Can Chinese Smartphones Bundled With Local Apps Challenge Silicon Valley?

Is Apple really worth 45x Lenovo’s market value or Samsung 21x, given the shift in incremental smartphone penetration growth to emerging markets? Is Facebook worth more than 10 times Sina and Qihoo combined? I very much doubt it and although the valuations of US web stocks are touching euphoric levels, there is no question that we are now seeing similar investor excitement over the potential of the mobile internet as the original PC based model back in 1999 (reflected in China’s buoyant Shenzhen market). The winners from the current land grab in China’s mobile search and social networking markets will likely become leading emerging market technology brands over the next 5-10 years by bundling localized versions of their services in the new wave of cheap Chinese smartphones. Local pure internet plays are highly valued; the cheapest, Sina, trades at 4.3x book and 8x EV/sales,  Baidu on 9.5x book and 11x sales while star performer Qihoo, is on 21x EV/sales and 17x book. The hottest web stocks in the US like LinkedIn and Yelp are valued at about 20x EV/sales range, but all are further along with monetizing their audiences. However there are several credible Chinese stocks offering pure play exposure on low double digit earnings multiples, from Giant Interactive to NetEase and in a global tech portfolio, I’d be switching Chinese for US mobile internet exposure.

China is the only country in the world with a domestic technology sector of sufficient scale to compete against the US web giants, and the breadth of software innovation combined with an indigenous hardware sector makes it unique among emerging markets. As the PC cycle ebbs (although reports of its death are exaggerated) we are already beginning to see Chinese brands expand beyond their home market – Tencent’s WeChat for instance now has 100m subscribers outside China while Baidu has launched a range of its services in Indonesia. The symbiotic relationship between Chinese smartphone makers and local internet brands monetizing web services via gaming and advertising revenues is crucial. Back in the 29th January note on the potential for a breakthrough by Chinese smartphone manufacturers, I noted that: The rise of the ultra-cheap smartphones from upstart vendors which run on Google’s Android OS and use off the shelf chip designs is going to transform the industry over the next couple of years, which will see the sort of price and margin pressure experienced in LCD/LED TVs, where sustaining a brand premium has proved impossible amid endless discounting.’ Samsung and Apple wouldn’t disagree with that analysis. The recipe is to take MediaTek chipsets, Korean touch screens, add say 8GB of flash memory, and load the phone with the Android OS stripped of all traces of Google but pre-loaded with about 30-40 Chinese apps, which are increasingly being localized for Asian export markets.

The internet sector is unique within the Chinese economy in that it is dominated by a handful of forceful self-made entrepreneurs, and yet has benefitted from de facto protectionist government policies shutting out global competitors. The local media market is already highly sophisticated and focused on mobile. Compared to the US, where Americans spend 42% of time watching TV and a combined 38% on internet (mobile plus PC), the Chinese spend a much larger percentage of their media consumption on the web. This in part reflects the dismal quality of local TV and the need to go online for American TV steaming downloads (under 25s in China watch foreign TV series on tablets rather than TV sets), but it should still enable and encourage Chinese innovation in the mobile space.

Emerging Markets Get a Wake Up Call From the Fed…

Just as the PBoC shocked markets last month (and perhaps itself) by engineering a record spike in interbank rates to instill some lending discipline, the RBI last week reversed course on easier policy as the INR broke the 60 level versus the USD, amid an ominous rally in oil prices. Growing concerns about bank asset quality and a looming surge in loan write-offs set against the backdrop of a structural economic slowdown is a narrative as relevant to India as China right now, although the key difference is in the huge divergence in their currency performance and capital flows. In real effective terms (i.e. trade weighted and relative inflation rate adjusted), the RMB has outperformed the INR by about 25% since early 2010, and the impact of FX moves as much as funding costs on sector selection has been critical in both countries (with an ongoing profit windfall for Indian exporters).  Indian bank NPLs reached 3.5% per at the end of the last financial year, with “restructured” assets now accounting for maybe 6% of loans. According to Fitch, the combination of bad and restructured debts will reach just under 12% of loans, or 3.5trn Rupees ($60bn), by next April, a level that has nearly doubled in just two years.

Short of reversing course and following Indonesia in raising the repo rate to stem the currency slide, this was a very aggressive attempt to draw a line at around 60 INR to the USD. The repo rate has been cut three times this year and was held steady at the RBI’s last monetary policy meeting in June. Given the risks of further global portfolio flow volatility, the rate cut cycle is almost certainly over for this year at least. In a statement published last week, the RBI said: ‘The market perception of likely tapering has triggered outflows of portfolio investment, particularly from the debt segment. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals.’ India’s current account deficit was 4.8% of GDP at the end of the fiscal year to March, or $88bn, up from $78bn a year earlier.

Since the Fed suggested its Q4 exit strategy, foreign institutional outflows from the equity market have reached almost $3bn (although still up a net $12bn YTD) and from debt markets over $5bn, while the rupee has depreciated by about 10%. As in Indonesia, the 10-year yield has broken 8% and interest rate sensitive equities from real estate to banks have been hit hard. The proposed liberalization of FDI limits in important infrastructure sectors such as telecoms is a minor positive against this backdrop, and we are going to see a surge in government expenditure pre-election (spending is set to rise 16% y/y in the current FY to end March 2014, versus 9.7% in the last) but the situation remains dangerous until the currency/current account stabilize.

