Reform Momentum Bittersweet For Growth Outlook

BMI View: We are starting to see signs of a broader realisation on the part of Beijing that the previous government's state investment-led policies were inherently unsustainable and have provoked risk of a systemic crisis. Should the new leadership reduce support for loss-making state-dominated industries, this would mean a much weaker H213 and 2014 for China's economy than the consensus currently expects. Extensive structural reform, while unlikely, could trigger a near-term growth collapse but lead to a major improvement in the country's long-term prospects.

For several months now BMI has been calling for a bounce in China's real economy ( see 'Growth: Upside Risks Amid Structural Downturn', November 12 2012). As we saw it, Beijing's renewed efforts to ignite both credit markets and infrastructure spending would lead to a tangible - if inherently unsustainable - rekindling in economic activity. Latest purchasing managers' index (PMI) data would suggest that this growth upturn is now well under way. If we strip out the Chinese New Year-distorted months of January and February, the simple average of China's official and unofficial PMI headline readings are at their highest level since May 2011, with new orders leading the charge.

Bounce Under Way
China - Average Of Official & HSBC PMI

The encouraging PMI data beg the question as to why we are sticking to our relatively downbeat real GDP growth forecast of 7.5% for 2013, which would not only imply a further deceleration from 2012's 7.7% print, but also sits some way off consensus projections of 8.1%. We could point to the fact that China's PMI is only just back above water (ie, the 50 expansion-contraction threshold) despite Beijing's renewed expansionary efforts last year. Measured against the credit-induced PMI surge of 2009, the recent uptick has been trivial, underlining our long-held concern about the diminishing returns of stimulus.

However, there is potentially an even more important story at work and, as has been our approach in recent times, we take our macro cues from the dynamics under way at an industry level. Three developments, in particular, have caught our attention.

Farewell Ministry Of Railways: The government announced in mid-March that the state behemoth Ministry of Railways (MoR) would be split into two smaller entities: the China Railway Corporation (CRC) and the State Railway Administration ( see ' Benefits Of Rail Ministry Break-Up Not Immediate', March 22 2013 in our infrastructure service). We have been tracking the MoR's fall from grace since first warning of an impending collapse in China's high-speed rail sector in early 2011. The ministry had more in common with a state-owned enterprise (SOE) than a government agency, and had been racking up debt for many years to fuel unprofitable railway development. The MoR's poor balance sheet health and alleged widespread practice of corruption are well known. The fact that the new leadership of President Xi Jinping and Premier Li Keqiang allowed the politically powerful railway ministry to be cut down to size is a positive signal, in our view.

Lights Go Out
Suntech - Net Debt, US$mn & Net Debt To Equity, % (RHS)

(Finally) A Corporate Default: On March 21, Chinese solar panel maker Suntech Power Holdings announced that it would be filing for insolvency following the default of US$541mn in outstanding bonds. Suntech's demise traces a similar pattern to that of the MoR - an unsustainable mix of overcapacity, high leverage, collapsing margins, and persistent losses ( see ' Suntech's Fall From Grace: Broader Implications', March 26). Again, it is not Suntech's failings that are particularly surprising to us, but rather that the company was allowed to fail. Suntech was, to our knowledge, the first corporate bond default in Chinese history - and a default of the world's largest solar manufacturer.

Surge In Securitisation
China - Trust Loans, CNYbn

WMP Regulations Tightened: We have written extensively about non-traditional lending inside and outside of China's banking system, and the associated risks posed to the country's financial and economic stability. For example, trust loans financed by 'wealth management products' (securitised retail products) have proliferated in recent quarters outside the realms of regulatory oversight. On March 27, the authorities finally responded, with the China Banking Regulatory Commission announcing that WMPs must henceforth be clearly linked to specific assets, each product must be audited individually, banks must disclose who such securities are being issued to, and that no more than 35% of a bank's total issued WMPs should be invested in debt or used to make loans. That Beijing has announced such explicit measures to curtail non-core lending is significant given how important such channels have been in driving China's recent credit resurgence (and, by extension, economic rebound).

What Does This All Mean?

From our perspective, the above developments are not merely a coincidence. They form part of a broader realisation on the part of Beijing that the previous government's state investment-led policies were inherently unsustainable and have provoked risks of a systemic crisis should the property bubble unwind, local governments face a credit crunch, or the wheels fall off the shadow banking system. Pre-empting Chinese policymakers has been a thorny task historically, but the official rhetoric of late has been notable for its matter-of-factness. As an example, Premier Li explicitly stressed the need to 'break up' existing state monopolies in his National People's Congress address, and recent actions suggest that the incoming administration is genuine in its intentions.

