This note was originally published September 25, 2013 at 16:16 in Macro
- Chinese policymakers appear to be embarking on a clever strategy to offset internal headwinds to growth with foreign capital.
- If executed properly, China’s structural economic outlook – one that we continue to think has many headwinds – will be much improved, on the margin.
- Near-term risks remain, however, including an additional round of property market tightening and a potential negative revision to China’s 2014 GDP growth target at the 18th CPC Central Committee's 3rd Plenary Session come NOV.
- Of course, one of, neither of or both of the aforementioned risks may materialize. We have no edge beyond stating that both are likely more probable than consensus may realize. This is the primary reason we are not outright bullish on China at the current juncture in spite of the developing intermediate-to-long-term bull case we have expanded upon in this note.
- One of the things we’ll monitor to determine whether or not it’s an appropriate time to A) buy China outright or B) trade it with a bullish bias is whether or not the insider-driven Shanghai Composite Index closes above its late-MAY highs. That lower-high came just before the JUN liquidity crunch and subsequent consensus debate about China’s financial sector risks.
PLEASE NOTE: The discussion below is a direct continuation of an analysis we presented in our SEP 12 research note titled, “DEBATING THE BULL CASE FOR CHINA”. To the extent you have not reviewed that piece, we encourage you to do so prior to examining the analysis below, as it will help elucidate the conclusions we continue to make. In the event you may have missed it come through, please email us for a copy of that note or to set up a call to discuss China more broadly.
This morning we received what we interpreted as positive news with respect to China’s TAIL-duration economic outlook.
Specifically, interest rates will be fully liberalized within the Shanghai Free Trade Zone and there’ll be no restrictions on raising capital – either from domestic or foreign banks – for companies operating inside the zone.
While still very much in the realm of conjecture, this piece of information is positive, on the margin, for the following two reasons:
- Interest rate liberalization will allow China’s liquidity-starved banks to compete for the acquisition of foreign deposits. This, of course, assumes some degree of capital account conversion.
- In a closed setting such as the Shanghai FTZ, the risk of a systemic unwind of the shadow banking system can be offset by continuing to restrict the broader Chinese public's access to liberalized deposit rates or international markets – effectively maintaining their incentive to speculate in the property market and/or in WMP and Trust Products.
- More deposits = more liquidity and more liquidity = faster credit growth, at the margins. This is a direct offset to what we believe to be the most convincing secular bear case for Chinese economic growth (i.e. sustainably slower credit growth born out of rising NPLs and waning liquidity from the current account).
- The unrestricted ability of Chinese firms – particularly credit-starved SMEs – to raise capital in the Shanghai FTZ is also supportive of faster credit growth, at the margins. This, of course, assumes an ample supply of foreign capital.
On that last point, we think the powers that be up in Beijing are no dummies when it comes to making China an increasingly attractive destination for foreign capital.
Not unlike the migration of foreign capital from the imperiled South America to the then-attractive Asian Tigers in the early-to-mid 90s, China appears to be inclined to promote itself as a bastion of economic and financial stability amid rising risk of EM crises in places India, Indonesia, Turkey and Brazil.
Perhaps that’s why the PBoC has been inclined to mark up the CNY over the LTM (+3% YoY and +1.8% YTD).
Amid that process, the CNY has hit an all-time high on a REER basis, imposing systemic risk to China’s export economy and its razor-thin margins. Moreover, they have done so in the face of some fairly obvious international headwinds to export growth.
No doubt, Chinese officials appear keen to sacrifice what little liquidity they are likely to receive from the current account over the long term for what may turn out to be a far deeper and more sustainable source of liquidity in the form of foreign portfolio and direct investment flows.
Furthermore, they appear willing to entice said capital flows with the allure of FX appreciation and higher real interest rates within the Shanghai FTZ (in addition to favorable corporate tax policies). Importantly, their strategy appears to be increasingly effective at improving foreign investor sentiment towards China, on the margin.
All told, if Chinese policymakers are, in fact, pursuing the growth strategy we have outlined above, then it would behoove us to have a bullish bias on the Chinese economy, its currency and under-owned stock market (less than 20% of Chinese households’ financial assets are allocated to equities vs. 33.7%% in the US).
In the face of the bear case getting “less bad” at the margins, easy comps and GDP seasonality support a sanguine 1H14 outlook for Chinese economic growth.
We can’t forget that China’s most recent real GDP growth rate of +7.5% was over a full standard deviation (-1.1x) below the trailing 3Y mean. The balance of risks imply some degree of mean reversion born out of a combination of marginal retracement and continued pressure on the average itself. Net-net, the likelihood of a downside economic surprise(s) in China is declining, at the margins, and should be rather muted on an absolute basis in 2014.
On the bearish front, the two most probable catalysts that would increase the likelihood of a downside economic surprise(s) over the intermediate term are:
- An additional round of property market tightening. To recap the recent developments, MOHURD has been investigating local authorities on their potentially lax implementation of the existing nationwide curbs to housing transitions and mortgage lending. Additionally, the latest statistics indicate serious froth in the property market at its most basis levels:
- Municipal residential land sales (to property developers) are up +26% YTD through AUG;
- The average price per square meter has increased +43% over that same period, bringing total land sale proceeds for municipalities to 816.5B CNY YTD (+80% YoY);
- The average starting price at residential land auctions has increased +16% in the YTD and final sale prices have exceeded initial asking prices by +25% on average in the YTD;
- In MAY ’11, the land ministry required all municipalities to report land sales when the final sale price was +50% higher than the starting auction price… there were 115 such transactions in 2Q13 vs. only 50 in 1Q13 and the average premium on those transactions was +142%!
- A negative revision to China’s 2014 GDP growth target. As a refresher, the 2013 target is equal to +7.5% with a “floor” of +7%; will the 2014 target be revised lower to +7% with a “floor” of +6.5%? We don’t know, but it is likely that we will have to wait until NOV’s Third Plenary Session to find out.
Of course, one of, neither of or both of the aforementioned risks may materialize. We have no edge beyond stating that both are likely more probable than consensus may realize. This is the primary reason we are not outright bullish on China at the current juncture in spite of the developing intermediate-to-long-term bull case we have expanded upon in this note.
One of the things we’ll monitor to determine whether or not it’s an appropriate time to A) buy China outright or B) trade it with a bullish bias is whether or not the insider-driven Shanghai Composite Index closes above its late-MAY highs. That lower-high came just before the JUN liquidity crunch and subsequent consensus debate about China’s financial sector risks (i.e. the same risks we called out in our Hedgeye Macro Emerging Market Crisis Risk Index back on APR 23).
Specifically, a close above that level would be akin to receiving a second quantitative “thumbs-up” (i.e. no more lower-highs) in our playbook (the first being the recent TREND line breakout).