The RBI raised its Marginal Standing Facility interest rate (the cost of borrowing from the RBI using its emergency liquidity mechanism) by two percentage points to 10.25%, bringing it to 300 bps above the repo, its main policy rate. The RBI’s Bank Rate – the standard rate at which it lends to Indian banks was also raised from 8.25% to 10.25%. Funds available under the RBI’s liquidity adjustment facility – which helps banks adjust daily mismatches in liquidity at a softer rate of 7.25% – have been limited to about 750bn rupees ($12.6bn). On the other side of the world, India has had a glimpse of what a reformist, ambitious government can do.

Mexico, which is already the biggest beneficiary of China’s deteriorating manufacturing competitiveness as reflected in US export market share and has been tackling rampant corruption (for instance, in the notorious teacher’s union), unveiled an investment plan to upgrade the country’s key infrastructure, which including investments from the private sector, could hit 4trn pesos ($314bn) between now and 2018 or almost a third of Mexico’s annual GDP. As I’ve long highlighted, the ‘rising tide lifting all boats’ macro scenario for GEM via the positive terms of trade boost from China via commodity prices and the resultant capital inflows is over, the quality of governance matters more than ever for investors, as evidenced by the execution of structural and institutional reforms to boost productivity and domestic demand. Mexico and China are voluntarily starting down that road, Indonesia and India are being forced to by markets, but with questionable technocratic competence to deliver while Russia and Brazil look hopelessly behind the curve. This is all an overdue wake-up call for complacent emerging market policy makers and indeed investors in the asset class.

As Chinese Trend Growth Slows To 6-7%, Is the RMB Now Overvalued?

Well, it’s certainly getting to harder to argue that it’s cheap. The Bank for International Settlements produces a real exchange rate calculation (adjusting for relative inflation rates) which shows that the RMB since 2010 on a trade weighted basis has risen faster than any other major currency. Using unit labour costs rather than CPI would show an even more dramatic loss of competitiveness, and every manufacturing SME owner I met on a recent trip to Zhejiang province was feeling the pain. The latest surge in the nominal RMB exchange rate is odd as it comes at a time of soft growth, falling inflation (only 2.1% y/y to May) and flagging exports (which grew by only 1% over the same period), and largely reflects a surge in hot money inflows until last month, when a regulatory clampdown on fake invoicing began. The RMB appreciated by an annualised rate of 5.5% in May, after rising at a 9.2% annualised pace in April but that is likely to slow dramatically and even go negative in coming months.

Slower capital inflows due to the crackdown on over-invoicing of trade, and the wider retreat from riskier assets by investors in global markets have reduced net capital inflows, exacerbating liquidity tightness inside the banking system are tight in China, reflected in interbank rates. Beijing is committed to increasingly the volume of buyers and sellers of the currency, thereby boosting liquidity and forcing financial institutions to adapt gradually to FX risks. While recent interbank tightness and endless growth downgrades have raised hopes of a rate cut, raising interest rates to slow investment growth and credit expansion is key to promote financial liberalisation, exchange rate reform, and capital account convertibility.

However, the financial constraints to raising interest rates are large because of the existing debt burden of Chinese local governments and SOEs, which, in the absence of alternative revenue streams, requires cheap and abundant credit from the banking sector. Interbank rates will come down over the next month as the central bank injects more cash through its open-market operations; funding can’t be sustained at such a high level because it will disrupt the whole lending market. If liquidity is so tight that it is even difficult for government to raise funds, it will be even more difficult for highly leveraged companies, many of which have short duration debt. Ultimately, it’s inevitable that we will see local equivalents to the current financial chaos surrounding Brazil’s EBX group, and indeed that process is crucial to establishing lending discipline.

On my recent trip around China, rising graduate unemployment and unsustainable levels of pollution were identified by many well-placed sources as key political threats which only a wholesale reform push can help solve. There is no going back to investment led stimulus to goose growth, and the diminishing marginal return in GDP terms makes it pointless anyway. Credit growth accelerated in Q1 to around USD1trn and in April and May and total social financing increased by RMB1.6trn in April and RMB1.19trn in May. New credit is generating ever weaker returns in the real economy, suggesting that there has been a breakdown in the credit transmission channel, such that credit is being directed into sustaining debt servicing burdens and loan roll-overs. Once interest payments consistently grow faster than income at a national as much as household or corporate level, debt becomes unsustainable and that ‘tipping point’ is the crucial one for China, with aggregate interest payments already amounting to about 10% of GDP.

For the past few months, as noted above trade data has been inflated by over-invoicing as speculators sought to bring in capital, largely through higher export receipts for tech goods via HK. The weak exports and imports data suggest consensus GDP growth forecast downside, although limited ‘hard landing’ risk at this stage. As the RMB has floated up within its daily band, the central bank has largely accommodated its movements, raising its morning reference rate by a similar amount, perhaps guided by larger reform plans.

Last month PM Li Keqiang said that an operational plan for easing capital controls would be put forward later this year; if the RMB was significantly below its market value, relaxing capital controls could attract destabilizing speculative inflows so the stronger RMB might be seen as a necessary precondition for looser controls. In the past few weeks, regulators have clamped down on hot-money inflows disguised as export earnings and the RMB appreciation has leveled out – a widened trading band should see downside volatility reemerge.

