Below greed n fear is a few weeks young, and I mostly agree w/ its points
From: J
Sent: Tue, December 14, 2010 8:57:37 PM
Subject: Why Chinese Inflation Is Not That Big Of A Deal, And Other Issues
CLSA' Chris Wood On Why Chinese Inflation Is Not That Big Of A Deal, And Other Issues
When it comes to China, few people are as erudite (if somewhat biased) as CLSA's Chris Wood. Below we present his latest thoughts on the world's most populous country, which after tonight's inflation news is sure to be in the headline news for at least a few days, or at least until an iPad 2 prototype is shockingly stolen from Apple's offices. And according to Wood, tonight's Chinese news are, in the grand scheme of things, not all that material:
"GREED & fear is not about to change the current view on China since the view here remains sanguine on the near-term perceived risk of higher CPI “inflation”. Still the issue of the fast developing non-banking financial sector needs to be watched closely; most particularly how the regulators respond to it since any aggressive crack down will have negative market implications. In the longer term, if the growing breed of financial entrepreneurs continue to find ways around the rules, that might ultimately make policymakers consider a more market orientated policy where interest rates are set by the market. But that would have major political implications as it would mark a fundamental departure from the command economy model. All this is just another way of saying that there are limits as to how long China can continue to run its weird hybrid of command economy and private sector economy. But for now at least GREED & fear is going to give Beijing the benefit of the doubt that the game can continue in 2011 since the empirical evidence continues to support it."
The much awaited Chinese CPI and PPI have been released: CPI came at 5.1%, on top of the whisper number, but higher than the official consensus of 4.7%, and the highest number by far in over two years. PPI beat by 100 bps, printing at 6.1%, compared to 5.1%. This "data" should be sufficient to negate the impact of last night's RRR hike and force the PBoC to raise its interest rate, as if the Chinese central bank does not act, one would wonder why the Politburo would allow the release of data which would only enflame the domestic inflation scare even more.
The view of the authorities is that headline CPI should peak at about 5% by the middle of next year at the latest, and decline back to below 4% in the second half of 2011 as the pressure from food prices goes out of the system. This is not far off from the view articulated by CLSA’s China macro strategist Andy Rothman, and would result in a cycle not so dissimilar from the food-driven inflation surge that occurred in 2007-08. It is true, however, that the pressure from food prices seems much more broadly based than in 2007-08 when it was primarily confined to pork prices.
True, the authorities could always be wrong about inflation; though in GREED & fear’s view it is a major assumption to believe that China is about to diverge wildly from its long established pattern of productivity-driven disinflationary growth. Far more likely is the pattern as described in the new proposed 12th Five-Year Plan where CPI inflation rises from a trend level of 3% to 4% on the back of a structural pick up in the share of wealth generation taken by labour in the form of higher wages. This is all part of the hoped for move to a more consumption driven economy, a trend which would surely be totally benign.
GREED & fear says “hoped for” since there is still no hard evidence that consumption’s share of GDP growth has stopped declining. Thus, final consumption expenditure accounted for 34.4% of real GDP growth in the first three quarters of this year, down from 76.8% in 1999 (see Figure 6). It is also the case that, with talk of yet more infrastructure projects in the continuing “Go West” programme, the escalating cranking up of social housing and the ongoing high speed development of a high-speed railway network, that China ’s growth is still going to remain to a significant degree investment driven for many years to come. (On the railway story read a recent report by CLSA’s regional head of transport and infrastructure research Robert Bruce – China transport: Fast tracking, 29 November 2010). This macro-economic outcome is also a function of necessity. Net exports are likely to make only a minimal contribution to estimated real GDP growth of 10.5% this year (based on the latest official estimates). The contribution of net exports is also likely to be minimal at best in next year’s 9.5% real GDP growth rate as forecast by the authorities.
If the PRC is not worrying about inflationary pressures surging sharply to the upside as measured in the official CPI data, the authorities do want to appear to be “prudent” on monetary policy; to quote a statement made by the Politburo of the Chinese Communist Party’s Central Committee last Friday. This is why the loan growth quota in 2011 is likely to be in the Rmb6.5-7tn range, down from this year’s official Rmb7.5tn figure. Further moves in reserve requirements and interest rates can also not be ruled out.
There will also be a continuing desire to rein in residential property prices, while it is clear that the government’s determination to deal with the housing affordability issue has this year seen the beginning of what is likely to be at least a five-year programme accelerating development of social housing. The official plan is to construct 5.8m units within this year (though GREED & fear hears that only 60% of that figure will be completed by year end) and for another 10m units in 2011. It is unclear whether the 10m figure includes this 40% not completed this year. But the point about these ambitious targets is less the details than that the central government is dead serious about social housing and local governments will be judged on their record in meeting such targets. This is good news for producers of steel and cement. Thus, 15% more cement per square metre is consumed building social housing than in regular private sector housing. While developers who want to get access to desirable land will need to show they have done their bit constructing social housing.
