SOEs and +160bps to +14.4% YoY for private enterprises).
  • Given the precarious nature of financial sector reform, however (as identified by our April 29 expert call on the Chinese Financial System), we’re not sure how much can actually be done to truly liberalize interest rates in China. Not to mention, ending financial repression by promoting higher real rates of return in traditional bank deposits would likely put an end to the country’s fixed assets investment bubble.
  • All told, we think the recent “hot money” inflows into the Chinese economy are a sign that Chinese enterprises levered to FAI are attempting to get ahead of what is likely to be the “rug” being pulled out from underneath them from a financing perspective. An exaggerated trend of export goosing and aggressive USD debt issuance (issuers on the mainland and in Hong Kong have sold $18.8B worth of bonds so far this year, more than six times the total for the same period last year) suggest that this is likely the case. Trends in the FX market are supportive of this view.
  • We do not, however, think the recent strength in the Chinese equity market is sustainable in the sense that FAI is what drives the growth boat in China; fixed capital formation accounts for ~46% of Chinese GDP. That will slow when the capital flows slow, as they should in the coming months post the very recent regulatory crackdowns. Moreover, China does not yet have the social safety net infrastructure in place to ensure a smooth handoff to domestic consumption at the current juncture. That could change come OCT, but, for now, the outlook for Chinese growth in 2H12 appears dicey at best.

According to Chinese local press, President Xi Jinping has taken charge of developing an aggressive reform agenda to help restructure the Chinese economy. It is widely speculated that he will present the reforms at the third plenum of the 18th Central Committee of the Communist Party, likely in October. Those reforms, which are likely to be met with resistance from vested interests throughout the Party, may include further liberalization of interest rates, an overhaul of local government finance and Hukou reform.

On these positive headlines, speculative capital continues to flow into the Chinese economy. According to PBOC data, growth in Chinese banks’ accumulated purchases of forex accelerated to +6.9% YoY from +5.5% prior (+1.1% MoM). The issuance of new RMB in this process is a tailwind for money supply in the Chinese economy.  

 CHINESE EQUITIES RALLY SUSTAINABLE? - 1

Given the precarious nature of financial sector reform, as identified by our 4/29 expert call on the Chinese Financial System, we’re not sure how much can actually be done to truly liberalize interest rates in China. Not to mention, ending financial repression by promoting higher real rates of return in traditional bank deposits would likely put an end to the country’s fixed assets investment bubble.

Regarding FAI specifically, Total Fixed Assets Investment is growing only marginally faster than its decade-low growth rate of +20.4% YoY. Growth in New Construction FAI has been slowing precipitously since OCT, while growth in Real Estate FAI had been accelerating since then, though well off prior peaks. It’s worth noting that this TREND-duration acceleration in Real Estate FAI is precisely why Chinese officials haven’t responded to their economic growth slowdown w/ any monetary easing measures.

 CHINESE EQUITIES RALLY SUSTAINABLE? - 2

From here, we think FAI is poised to continue slowing over both the intermediate-term and long-term durations, as:

  1. Incremental tightening measures by the PBOC and CBRC slow the rate of credit expansion (see: YTD repo activity and the recent resumption of PBOC bill issuance); and
  2. The Chinese Communist Party’s economic rebalancing agenda is accelerated in accordance with the aforementioned expectations.

Additionally, the stimulus package of 2009-10 has soured Chinese state bank balance sheets (where ~89% of all outstanding corporate loans and bonds are held – to maturity, nonetheless) with not-yet-reported NPLs. In addition to tighter regulation of LGFVs and WMPs, this cultural “extend and pretend” phenomenon (NPLs were perpetually rolled over from the late 80s until the late 90s/early 2000s bank recapitalization) will slow the rate of new credit growth in the Chinese economy, at the margins, by slowing the flow of incremental liquidity within the system.

Another headwind for growth of incremental liquidity within the Chinese banking system is a perpetually-dwindling current account surplus. China’s gross national savings (~50% of GDP) have been buoyed over the past 10 years by China’s entry into the WTO – a one-time, rear-view stimulus that is not likely to reoccur in the foreseeable future. Moreover, it is no longer politically palatable within the int’l arena for China to continue taking market share in global trade.

 CHINESE EQUITIES RALLY SUSTAINABLE? - 3

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 4

Net-net, both factors translate to less currency coming into China via the current account, at the margins. As an aside, this is precisely why Chinese exporters have been goosing export figures as of late (i.e. they are “importing liquidity” via mislabeled capital flows).

Slower growth in current account flows directly translate into slower bank deposit growth, at the margins. And, since we know the Chinese economy is merely just one, large experiment w/ politicized financial repression, that ultimately translates into less speculation in fixed assets. The law of large numbers means that China actually needs to be accelerating this activity if it wants to maintain its trend GDP growth rates, not allowing said activity to slow (as dictated by the Party’s politicized push for “socially inclusive growth” and environmental reform).

All told, we think the recent “hot money” inflows into the Chinese economy are a sign that Chinese enterprises levered to FAI are attempting to get ahead of what is likely to be the “rug” being pulled out from underneath them from a financing perspective. An exaggerated trend of export goosing and aggressive USD debt issuance (issuers on the mainland and in Hong Kong have sold $18.8B worth of bonds so far this year, more than six times the total for the same period last year) suggest that this is likely the case. Trends in the FX market are supportive of this view.

 CHINESE EQUITIES RALLY SUSTAINABLE? - 7

On these increased inflows of “hot money” the Shanghai Composite closed up +1.6% week-on-week on good volume into a bullish TRADE/TREND/TAIL setup, so there is little-to-no sense in fighting the tide here – especially given the positive outlook for China’s consumer economy (real wage growth accelerated +30bps in 2012 to +9.3% YoY for state owned enterprises and +160bps to +14.4% YoY for private enterprises).

 CHINESE EQUITIES RALLY SUSTAINABLE? - 5

We do not, however, think the recent strength in the Chinese equity market is sustainable in the sense that FAI is what drives the growth boat in China; fixed capital formation accounts for ~46% of Chinese GDP. That will slow when the capital flows slow, as they should in the coming months post the very recent regulatory crackdowns. Moreover, China does not yet have the social safety net infrastructure in place to ensure a smooth handoff to domestic consumption at the current juncture. That could change come October, but, for now, the outlook for Chinese growth in second half 2012 appears dicey at best.

 CHINESE EQUITIES RALLY SUSTAINABLE? - 6