Investment in real estate is slowing and fell from 24.4% in April to just 23.6% in May. Meanwhile, investment growth in manufacturing has slowed from an average of 43% each month in 2011 to 25% in 2012, and to just 17.8% in May. The combined reading of the official and HSBC/Markit PMI for manufacturing has now slipped from an average of 51.4 in March to 50 in May. In addition, the employment sub-index for the PMI for manufacturing has now had 12 consecutive months of sub-50 readings. New exports orders remained in contraction for the fourth month this year so far in May. In fact, with the exception of a run of 10 consecutive months of sub-50 readings from July 2008 through April 2009, China’s new export sub-index of the PMI hasn’t had a worse year-long stretch since data started being collected in 2005. Given that 58% of exports now go to other emerging economies, few of which are in good shape, that’s not surprising.

The virtuous trade circle around the emerging economies which insulated them from the worst effects of the 2008/9 crisis and which saw intra GEM trade soaring is now a drag as they simultaneously slow. China is better placed to adapt to the new reality (and its markets better discounting the impact) than many of the countries which profited from entering its economic orbit in recent years. The World Bank has forecast that real interest rates are likely to jump by up to 270 points in the more heavily indebted emerging markets as the Fed unwinds quantitative easing, and the tightening cycle starts in earnest. Coming on top of the terms of trade shock from weaker commodity prices as China shifts its growth focus that will create sustained volatility and a polarisation in valuations across GEM between the relative macro winners and losers (the former net commodity importers, particularly those which haven’t seen excessive real estate/lending booms) in this on-going paradigm shift. Once the dust settles on the current Fed tapering volatility, that structural shift will be the key GEM investment theme through mid-decade.



Global Iron Ore Glut Looms…

I’ve been a skeptic of the sharp rally in iron ore prices since Q4, which runs contrary to the weakness seen across industrial metals on growing global inventories and relatively weak Chinese demand, and has begun reversing. The Australia Bureau of Research and Energy Economics in its latest analysis forecasts the key 62% iron content contract price averaging US119/mt this year from a current price of US$136, but falling below $90 by 2018. In 2013, Australian iron ore exports are forecast to increase by 12% y/y, to 554mt on higher production at a number of existing and new mines. Global seaborne supply will head into surplus this year, outpacing demand by 20-25m mt, from a near 40m mt deficit last year. Heavy Australian investment in new capacity is expected to drive export growth of 8% a year from 2014 to 2018, to reach 831m mt. Where is the additional supply, equivalent to half last year’s output, going to go?

Back in the 29th June 2011 note on the Chinese steel industry, I noted that: ‘For investors in Australian resource companies, it’s worth noting that Chinese iron ore capacity is still expanding and won’t peak before 2015 at between 1.5bn and 1.6bn mt, up from less than 1.1bn mt last year and an anticipated 1.3bn mt in 2012. Even allowing for the inferior quality of local ore, as China increases its iron ore production capacity and smaller mills curtail production, iron ore imports should begin to fall as soon as early 2012, undermining global prices.’ That was pretty much the beginning of a sharp de-rating for global resource stocks sustained into Q4 last year, and that slump in iron ore prices indeed happened, before an unsustainable bounce in recent months on the China fixed investment surge and opportunistic restocking.

Crude steel output rose 9.8% last month to 2.21m mt on a daily average basis, breaking the previous record of 2.05m, set in January and versus only 1.86 million tons in December. That reflects investment in fixed assets rising 21.2% y/y in the January-February period and the auto market starting the year with a 15% sales gain. Cement and copper production have also been rising in anticipation of a renewed construction boom. However, China’s steel industry has about 35% excess capacity totaling 970m mt in 2012, while output was only 717m mt and consumption at around 700m. The government has been trying to cull capacity and consolidate the industry; Hebei, which is China’s largest steelmaking province and  accounts for more than 25% of national output, is pushing to cut its output by 60m mt this year, but implementation remains a challenge and curtailing steel overproduction will be a key test of the rebalancing/reform agenda. The Chinese government is seeking to encourage mergers and close obsolete smelters, with the aim of bringing 60% of total capacity under the control of the top 10 mills by 2015. 

Exports of Chinese steel products last month rose 25% y/y to 4.24m mt, and exports have exceeded 4m mt every month for the past year, depressing global steel product prices and profitability. Despite modestly rising prices since Q4, many domestic producers of long semi-finished steel stock reported losses of up to 300 RMB/tonne last month as prices for iron ore surged. The economics of Chinese steelmaking are clearly unsustainable without massive capacity write-offs and lower input costs. Meantime, major Australian miners are committed to significant capacity expansion over the next three years. Despite recent pro-shareholder value management changes after a spate of value destructive acquisitions and weak share price performance versus the wider equity markets and commodity prices, it would be very hard to reverse these plans. Somewhere in the region of 90m mt of additional iron ore supply will hit the market by end 2013. There is also the possibility of India lifting a ban on iron ore mining in Goa during 2012, accounting for 40-45Mtpa of exports, which would add to potential oversupply.

China’s total iron ore imports hit a record of 743.6m mt in 2012, up 8.4% y/y, even though steel output was only up 3%, versus almost 9% in 2011. The jump in Chinese demand in Q4 was partly opportunistic buying after the sharp price declines, and partly driven by a pickup in construction related output as infrastructure related FAI surged.  GDP in China at 7.5-8% should translate to a 3-4% steel output growth per annum given the historical FAI relationship, but it’s likely that the investment and thus resource intensity of that growth is now peaking. Meantime, probably about half of China’s steel industry is unprofitable at current ore prices and domestic producers continue to complain about a pricing cartel in iron ore, driving China’s efforts to directly secure its own overseas supplies.