If all of the above is clear and reasonably well understood, a far more opaque issue in China is the real level of credit growth. GREED & fear refers specifically to a report issued by the credit agency Fitch Ratings this week arguing that credit growth has not slowed this year from the frantic pace seen in 2009 when new credit totalled Rmb11tn despite the slowdown in official bank lending data (see Fitch Ratings report – Chinese Banks: No pause in credit growth, still on pace with 2009, 2 December 2010). Fitch notes two reasons for this; first the growing use of higher yielding securitised products sold by banks and trust companies and second the manipulation of discounted bills. Thus, by the end of November an estimated Rmb2.5tn in credit was sitting off bank balance sheets in credit-related wealth management products while credit-related trust products had risen to about Rmb485bn. Fitch also estimates that the balance of Chinese banks’ discounted bills was understated by as much as Rmb1.65tn at the end of 3Q10. Adjusted for both factors, Fitch estimates that the amount of new credit extended in the first three quarters of this year is on pace with the Rmb9.3tn extended during the same period last year.
The above is a relatively non-transparent issue about which GREED & fear has in no way done enough legwork to make a definitive judgment on. But that Fitch may be on to something is suggested by the macro data. Thus, a look at the People’s Bank of China’s depository corporations survey data shows that bank loans and claims on other depository corporations and financial institutions grew by Rmb10tn through to the end of September (see Figure 7), or at an annualised rate of Rmb12tn which is equivalent to the level of lending seen in 2009 when the Chinese government abolished the loan quota given the PRC’s desire to use the command economy banking system to combat the post-Lehman collapse in growth.
If this is the top-down macro evidence of the growth in the non-banking financial sector, it is also clear from a bottom up level that bank depositors with capital to invest are now aggressively sold “guaranteed” securitised trust products offering yields on corporate loans of 3-4% and higher. Interestingly, in some cases the bank is selling as an agent loans made by a so-called trust company where the guarantee is made by a third party, be it a private or state-owned guarantee company.
GREED & fear hears that there are two basic types of credit-related wealth-management trust products. For the first type, the bank makes the loans and then sells them to a trust company which repackages the loan assets and sells them as a trust product. The incentive for the banks is that this process allows them to move the loan off balance sheet thereby getting around the loan quota. This type of product offers annual yields of 3-4.5% with a maturity period of up to three years. The second type of product is where the bank only acts as a sales agent for the trust company which makes the loan themselves and sells the repackaged trust product to the bank’s clients. This tends to be higher yielding product with annual yields ranging from 5-15% depending on the credit risk and a maturity period of up to three years. Note that both types of credit-related wealth-management products are usually built around loans to a single borrower or “credit”. One sector which has taken particular advantage of the second type of product is the property development industry. This is because of regulatory controls on lending to that sector.
It should be noted that in July the CBRC issued regulations which targeted the first type of product by ordering banks to move any loans securitised on to trust companies back on to their balance sheets, though implementation apparently only really started in November. Banks will, therefore, no longer have the incentive to do the first type of trust product. GREED & fear hears that, in practice, going forward the first type of product will likely shrink in size and the second type will grow.
All of the above is, as noted, a reflection of the rapid development of an increasingly entrepreneurial non-banking financial sector, a sector which seems to have expanded as a consequence of the liquidity surge triggered by the post-Lehman expansion in lending; as well as increased private sector demand for credit combined with depositors’ appetite for yield. The appearance of China ’s version of the West’s now no longer expanding shadow banking system raises the issue whether this phenomenon can be managed by the PBOC and the China Banking Regulatory Commission given the somewhat primitive command-economy loan quota system. For if the Fitch analysis is accurate, it would suggest that credit now leaks to other channels not managed by the authorities.
Still even if it is assumed that the authorities are not on top of the issue, and that is a very big if given the PRC’s impressively pre-emptive track record over the past ten years and more, the publicity generated by the Fitch report will presumably have the merit of alerting them to it. Still a failure to bring the non-banking financial sector under control could ultimately serve as the trigger for the over-investment bust that many have been predicting for so long in China given the economic model’s addiction to investment and given the fact that interest rates have always been unnaturally low raising longstanding concerns about the inefficient allocation of capital. This is because it would mean the authorities were losing control of the credit cycle, meaning the banking system was less “command economy-like” and therefore more vulnerable to a classic capitalist over-investment bust.
