Conclusion: A lack of lending in Europe will likely lead to an incremental slowing of growth in China.
If we have learned anything in the last few years, it is that all major markets are connected. The classic example of course, was the subprime crisis in the United States, which roiled almost all global markets across asset classes in 2007 and 2008.
The 2010 consensus global risk factor is European sovereign debt and the risk of defaults. Our view is that consensus is still not negative enough on the potential implications of a global sovereign debt unwind, primarily because believe the issue related is still deemed to be primarily specific to Europe. But, as ever, the global markets are interconnected with trade being a primary connector.
Specific to that, China reported an export number that was up 48.5% year-over-year in May, which exceeded most estimates. As it related to the 27-nation European Union, exports were up 34.4%. The European Union accounts for the largest share of Chinese imports (or exports from China as this data measured) followed closely by the United States. In May, this number amounted to $25.9 billion in exports to the European Union, or roughly 20% of total Chinese exports. Clearly, any slowdown in Europe will have a direct impact on European purchasing power and Chinese export growth.
At face value, the export data from May seems to suggest that sovereign debt issues had a negligible impact on global commerce and, if anything, the issues were specific to troubled countries within the European Union. Unfortunately, exports, like many economic indicators, are backwards looking in nature. In fact, according to the Chinese Ministry of Commerce, it typically takes Chinese companies two months or so to fulfill orders. Therefore the May export number actually reflects orders from March, which would predate any slowdown in the European Union caused by sovereign debt turmoil.
As always, it is difficult to get a real time read of the underlying growth in an economy until after the fact. While we can read the tea leaves from company earnings announcements and delve into economic releases from the government, neither of these are typically real time, let alone leading indicators. One real time leading indicator though is the amount of liquidity in an economy at any time, which can be measured by the banking system’s willingness to lend.
As it relates to liquidity in Europe, we have been very focused recently on European Central Bank overnight deposit facility usage. As outlined in the chart below, in lieu of lending to each other, banks are depositing funds with the European Central bank at record levels. The best way to think about this chart is as a measure of banks’ willingness to lend to another bank, so their inherent trust in the counterparty’s credit worthiness. As we can see, there is now less trust, on this basis of more money being deposited with the European Central Bank versus being lent on a short term basis to other banks, than around the time of the implosion of Lehman Brothers.
European banks are, en masse, choosing to deposit funds with European Central Bank, at rates of just 0.25%, as opposed to lending to other banks at higher rates. The decision is primarily based on a concern over the credit worthiness of other European Banks due to their holdings of European sovereign debt.
So, what exactly does this have to do with China? Very simply, the less banks lends to each other, the less that is lent to consumers and businesses. As money piles up in the ECB deposit facility it is not circulated and used in the economy, therefore it is not supporting commerce.
In the attached chart we compare deposits in the ECB facility to Chinese exports. Deposits hit an extreme of $210 billion in November of 2008, which was a dramatic increase from October 2008 of $19.9BN, so indicative of declining intra-bank lending and overall liquidity. By February 2009, on a reported basis, exports from China to Europe were at 56% of prior levels. Clearly, as liquidity was pulled out of the system and banks stopped lending, business slowed orders from China and this was eventually reflected in Chinese exports numbers a couple of months into the future.
Coincident with this dramatic drop off in exports to Europe of course was the decline of all things related to sustaining Chinese growth. Think oil, copper, steel, plastic, most basic materials, and the multiple on the Chinese stock market. As orders from Europe slowed for Chinese goods, so did the demand for raw inputs. It was not coincidence that the price of Oil bottomed in February of 2009, which was the same month, as noted above, that year-over-year declines in exports to China’s largest trading customer, the European Union, were at their worst.
It is likely that we have yet to see the worst of the sovereign debt issues in Europe, and we certainly haven’t seen the broader implications of the tightening of liquidity in Europe. Obviously, to believe that the world is not interconnected and that European sovereign debt is an isolated issue is naïve at best.
Daryl G. Jones