Iron ore is essentially in a transition to structural oversupply and below-trend prices by mid-decade. Aside from the surge in Australian output, key drivers of this more subdued demand outlook are the growing role of scrap in Chinese steel production, and ongoing investment in Chinese domestic iron ore production. After its decade long production boom, China will be generating growing volumes of steel scrap through this decade, in line with historical trends in more mature economies. Secondary steel production look set to account for about 20% of total production in China by 2020, up from 12% in 2012. This implies a reduction in iron ore consumption of 140mt, all else being equal.

An iron ore price recovery from a brief slump that pushed the spot iron ore price down to US$86.70 last September peaked at US$158.90/mt on February 20th; since then it has fallen to $136. The key question is whether high-cost Chinese iron ore production will be shut as iron ore production expands in Australia and elsewhere and if so at what price for iron ore. It seems unlikely that an iron ore price much above $85-90 can be sustained medium term, unless China slashes domestic mining output. Total sea-borne iron ore exports will surge from 1.15bn mt this year to 1.5bn mt by 2015. Chinese iron ore production is still expected by most independent analysts to increase by 3-5% a year over the same period, even though it is much higher cost. This is contrary to the previous consensus view that lower-cost foreign production will replace higher-cost Chinese production as it comes on stream. Miners have argued that prices will be underpinned as marginal Chinese iron ore producers shut down, but excess capacity across all sectors in China rarely obeys strict economic logic, given the role of provincial governments in supporting ‘strategic’ high-employment industries.

If they don’t shut, the likely global surpluses looks set to exceed 200m mt by 2015 and approaching 350m by 2017. A reasonable longer-term (2015-20) price projection is US$90 a tonne landed in China; given that iron ore costs about US$20 a tonne to ship to the Chinese steel mills, the only local iron ore miners that will be clearly profitable at that price are Rio, which have cash production costs of US$25-30/mt, versus Fortescue at over US$50/mt, although additional scale for the latter will bring its average cost of production closer to Rio’s.  Therein lies the industry dilemma; it makes perfect sense for the likes of Fortescue to ramp up production to reduce  marginal production costs toward industry average, even as it helps crash overall prices. The iron ore price is unlikely to sustain a move above US$100 until about 200m tonnes of high marginal cost production are forced out by cutbacks and closures though late decade, either in China or overseas, bringing the market closer to balance given global demand growth. For the leading Chinese steelmakers, a culling of domestic smelting capacity but not of iron ore output would be a very positive structural margin story.

China’s Mysterious Floating Pigs, as Hard Landing Risks Recede…

On my recent visit to Shanghai, a scandal was breaking involving carcinogenic dyes being used in primary school uniforms; since I left, over 3,000 pigs have been discovered floating downriver toward the city, following a police campaign to curb the illicit trade in pork from diseased animals, which are meant to be buried or incinerated. That backdrop of on-going public health outrages and a blatant disregard for product integrity by domestic suppliers is underlined by HK’s strict new limit on mainland purchases of baby formula, as mainland mothers have been paying a huge premium for reliable HK sourced product rather than the all too often adulterated local version. Coming on the heels of record airborne urban pollution in recent months, the environmental remediation bill for China’s headlong boom is rising fast. All of these disturbing and bizarre stories point to the fundamental lack of trust and strictly objective regulatory oversight within Chinese society as a fundamental issue retarding the next stage of development.

Attempting to establish some semblance of either will be critical to reforming the economy, but implies for the first time imposing formal legal constraints on the party and its wayward officials. Investors are more worried right now about floating shares than pigs, as a record A-share IPO backlog builds, with a surge in issuance threatening to overwhelm equity inflows and net earnings upgrades, as in 2010/11. The Public Offering Review Committee (PORC, how appropriate) at the CSRC determines whether a listing can proceed, and the regulator differs from its global peers in investigating an IPO candidates financial status directly and bearing responsibility for investigating potentially fraudulent activity as part of a 10-step review process. Of over 800 companies applying to the CSRC for a listing, 90 are at the final stage before approval, but more significantly, the new leadership is likely to push further SOE privatisation via secondary and primary A-share listings. Overall, while the IPO pipeline will re-open this year after a long hiatus to restore investor confidence, it is in Beijing’s interest to boost levels of activity and valuations via deregulation of domestic institutional investment rules etc. in order to absorb the much bigger SOE deals likely in 2014 and beyond.


As expected, bank lending slowed in February, to 620bn RMB, but February total social financing growth of Rmb1.07trn was 9.7% higher than January 2012, when the last New Year fell and the combined two-month total was a record, despite a still narrowly based FAI led recovery.  Wealth management products (WMPs), the deposit-like instruments that banks offer to customers at higher interest rates than savings accounts, saw issuance fall 24% in February m/m, a decline that was exaggerated by the New Year holiday but it seems likely that regulatory efforts on bank reporting of off balance sheet activities etc. are tempering the growth of shadow banking. The banks allocate the WMP-raised funds to investments in bonds, money markets and trusts to generate higher returns; much seems to have found its way into local government funding vehicles to pay for infrastructure projects and provincial SOE real estate activities.