Still all of the above is for now only interesting conjecture. GREED & fear’s point is to make investors and indeed bank analysts aware of the above issue, and to highlight the need to be alert to any possible policy measures that might be announced to address it; though ironically the greater reliance on quotas by administrative fiat the greater the entrepreneurial incentive for the banking sector to find new ways to get around them.
Meanwhile, the medium-term threats to the Chinese macro story posed by the development of a non-banking financial sector, in China ’s command economy context, are a very different issue to the issue of whether inflation is about to surge in China today. In GREED & fear’s view, as already noted, there is no compelling evidence that inflation outside food in China is about to take off in coming months. This makes it less likely that the authorities are going to crack down aggressively on the trend highlighted by Fitch.
What about the macroeconomic argument that a surge in liquidity since 2009 is leading to an inflation threat, an argument clearly linked to the expansion of the non-banking financial sector? GREED & fear’s prime view remains that the liquidity is more likely to be reflected in rising asset prices in China than in a generalised rising CPI trend. The other point which has already been highlighted by Rothman (see CLSA research Sinology – Inflation: Causes and consequences, 30 November 2010), is the sharp decline in velocity of money which has occurred since 4Q08 (see Figure 8). This is the opposite of inflationary. Still the surge in overall credit in the system beyond formal bank lending is exactly what would be expected as a prelude to an over-investment bust, most particularly if it is taking more and more credit to produce a certain level of economic growth as was the case in Asia ex-Japan in the lead up to the Asian Crisis. See the chart below on the historic trend in Thailand and China (see Figure 9).
Clearly, over-investment busts are normally preceded by high investment to GDP ratios and asset bubbles. In China ’s case the investment to GDP ratio has been at seemingly stratospheric levels for a long period (see Figure 10). Hence those premature forecasts of a collapse. It is also the case that the continuing policy of holding down the currency via intervention also encourages higher asset prices raising asset bubble risks. On the specific point of the renminbi, GREED & fear heard this week there will only be a 3-5% appreciation next year against the US dollar which, if true, is not going to please Washington .
Meanwhile, Beijing remains obsessed with the asset bubble risk, as reflected in the continuing focus on residential property prices. On that point nobody is expecting any easing of policy towards that sector. Rather if the official data shows property prices rising by more than 1% a month, then there will be growing expectation of more policy action. But for now the official residential property price index of 70 mainland cities rose by only 0.3% MoM in October (see Figure 11).
The net of all of the above is that GREED & fear is not about to change the current view on China since the view here remains sanguine on the near-term perceived risk of higher CPI “inflation”. Still the issue of the fast developing non-banking financial sector needs to be watched closely; most particularly how the regulators respond to it since any aggressive crack down will have negative market implications.
In the longer term, if the growing breed of financial entrepreneurs continue to find ways around the rules, that might ultimately make policymakers consider a more market orientated policy where interest rates are set by the market. But that would have major political implications as it would mark a fundamental departure from the command economy model. All this is just another way of saying that there are limits as to how long China can continue to run its weird hybrid of command economy and private sector economy. But for now at least GREED & fear is going to give Beijing the benefit of the doubt that the game can continue in 2011 since the empirical evidence continues to support it.
If Chinese savers are pursuing yield, as reflected in the surge in so-called trust company wealth-management products, it is also interesting to note that the chairman of the Shanghai Gold Exchange, Shen Xiangrong, stated last week in a speech that gold imports into China rose 480% YoY to 209.7 tonnes in the first ten months of this year. While there is no way to verify independently the figure, there seems no reason to assume he has made it up. It is also interesting to note that this import number is equivalent to about two thirds of China ’s estimated annual gold output of 340 tonnes.
For those who believe the US economy will not get real traction resulting in ever greater waves of monetary and fiscal stimulus, gold remains an essential hedge. On this point CLSA’s Australia office has this week published a research report covering seven Australian mid-cap gold mining companies (Australian goldminers - The elusive quest, 7 December 2010). Meanwhile, GREED & fear maintains the biggest Australian goldminer Newcrest Mining with an 8% weighting in the Asia ex-Japan long-only portfolio. The operating leverage of those mining companies who actually produce gold remains an interesting investment story for those equity investors who sympathise with GREED & fear’s longstanding gold price target of US$3,360/oz. Meanwhile, back in China , the China Securities Regulatory Commission (CSRC) in late November approved the first QDII gold fund where domestic Chinese investors can invest in a fund of offshore gold ETFs. It will be interesting to see how much money is raised in this product. |
