China: All Signs Point To A Recession In Second Half Of 2013
China’s economy finally appears to be buckling under the weight of its credit binge. Despite record new credit issuance in recent months, the manufacturing sector has once again experienced contraction in line with our view. Efforts to reform and rebalance the economy are too little, too late, to avoid the hangover effects of past stimulus measures, and we believe that a recession is at hand (although frankly, we do not expect China to admit economic contraction in its official GDP data). Expectations of a robust recovery in 2014 are likely to be met with disappointment, as the rebalancing process proves to be a long and drawn out affair.
We have written on numerous occasions about the risks facing the Chinese economy as a result of the cheap credit-fuelled boom seen since the global financial crisis. In short, it has been our belief that the Chinese banking system has directed credit to unproductive sectors of the economy, generating headline real GDP growth, but undermining wealth creation in the process. This wealth destruction has been covered up by the rolling over of poor quality loans and continued asset price appreciation.
Beneath the surface, though, corporate finances have been deteriorating significantly. Profit growth has turned negative (a clear sign of economic stress), but even more ominous is the deterioration in corporate cash flows, with operating cash flow as a share of profit falling sharply and receivables skyrocketing. These developments reflect poor returns on investment that have resulted from the distortions in the production structure, and the failure of investment projects to make returns in excess of the interest costs on the debt that is financing them.
Banking Sector Delivers A Warning Signal
We have seen in recent weeks the first signs of trouble in the Chinese banking system as fears over credit quality led to a liquidity crunch, forcing up interbank rates. This is likely to be a sign of things to come, as credit growth slows further. Over recent years, artificially suppressed volatility in the banking system has allowed credit growth to soar, juicing asset prices and economic growth. The recent surge in risk aversion in the interbank market may be a sign that the days of low volatility are behind us, and that the virtuous cycle may go into reverse.
Another dynamic at play is the newfound reform zeal of the Chinese leadership. The People’s Bank of China (PBoC)’s refusal to intervene to stabilise interbank rates in mid-June was in our view a positive signal that the new leadership is keen to send a message to the banking system that credit risks are real and that it is willing to tolerate some short-term growth weakness to avoid longer-term stagnation. Premier Li Keqiang’s willingness to allow China’s first corporate bond default, efforts to reform the country’s distortive industrial input cost system, and comments that there would be limited room for stimulus measures, all signal a renewed focus on the long term.
Newfound Austerity A Double-Edged Sword
The big problem is that efforts to reform the economy now risk exacerbating the economic downturn in the near term. With interbank rates remaining elevated, the PBoC will effectively be presiding over an eventual hike in corporate borrowing costs (as higher funding costs feed through to borrowers). Meanwhile, the realisation that the government will not necessarily stand behind troubled sectors is likely to add to the risk aversion facing the business community as the slowdown intensifies. Again, while this is unequivocally positive for long-term wealth creation, these policies will almost certainly exacerbate near-term headline real GDP growth weakness.
Our full coverage of China’s credit crunch, impending recession, and other risks facing China is available to subscribers at Business Monitor Online.