This is the area of the shadow banking system that has most concerned regulators because it risks default scandals as poorly understood lending risks blow up for naïve retail investors. Regulators in Shanghai have gone so far as to make local banks register all the WMP products they issue, and there also have been discussions about quotas on overall issuance. However, on the demand side, depositors face the reality of negative real rates again; CPI has averaged 2.6% y/y YTD, while the one-year deposit rate at Chinese banks is currently capped by the government at 3.575%.  Overall, hard landing fears are misplaced near-term and China looks set for a 7-7.5% GDP growth year, as last year’s investment project approval surge sees funds disbursed and concrete poured but to sustain investor enthusiasm and inflows, tangible reform news flow will be crucial.

Chinese New Year Credit Fireworks…

The fireworks display was underwhelming this week in Beijing to reflect the new mood of official frugality, but China’s spectacular credit growth in January was more jaw dropping than any pyrotechnics. New RMB lending surged to 1.07trn RMB ($172 billion) in January, the highest since January 2010 amid the last cyclical credit boom, when loans hit 1.39trn RMB, while M2 money supply growth accelerated to 15.9% y/y. Aggregate financing in the month exploded to 2.54trn RMB ($410bn). Overall, 60% of total credit creation originated from the shadow sector of trusts, corporate bonds, loans by investment companies, direct intercompany lending and banker’s acceptances and the 40% share of core banks was up from its lowest ever level in December, but well below the 52% of annual 2012 aggregate financing. Overall, the recent credit injection (even allowing for fast deteriorating incremental credit efficiency, with each new RMB of output now requiring about 6 RMB of credit) suggests that the Chinese economy is likely to accelerate in Q1 to 8.5% plus growth, but systemic risks are once again building.

It’s getting increasingly hard for the central authorities to clamp down on ever mutating off balance sheet credit conduits, and brokerages are the latest one to emerge. When the government tried to clamp down on investment companies known as trusts, securities brokerages stepped into the off-balance sheet breach. They have been allowed to invest their own money and assets managed for clients in a much wider range of financial products, including bank wealth management schemes, since the securities regulator started implementing a series of new policies from October 2012. Banks favour securities firms over trusts because loans made through their asset management schemes do not count towards bank lending quotas. Trust companies have a fiduciary duty to investors (though their role has been limited to being only a capital conduit in the bank schemes); securities firms don’t even have this minimal responsibility, and hence charge much lower fees to the banks, a further incentive for banks to redirect flows their way.

The amount of assets managed by Chinese brokerage firms exceeded 1.2trn RMB at end 2012 from 280bn at the beginning of the year. Up to 90% of that total was tied to banks; in a typical structure, the bank entrusts the securities firm with funds raised from wealth management products, and the securities firm uses the money to buy the bank’s notes or invest in other types of financial instruments. The arrangement allows the bank to shift assets off its balance sheet and circumvent lending restrictions. The securities firm, in return, charges the bank a fee for using its service. The schemes mirror arrangements that allow banks to channel money through trust products to borrowers otherwise ineligible for bank loans. 

That tactic is used much less frequently because the CBRC since August 2010 has required all trust companies to cap the value of trusts tied to bank loans at 30% of their total outstanding products, while banks were required to include loans made through trusts on their balance sheet. It looks like similar measures may have to be implemented regarding brokerage products. Overall, the investment surge since mid-2012 is being enthusiastically funded, underpinning near term growth momentum. However, this is likely the last throw of the fixed investment policy dice. After a five year 60 plus percentage point surge in the outstanding credit/GDP ratio, China’s capital balance is approaching a similar and globally disruptive inflection point to that seen in coal or soybeans in recent years. The country looks set to become a sustained net importer of capital by late decade as domestic corporate and household savings peak, amid widespread post credit bubble asset deleveraging and balance sheet recapitalization. Enjoy the party while it lasts…

China Rebounds, But Can it Rebalance?

China’s economy is bottoming out on schedule (albeit from something closer to 6-6.5% growth than the official data), as the lagged impact on activity of infrastructure announcements since late Q1 is felt. In real terms, retail sales were up 13.5% y/y (helped by the Golden Week holiday), industrial production growth accelerated from 9.2% y/y in September to 9.6% y/y in real terms while the closely watched ‘reality check’ metric of electricity output growth rebounded significantly to 6.4% y/y after staying in low single-digits for the whole of Q3 (see below re coal implications). The recent export rebound (and exports were worth about 31% of GDP in 2011) is impressive considering that the RMB has appreciated by 2.4% against the USD since August, and the euro zone remains grim. However, despite the recent pick- up, China will miss its target for 10% export growth in 2012; exports have increased just 7.8% YTD. There is the risk of a strong base effect flattering the H1 numbers next year, but total planned investment in newly started projects, a leading indicator of FAI, accelerated to 35.2% y/y in October from 31.3% in September.

Consumer inflation eased to its slowest pace in nearly three years in October, with the 1.7% y/y rise below consensus expectations, and surprisingly food prices down m/m, allowing scope for further policy action into Q1 if required. More significantly, corporate deflation pressures eased; PPI fell 2.8% y/y, from September’s 3.6% drop, a marginal boost for companies struggling with falling margins and lengthening receivables. As I’ve highlighted in previous notes, no ‘V’ shaped recovery back to near double digit growth rates is plausible on any sustained basis, given the structural headwinds from low industrial capacity utilization, weak corporate cash flows and  inevitable systemic deleveraging. Near term, the PBoC has used aggressive reverse repos to stabilize liquidity conditions, while the effective lending rate floor is now as low as 4.2%, as the discount rate on the lending rate floor was also widened from 10% to 30% at the same time as the last interest rate cut in July. Since May total social financing has been rising y/y, led by the non-bank sector. In fact, China’s trust companies, with more than $1 trillion under management, provided 755bn RMB worth of new funding to infrastructure projects over the course of the first nine months of the year. Local government financing vehicles (responsible for funding most of the country’s infrastructure construction) raised a further 716bn RMB from bond issuance, according to CICC data.

