This note was originally published November 08, 2013 at 14:22 in Macro
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- This weekend top-ranking officials will convene in Beijing for the Third Plenary Session of the 18th Communist Party Central Committee (NOV 9-12).
- Historically, the 3rd Plenary Session has been one of great change with respect to economic and financial market reforms that have ultimately shaped the Chinese economy in the years and decades following. Bold promises for meaningful reforms out of President Xi would suggest 2013’s version is likely to not disappoint.
- While a number of key socioeconomic strategies will be debated and outlined (such as rural land rights reform, nationwide social security, etc.) we are strongly of the view that some reforms are more impactful than others as it pertains to our long-term TAIL duration (i.e. 3Y or less). On that note, we are keenly focused on concrete solutions (if any) to China’s ongoing credit binge and financial risks.
“Hi I’m China, and I have a problem…”
SETTING THE STAGE
For much of the spring and summer months, we held an explicitly negative view on China’s structural economic growth potential. Specifically, we believed that a persistent rise in non-performing assets across the financial system would effectively tighten liquidity across the financial sector, at the margins, thus acting as a sustainable drag on incremental credit creation.
To review that thesis:
We first noticed pervasive risks in China’s financial sector upon completion of our proprietary EM Crisis Risk Model in mid-APR:
Digging deeper into the weeds confirmed much of what we already knew – Chinese credit growth has grown far too fast in recent years and a sizeable portion of that credit has done little more than support asset prices or existing liabilities in lieu of marginal economic activity:
The aforementioned dynamic has caused Chinese economic growth to slow, with the +7.7% YoY run-rate of headline GDP in the YTD threatening to claim the title of China’s slowest expansion since 1999. Moreover, forward-looking expectations for Chinese growth are even more lethargic:
We backed away from the short side of China in early SEP (click HERE and HERE to review why) and followed that up with an incrementally more sanguine tone in the subsequent months, as the Shanghai FTZ looked to be a meaningful enough catalyst to offset the aforementioned financial sector headwinds, at the margins (click HERE and HERE to review why).
With only 157 firms holding a combined capital of $829M having registered for the Shanghai FTZ (mostly in the trade and services industries) as of OCT 23, it’s pretty clear the aforementioned catalyst has not yet addressed our initial concerns surrounding the structural lack of liquidity in the Chinese banking sector.
Specifically, we thought there would be significantly more activity regarding the importing of fresh capital into China’s financial system; thus far, results have been largely disappointing on that front.
PREVIEWING THIS WEEKEND’S PARTY
Now that we have reestablished the facts of China’s financial sector headwinds, we can now focus on what Chinese policymakers must do to overcome them – especially if China is to achieve what Premier Li has recently termed, “a golden mix” of structural reform and economic growth.
Simply put, if Chinese policymakers are going to avoid seeing GDP growth slow materially from here in the coming quarters and years, they absolutely have to outline [and eventually execute upon] specific and credible strategies that are expressly designed to relieve the banking sector of its structural liquidity constraints.
I’ll be the first analyst to tell you openly and honestly I have absolutely no idea what they plan to do with regards to this key issue, nor am I able to accurately gauge the momentum (or lack thereof) for meaningful changes on this front. All I know is that China must do something.
“Something” would include, but is not limited to:
- Step 1: admit the country has a problem (i.e. it’s addicted to cheap credit);
- Step 2: clearly delineate which institutions and corporations are to be saved and which would be allowed to ultimately fail or forced to sell/restructure;
- Step 3: liberalize deposit rates so that weaker financial institutions are ultimately priced out of the market and forced to delever (CLICK HERE for more color on the threat deposit rate liberalization poses to China’s economy and general financial stability);
- Step 4: recapitalize the remaining or systemically important banks and concomitantly force banks to write down non-performing loans that are currently being systematically rolled over (the aggregate loan-loss provision ratio of 279% of NPLs at the Big Four banks is well in excess of the 150% regulatory requirement and only begins to highlight the magnitude of China’s current problem with evergreening);
- Step 5: introduce rigid targets for provincial-level GDP growth and subdued quotas for credit allocation to various industrial sectors so that banks don’t take steps 2-4 as a signal to inflate new bubbles; and
- Step 6: allow for corporate defaults, the proliferation of financial insurance products and a dramatic expansion of the mutual fund industry so that Chinese financial markets can eventually learn to appropriately price, hedge and allocate risk across the system.
With the convoluted structure of bank and securities market regulation in China – the CBRC, CSRC, MoF and PBoC all operate largely independently of each other – we have little faith that such a wide-ranging reform process would be able to be implemented quickly.
That said, we’d settle for Chinese policymakers simply admitting to the fact that the country has a structural liquidity problem and subsequently outlining credible strategies to address it over the long-term TAIL. If they do not, we’d argue that Chinese tail risk – or a “hard landing” as it is more commonly referred to – should and would eventually heighten dramatically in the eyes of global investors and capital allocators.
PLAYING CHINA FROM HERE
Lastly, for those of you looking for answers with respect to our intermediate-term TREND duration, please review our OCT 24 note titled, “IF YOU HAVEN’T YET HEARD, CHINA IS TIGHTENING MONETARY POLICY”. Specifically, the PBoC’s recent tightening of monetary policy is in-line with our call for China to take a brief trip to Quad #3 (i.e. #GrowthSlowing as inflation accelerates) within our proprietary GIP framework here in 4Q13.
It’s worth noting that Chinese property price pressures have continued to accelerate since then, with the latest data out from the China Real Estate Index System’s nationwide property price index (100 cities) showing prices up +10.7% YoY on average in OCT vs. +9.5% YoY in SEP. Moreover, OCT marked the 17th consecutive month of sequential appreciation (+1.2% Mo M vs. +1.1% MoM prior). Moreover, property price trends in China’s 10 major cities continue to outpace the national averages, with prices up +15.7% on a YoY basis and +2% on a sequential basis.
On that note, both Shanghai and Shenzhen have recently taken a page out of Beijing’s playbook by lowering peak LTV ratios on mortgages for 2nd homes to 30%, down from 40% prior. Perhaps that’s a signal that this weekend’s plenum may bring about broad-based tightening in the property market. The implementation of a nationwide property tax – while a huge positive for currently impaired local government finances over the long term (as would be expanding the muni bond market) – would obviously be serve as a meaningful blow to demand in this key segment of the Chinese economy.
All told, the 3rd Plenary Session has historically been one of great change with respect to economic and financial market reforms that have ultimately shaped the Chinese economy in the years and decades following. Bold promises for meaningful reforms out of President Xi would suggest 2013’s version is likely to not disappoint.
While a number of key socioeconomic strategies will be debated and outlined (such as rural land rights reform, nationwide social security, etc.) we are strongly of the view that some reforms are more impactful than others as it pertains to our long-term TAIL duration (i.e. 3Y or less). On that note, we are keenly focused on concrete solutions (if any) to China’s ongoing credit binge and financial risks.
Please feel free to email us with any follow-up questions; have a great weekend,
Associate: Macro Team