- Below, we offer our abbreviated thoughts on the three most thoughtful questions on China that we have received in recent days. The analysis below is for those of you who like to get into the weeds on the numbers; for those of you who prefer the 30,000-foot view, just stick w/ the long “New China”/short “Old China” investment strategy call we’ve been making since early DEC.
- Inclusive of today’s mini crash in the Chinese equity market (-2.9%), our strategy has performed extremely well and our analysis suggest that is likely to continue to be the case going forward.
- Q: Is the $14.7M default by Shanghai Chaori Solar Energy Science & Technology Co. the first of many corporate defaults in China? A: Probably. (refer to Q&A section #1 below for more details)
- Q: Is recent CNY weakness a sign of material capital outflows that may escalate and push the Chinese financial sector over the cliff? A: No. (refer to Q&A section #2 below for more details)
- Q: The PBoC continues to drain liquidity from the banking sector in the face of sharply decelerating growth data. In light of this, do you still think the PBoC is setting up to ease monetary policy over the intermediate term? A: Yes. (refer to Q&A section #3 below for more details)
From Monday through Wednesday of last week Keith, Ryan Fodor and I did about 15-20 meetings with existing and prospective customers up-and-down the West Coast; after that I was out of the office Thursday and Friday. As our China analyst, I couldn’t have picked a better period to be offline given the slew of seemingly impactful headlines that emanated from the mainland last week.
As counterintuitive as that may seem, I actually enjoy being away from my desk during such periods of macroeconomic entropy, as headlines almost always appear substantially more impactful than they actually wind up being on a forward-looking basis. As such, grinding through the numbers all at once tends to lead to a better understanding of the evolving mosaic – at least for me.
Below, we offer our abbreviated thoughts on the three most thoughtful questions on China that we have received in recent days. The analysis below is for those of you who like to get into the weeds on the numbers; for those of you who prefer the 30,000-foot view, just stick w/ the strategy call we’ve been making since early DEC. Inclusive of today’s mini crash in the Chinese equity market (-2.9%), our strategy has performed extremely well and our analysis suggest that is likely to continue to be the case going forward.
Q: Is the $14.7M default by Shanghai Chaori Solar Energy Science & Technology Co. the first of many corporate defaults in China?
A: Probably. The Chinese economy is very long of over-levered companies in over-supplied industries that Chinese officials continue to target for capacity reduction and general consolidation. As such, we would anticipate an acceleration of corporate defaults over the intermediate-term TREND and long-term TAIL durations. Per Bloomberg News:
- Publicly traded non-financial companies with debt-to-equity ratios exceeding 200 percent have jumped 57 percent to 256 from 163 in 2007, according to data compiled by Bloomberg on 4,111 corporates.
- Some 63 companies have a debt-to-equity ratio exceeding 400 percent, compared to the average of 73 percent.
- In latest filings, 351 have negative ratios of earnings before interest, taxes, depreciation and amortization to interest expenses, while 409 have coverage of less than 1.
- Total debt of publicly traded non-financial companies in China and Hong Kong has surged to $1.98 trillion from $607 billion at the end of 2007.
- Data from JPMorgan showed overall corporate debt jumped to 124% of China's GDP in 2012 from 92% in 2008, which exceeds the 81% for the US and far higher than the 40-70% of other emerging economies.
While these metrics are, in fact, worrisome – especially for smaller corporations that do not have the benefit of morally hazardous bailouts – we must not overlook the fact that China’s equity market cap (and, by extension its corporate debt balances) is dominated by SOEs. For all intents and purposes, these corporations have little-to-no default risk as long as the Chinese sovereign remains solvent (which we think it does).
For argument’s sake, adding the aforementioned JPMorgan figures with IMF data on outstanding sovereign debt balances yields a ratio of 147% for China versus 187% for the US. That would suggest that the Chinese government can bail out every single domestic enterprise and still not be as indebted as the US government would be in a similar scenario. But of course, the US is a “bastion of capitalism” and we have “free markets” and “entrepreneurialism”, so investors should just sell China to buy US equities irrespective of the data… right.
As an aside, we’d be a lot less sanguine about the impact of corporate defaults accelerating over the intermediate term if credit spreads (AA-/AAA) weren’t making lower-highs versus their cycle peak of 225bps on FEB 10. Clearly this risk has been priced in – perhaps overly so…
Q: Is recent CNY weakness a sign of material capital outflows that may escalate and push the Chinese financial sector over the cliff?
A: No. We’ve said it once and we’ll say it again: the Chinese yuan is declining in value because the PBoC wants to deter speculative capital inflows at the current juncture; the reference rate has been marked down -62bps since its JAN 14 post-peg peak and investors have been reacting to the go-forward expectation of increased volatility by selling CNY (down -1.6% since JAN 14).