If the decision to strip down the MoR and allow the Suntech default means that the government will no longer throw good money after bad, this has massive implications for the Chinese economy's cyclical and structural trajectory, such has been the importance of state-led investment as the primary engine of economic growth. Starting with 2013, the developments outlined above provide us with comfort that China's current rebound will prove fleeting and that a growth relapse is on the cards in H213. Our baseline scenario sees economic growth falling back towards 7.0% in the coming quarters, contrary to the mainstream view of a V-shaped recovery.

No V-Shaped Recovery
China - Real GDP Growth, %

Additionally, such measures could be setting the stage for near-term interest rate hikes. We are presently calling for the People's Bank of China to stay on hold in H113, before delivering a rate cut in the second half of the year as it grapples with a weakening economy. However, with inflation back on the rise (consumer price inflation hit a 10-month high of 3.2% year-on-year in February), the authorities may be tempted to tighten monetary policy in the near term.

The Alternative Scenario: Growth Collapses, Crisis Averted?

We continue to hold reservations as to whether the new leadership has the appetite and ability to push through much-needed structural reform. This includes: extensive privatisation of SOEs (whose total assets stood at CNY85.4trn, or 183% of nominal GDP, in 2011); exchange rate, capital account and interest rate liberalisation; reform to the hukou household registration system; and resource pricing reform, to name a few. Firstly, wholesale reform will require Beijing to take on the vested interests of local governments and politicians, whose performance is inextricably tied to land sales, property markets, and flagship infrastructure projects. Secondly, we have yet to see a reining in of credit excesses. On a 12-month moving average basis, net new total social financing (TSF, a measure of aggregate credit supply) came in at an all-time high of CNY1.45trn in February. If the current pace were sustained, new credit issuance would equate to a whopping 30.5% of GDP in 2013 .

Credit Still Flowing Freely
China - New Total Social Financing, CNYbn

However, if we assume that the current leadership enacts sweeping reform initiatives, this would have game-changing implications for the economy. We actually attempted to answer this question all the way back in 2009 ( see 'Three Scenarios For Growth', October 7 2009). At that time, we wrote:

'...the authorities could step in to cool credit growth in the near term. This would undoubtedly, in our view, lead to reversal in recent asset price inflation, and would see investment spending (and to a lesser extent private consumption) fall sharply...'

The above sentence still holds true. Concerted efforts to apply the brakes on credit growth, allow loss-making SOEs to fail, and enact structural reform would almost certainly trigger an economic growth collapse in China. To illustrate this point, if we assume no real growth in gross investment - and make the crude assumption that private and public consumption remain unaffected - headline real GDP growth would fall to around 5.0%. The reality would most likely be more severe as China's banks would be on the hook for major credit write-downs, and deflation in asset prices would hit consumer spending. However, such a scenario would warrant an upgrade to China's long-term growth prospects (we currently see long-term growth trending at around 5.8%), as the realisation and liquidation of poor investment would allow capital to be reallocated to more productive areas of the economy.

Market Implications: Staying Underweight Financials

From a China asset allocation perspective, we maintain our view that financials will underperform the market in 2013, which we are expressing via a 'Shanghai Industrials Over Hang Seng Financials' stance in our regional asset class strategy. For some, the H-Financials valuations may appear relatively attractive, with the trailing price-to-earnings (P/E) ratio currently sitting at just 8.1x. However, we would point to the 'attractive' single-digit P/E ratios enjoyed by both US and UK banks in 2007, on the eve of major housing market corrections, which exposed major asset-liability mismatches and led to a collapse in sector earnings.

Look Out Below
China - Ratio Of H-Financials Over Shanghai Industrials

On a more positive note, diminishing SOE influence could create a more level playing field, not least in terms of credit allocation (at least over the medium term) and we continue to target consumer goods/service-orientated firms with sizable market share, healthy balance sheets and (ideally) overseas aspirations. Despite closing out our bullish view on Chinese drug distributor Sinopharm on January 31 (locking in respectable gains of 30.9%), the HK-listed equity remains a good long-term play. Other sectors to watch include telecoms services, insurance and online retail.

This article is tagged to:
Sector: Country Risk, Infrastructure, Renewables
Geography: China

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