The trend marks a transfer of default risk from the state (in the form of implicitly central government backed policy bank lending to LGFVs) to private investors, at a time when local government finances are in a very bad shape (with revenues in many large cities typically up 10% y/y and spending up 25-30% YTD). It seems that not only have the banks stepped back from taking the primary role in funding the latest round of infrastructure expansion, but that a portion of funds raised from trusts and bonds has gone toward repaying older bank loans. Xiao Gang, chairman of Bank of China, writing in the China Daily last month, noted that: “It is shadow banking activities that have allowed many projects to obtain fresh funds and hence avoid default …this could be one of the major reasons why the formal banking system in general is still enjoying declining non-performing loan ratios, despite the weakening repayment capabilities of some borrowers”. Despite the pick-up in high frequency data, the quality of incremental credit is a concern.

Overall, Armageddon scenarios were never plausible at this stage, but a decline to 4-5% growth remains feasible by mid-decade if deep reform measures to boost trend productivity growth from current levels at about half of wage growth are not pushed through in 2013. The next couple of quarters should be bullish for Chinese risk assets, but the challenges and inevitable upheaval of the looming economic transition will be the key investor focus by this time next year. It’s clear that China’s new leadership must be comfortable with “the new normal”, and focus on efficiency enhancing reforms. During his opening speech of the 18th People’s Congress, Chinese President Hu Jintao stated that GDP must double by 2020. That implies an annual growth rate in excess of 8%, which is implausible given demographic headwinds without a much larger role for the private sector and radical structural reforms.

The debate is raging in policy circles about now to halt the trend known in Chinese as guojin mintui, roughly translated as ‘the state advances while the private sector retreats’, a trend since 2008 which has driven productivity growth lower and led to diminishing capital returns across the economy. Reformists generally see the growing power and share of  GDP held by state-owned  companies  as  the biggest structural risk facing the Chinese economy. Private SMEs are blocked from investing in sectors such as oil and shipping, over which the government asserted ‘absolute control’ six years ago, and they have limited access to nine other sectors including autos and construction in which state companies were granted ‘relatively strong control’, leaving cash surpluses from the export sector  to  be  reinvested  unproductively  into  real  estate.  Opening  these  key  sectors to both FDI and local SME activity will be an important signal of intent in coming months.

Meantime, a new hukou (residence pass) policy was announced in February 2012, allowing migrants in small cities to apply for local residence if they have a stable job and a place to live. Migrants in medium-sized cities can do the same if they have worked and lived in the same city for three years. This policy, if it is implemented, will greatly boost domestic consumption as rural migrants save much of their income because they have to prepare for going back home someday and China’s household consumption would increase by 3-4 percentage points as a share of GDP if the consumption level of rural migrants were increased to the average level of urban Chinese citizen. Migrants will bring their children and parents to the city once they get the urban hukou (a key factor behind the opposition of urban residents worried about competition for social services like schools). However, this reform in conjunction with a wider social safety net would provide a larger market for services, a sector still hugely underdeveloped and with the potential to offset the falling share of manufacturing in the second half of this decade.

China Rebalancing Trends Deteriorate in Q3…

While the consensus obsesses over GDP growth, the key issue for investors in China and the incoming leadership remains the quality and sustainability of incremental activity. We introduced the China Rebalancing Index back in the February monthly note, and updated it in a July weekly; it’s an equally weighted diffusion index taking a standardized composite measure of seven key economic trends to act as a statistical summary of evolving structural trends, rather than looking for contemporaneous or lagging correlations or cyclical turning points as with a composite leading/coincident index approach. The components offer an insight into whether the Chinese economy is evolving in a sustainable direction toward greater household consumption/private sector service growth or further structural imbalance by experiencing incremental growth driven by SOE/heavy industry/fixed investment activity.

Readings  above  50  represent  trend  imbalance,  and  readings  below  50  represent  trend rebalancing. The methodology follows that used in constructing a Purchasing Managers’ Index (PMI). Quarterly data is used as a default rather than the usual and dubious linear interpolation to create a monthly series; where monthly data is available, the end of quarter data point is selected. Broadly, significant trend shifts in the CRI as seen in 2002/3 and 2009/10 lead the relative consumption share of GDP growth by 9-12 months, which is in line with the real economy lagged impact of factors such as the real deposit rate and REER in terms of metrics like the savings ratio/consumer purchasing power.

The CRI components are:

1. The real (CPI deflated) 1-year bank deposit rate deviation from neutral (defined as 100bps positive i.e. a level at which monetary policy is neither expansionary or restrictive) – every 1% rise in the real interest rate will reduce the savings rate by 60bps on IMF analysis, and vice versa – a positive in Q3 as the decline in average CPI outpaced the cut in deposit interest rates.

2. The Real Effective Exchange Rate (REER) y/y change i.e. the trade weighted and relative inflation adjusted change in the RMB rate as calculated by the Bank of International Settlements – an accelerating REER trend will be positive for rebalancing by boosting domestic retail spending power/curtailing marginal industrial activity –negative contributor in Q3 on relative inflation rates and RMB volatility, as the y/y growth rate fell to 3.5%.