Recall that our initial work on EM crises cycles shows that certain EM economies tend to be the beneficiary of capital inflows as investors sort through an increasingly smaller list of places to allocate assets amid broader turmoil. We’ve held a sanguine view on China in recent months because we believe the stated economic reform agenda puts China into a great position to be a core beneficiary of said cross-country rotation – among other factors, which we detailed in our most recent strategy note on China.
A sharp uptick in capital inflows in JAN is primarily why the PBoC subsequently drained liquidly from the banking system in recent weeks via issuing repos. The FEB M0 (slowing dramatically) and M1 (accelerating) money supply growth figures confirms just that (i.e. tighter monetary policy amid rising banking sector liquidity).
If Chinese policymakers thought for one second that systemic economic and financial market risk was accelerating in a material fashion, they would not be tightening monetary policy at the current juncture. Much like in the period of tighter monetary policy leading up to last JUN’s mini-crisis, the PBoC does not see material risks to growth, but rather material risks to financial instability born out of aggressive credit expansion. They are likely pleased with the sharp deceleration in both total social financing and shadow credit growth for the month of FEB, after JAN’s record nominal growth rates:
- Total Social Financing: 938.7B CNY in FEB from 2,584.5B in JAN
- New CNY Loans: 644.5B CNY in FEB from 1,320B in JAN
- Non-traditional Financing (i.e. “shadow” banking): 17.2B in FEB from 993B in JAN
- Ratio of Non-traditional Financing to Total Social Financing: 1.8% in FEB from 38.4% in JAN
Q: The PBoC continues to drain liquidity from the banking sector in the face of sharply decelerating growth data. In light of this, do you still think the PBoC is setting up to ease monetary policy over the intermediate term?
A: Yes. Chinese growth data sucks, as evidenced by the balance of last week’s FEB PMI figures and this weekend’s FEB trade data (which, admittedly, was impacted by Lunar New Year seasonality).
- Official Manufacturing PMI: 50.2 in FEB from 50.5 in JAN; FEB ’14 marked an 8M-low for the index
- New Orders declined -40bps to an 8M-low of 50.5
- Export Orders declined -110bps to an 8M-low of 48.2
- Official Non-Manufacturing PMI: 55 in FEB from 53.4 in JAN
- HSBC Manufacturing PMI: 48.5 in FEB from 49.5 in JAN; FEB ’14 marked a 7M-low for the index
- New Orders and Output both fell below 50 (i.e. contracted) for the first time 7M
- Employment dropped to 47.2, which is its lowest reading since MAR ‘09
- HSBC Non-Manufacturing PMI: 51 in FEB from 50.7 in JAN
- Exports: -18.1% YoY in FEB from 10.6% in JAN vs. a Bloomberg consensus estimate of 7.5%
- Imports: 10.1% YoY in FEB from 10% in JAN vs. a Bloomberg consensus estimate of 7.6%
- Trade Balance NSA: -$23B in FEB from $31.9B in JAN vs. a Bloomberg consensus estimate of $14.5B; FEB ’14 marked the largest trade deficit since FEB ‘12.
- Trade Balance YoY: -$37.8B YoY in FEB from +$3.8B YoY in JAN
In the context of the policy objectives detailed in the previous segment, it would seem rather foolish for Chinese officials to ease monetary policy in the next 3-6M. We concur. That being said, however, monetary conditions continue to soften at the margins – having already softened dramatically in the YTD. We take that as a sign that market participants are looking for some form of policy dovishness on interest rates over the intermediate term – be that manifested in RRR cuts, imposing official caps on money market rates and/or extending the timeline for deposit rate liberalization, which would be akin to the dovish forward rate guidance investors are increasingly expecting the Fed to implement.
Moreover, the official growth and inflation targets as put forth by officials at last week’s National People’s Congress would suggest that Chinese policymakers do, in fact, have a fair amount of scope for a dovish adjustment to their monetary policy bias – particularly on the inflation front. The 2014 real GDP growth target of +7.5% is unchanged from 2013 and the 2014 CPI target of +3.5% in also unchanged from 2013. It’s worth noting that recent Chinese inflation trends are very dovish indeed.
- CPI: 2% YoY in FEB from 2.5% in JAN; FEB ’14 marked the slowest pace in 13M
- Food CPI: 2.7% YoY in FEB from 3.7% in JAN; FEB ’14 marked the slowest pace in 11M
- Non-Food CPI: 1.6% YoY in FEB from 1.9% in JAN
- PPI: -2% YoY in FEB from -1.6% in JAN; FEB ‘14 marked the 24th consecutive annual decline
Shifting back to the growth front, perhaps FEB was the trough in Chinese growth data and Chinese shares are setting rally sharply over the coming weeks and months in typical high-beta, short-cycle fashion. We won’t know until we know, but our market-based leading indicators for Chinese economic growth lend credence to that view.
But rather than play China with the expectation (or hope) for positive beta, we recommend just sticking to the hedged or overweight/underweight strategy we outlined at the start of this note.
We hope this piece helps clarify some things for you with regards to the Chinese economy. Please feel free to ping us with any further questions as you see fit.
Associate: Macro Team