3. The differential between real per capita household income growth (rural and urban, weighted by the annual urbanization rate) and real GDP growth. This is a proxy for wage growth in the absence of direct statistics – positive in Q3 with per-capital real urban incomes rising 9.8% and rural by 12.3%, well ahead of GDP growth.

4. The differential between Secondary (industrial) and Tertiary (service) shares of incremental GDP growth – acceleration in SME service activity is crucial to several positive trends from reduced energy intensity of incremental GDP to absorbing underemployed graduates. Small positive in Q3, as manufacturing industry suffered disproportionately from the policy led slowdown, and services activity accelerated slightly to 7.9% from 7.7% in Q1, both on a YTD y/y basis.

5. The % change in the quarterly Entrepreneur Confidence Index for SOE dominated sectors versus private to capture trends in private SME momentum; the Shibor interbank rate is a useful proxy for funding stresses in this sector but the history only extends to 2006 and this index correlates positively with revenue growth and negatively with funding cost trends. Largest contributor to imbalance in Q3 as SOE/heavy industry confidence stabilised amid on-going weakness in SME sentiment (notably in the social services sector, down from 131.5 in Q2 to 122).

6. The differential between real Fixed Asset Investment (deflated by 6mma Building & Construction PPI) and real Retail Sales (deflated by CPI) growth rates (note as discussed in previous notes that FAI includes land values, which creates distortions in drawing international comparisons, but not in terms of broad GDP trends). Falling inflation helped China’s retail sales rebound to a real growth rate of 12% y/y in Q3 but the 6mma construction PPI slumped far faster than CPI, boosting the real FAI growth rate to 22%, so marginally negative contributor.

7. The differential between heavy and light industry output growth (on a VAI basis) within the Secondary sector of GDP – heavy industry such as cement and steel is capital and energy intensive, and dominated by SOEs with preferential funding access. Light industry is predominantly consumer demand focused, although the category is also exposed to construction activity. Value added of industry = gross industrial output – industrial intermediate input + value added tax; the growth rate is calculated at constant prices. Value-added of Industry refers to the final results of industrial production of industrial enterprises in money terms during the reference period. Neutral in Q3, as the decline in value added output growth for heavy industrial sectors like steel was matched by light industry suffering from softer consumer demand growth.

China Turns on Investment Tap to Offset Liquidity Trap

The tendency of Asian rich brats from Bangkok to Singapore and Beijing to treat city streets as racetracks (frequently crashing their Ferraris spectacularly, and often mowing down pedestrians and fleeing the scene) is a disturbing insight into the sense of elite entitlement which is exacerbating political risks from historic levels of wealth and income inequality. That backdrop complicates the very predictable transition underway in China not only to a lower trend growth rate but with a very different incremental composition (despite the current Pavlovian policy response of state bank funded infrastructure stimulus). Back in the 27th  July Weekly, I concluded that: ‘Every traditional policy lever will be pulled in coming months to restore momentum, and we’ll soon find out whether they’re still attached to anything in the real economy’.

The August lending data suggests that they are, and we should consequently get a ‘dead cat’ bounce in some cyclical sectors this autumn. However, beyond the current slowdown, recent well publicised events suggest that the party probably faces a legitimacy crisis to rival 1989, when Beijing students were more worried about being crushed by tanks than Italian sports cars. Cancelled Macau junket trips, Burberry coats left on the racks and slumping steel and other commodity prices all reflect the aftermath of the deflating 2009-11 credit bubble which much as many commentators seem to wish, can’t be resurrected.

The downside risks in the Chinese steel sector were obvious early last summer as the policy squeeze began, and covered in a note at the time; prices for hot-rolled steel fell to an almost two decade low in recent weeks, the latest sign of deflationary forces engulfing the heavy industrial parts of the Chinese economy, reflected in a still slumping official PPI. The China Iron & Steel Association has said the situation is “disastrous”, with even the strongest groups such as Baosteel losing money. Even before the impact of inflation and GDP growth since, the latest RMB1trn investment package compares poorly to the RMB4trn stimulus after the Lehman crisis, although is combined with a provincial spending spree of dubious funding; Chongqing and Tianjin have each unveiled $240bn programs.

Having been bearish since last summer on the whole construction related heavy industrial area of the market, if I had to bet on one cyclical Chinese sector as a Q4 trade it would be cement, simply because the product is inherently perishable and hence not subject to the vast inventory overhang in say steel and non-ferrous metals. It’s also distinctive in that output trends are already stabilising. Overall, the headwinds on the cyclical part of the market should abate in coming months, although that doesn’t help the longer-term rebalancing narrative. The biggest question for global investors right now is whether China is fully invested in terms of its physical capital, and the answer depends on how you view the data. On a per-capita basis, the country’s capital stock remains a fraction of that in more developed Asian economies such as Malaysia or Thailand, let alone the US and Germany. However, relative to the country’s GDP (or indeed GDP per capita), things look more ominous for industrial commodity bulls.

The bottom line is that while you can make a cost-benefit analysis argument for urban mass transit etc., the number of truly economic infrastructure projects in China at its current level of per-capita GDP/household income is probably tiny after the fast-forward rollout of projects previously planned to 2020 and beyond funded by the post-crisis stimulus. A 200km race track around Beijing for those Ferraris would be a nice multi-billion project appreciated by the party princelings and which would technically add to GDP as it absorbed steel and cement, but it would also add to an economy wide debt burden heading for 200% of GDP. There is a widespread misconception that China has overturned the dismal laws of economics and doesn’t face financial constraints because of the 50% of GDP in foreign reserves etc., but that is simply deluded as the FX inflows those reserves represent have already passed through the economy when sterilised by the PBoC.

Investors are as addicted as Beijing policymakers to the investment ‘fix’, and when last week the NDRC approved 60 new projects, led by railways, roads, harbours and airports; the Shanghai Index jumped 3.7% (although the ECB news was at least as important on the day) and even steel shares bounced, despite chronic overcapacity and unprofitability. Between January and July, China churned out 419mt of crude steel, still up 2.1% y/y despite crumbling demand. The fragmented industry’s gross margin was as low was only marginally positive  and sector wide profits sank 49% y/y to 66bn RMB in H1 according to data from the NDRC.

Sentiment if not financial reality should benefit from project approvals and new investment picking up with bank lending and total credit growth, consistent with a more proactive policy stance in recent months (and signs of life in real estate, a very mixed blessing).  Of the new loans in August, medium- to long-term loans accounted for RMB286bn, versus RMB210bn in July, with their share of total new loans rising to 40.6% from 38.9%, suggesting that banks are funding the pickup in infrastructure investment from announced new projects in Q2. While this will help draw a line under the recent free-fall, it’s constructive only in the literal sense. Banks are supporting the government’s move to fast-track infrastructure projects (not that they had much choice when those red phones rang).

The cash flow squeeze throughout the corporate sector remains intense, but there are signs of credit life; China’s total social financing aggregate, a broad measure of liquidity in the economy, rose to 1.24trn RMB in August from 1.04trn in July. Soft M2 growth was probably due to a transfer of RMB savings to deposits in USD on expectations of further local currency weakness, a trend I covered in the 24th  August Weekly. Outstanding deposits in foreign currencies rose 62.1% y/y at the end of August to $415.1 billion while RMB outstanding deposits rose only 12.2% y/y to 88.31trn at the end of last month.

One positive from the slowdown in FX inflows is that the PBoC is becoming a more ‘normal’ central bank, freed from the straitjacket of relentless FX sterilisation and increasingly reliant on the policy tools of its global peers such as reverse repos in its open market operations to support interbank liquidity growth; that also implies that the period of explosive M2 growth in China is now over. Looking ahead, in H2 only RMB275bn of bills and RMB40bn of repos are set to mature, counterbalanced by the RMB300bn of reverse repos outstanding, limiting the ability for open market operations to boost liquidity further. That makes a belated further reduction in the RRR more likely. Added to some form of export support scheme in the works, it all should goose animal spirits at the margin but 7.5% growth is the ‘new normal’ for China and would actually be a good result.

Value-added industrial output in China rose 8.9% in August from a year earlier, down from 9.2% in July, and the slowest growth since May 2009. The slower industrial production growth was likely due to continued destocking of inventories in cyclical sectors as well as weak domestic demand. This destocking process is likely to continue until late Q4 or early Q1 next year. The country’s CPI rose 2% y/y in August, up from July’s 1.8% rise; the main driver was the price of food, which rose by 3.4% from a year earlier, compared with a 2.4% rise in July. China’s inflation always looked likely to pick up in the coming months due to the upswing in global food prices caused by drought conditions in the US, which alongside a stubbornly resilient real estate market is restricting the opportunity for aggressive stimulus measures. Meanwhile, China’s PPI fell 3.5% y/y, compared with a 2.9% decline in July, and a sustained debt deflation across heavy industrial sectors plagued by chronic overcapacity is another threat to bank NPLs. Fixed Asset Investment growth stabilised at just over 20% growth y/y. Even before the latest spending plans were announced, the fiscal deficit was widening; fiscal expenditure growth accelerated from 17.7% y/y in June to 37.1% in July but revenue growth slowed from 9.8% y/y in June to 8.1% y/y in July.

The level of economic activity in August looks consistent with economic growth of about 7.5% for this year, against the 9% plus consensus forecasts coming into 2012, and no significant rebound should be expected next year. Headwinds from excess capacity and inventory build-up, corporate deleveraging, subdued investment, and banks facing rising NPLs mean that the best hope is that with appropriate policy easing growth will stabilise in a 7-8% trend range. In the February 2011 monthly on China’s sobering historical parallels, I concluded that: ‘The key is a rational capital allocation system which finances projects based on marginal economic returns…that economic ‘reboot’ will inevitably mean a major dip in growth to maybe 6% for 2-3 years before it reaccelerates toward a trend 7-8% on a more sustainable services and consumption led basis. If the current distorted and increasingly wasteful model is pursued much beyond 2012/13, a hard landing is likely soon after which will depress growth for the rest of the decade and have destabilising political implications.’

As foreign investment banks scramble to downgrade 2013 growth estimates toward 7.5%, it’s still plausible that a multi-year growth dip to as little as 6% is in prospect as the economy deleverages amid huge asset write-offs (whether than number is ever reported as such is a different matter). If that leads to productivity rather than input driven growth amid wider reforms/deepening of capital markets, it should ultimately be very positive for long-term China investors. After all, crude GDP growth has never correlated well with EM risk asset returns, and nowhere less so than in China…