While market gyrations provide great headlines, what matters much more is the likely trajectory of the Chinese economy and the growth repercussions on world economy. Even before the Chinese stock market fell, there doesn't seem to be any doubt that Chinese economic growth was slowing, but...
...it seems that the market meltdown may have pushed Chinese economy to past its tipping point as well.
Bridgewater turns bearish on China
Last week, one of the most prominent macro focused hedge funds did an about-face and turned bearish on the Chinese growth outlook, as per the WSJ. Here is Ray Dalio of Bridgewater and his U-turn on China:
Bridgewater Associates LP, one of Wall Street’s more outspoken bulls on China, told investors this week that the country’s recent stock-market rout will likely have broad, far-reaching repercussions.FT Alphaville helpfully put the full Bridgewater note on their website here.
The fund’s executives once had been vocal advocates of China’s potential. But that was before panic in the country’s stock markets shaved a third of the value off Shanghai’s main index, battering hordes of mom-and-pop investors and hedge funds alike, before partially rebounding.
“Our views about China have changed,” Bridgewater’s billionaire founder, Raymond Dalio, wrote with colleagues in a note sent to clients earlier this week. “There are now no safe places to invest.”
The change by Bridgewater is a particularly sharp reversal. Mr. Dalio has gone out of his way in the past to praise Chinese President Xi Jinping and has compared the country’s economic environment to a patient undergoing a heart transplant by a skilled surgeon.
In a note to clients in June, Mr. Dalio said China’s problems “represent opportunities” because they give policy makers a chance to make positive reforms. As recently as earlier this month, Mr. Dalio wrote that the stock-market move was “not significantly reflective of, or influential on, the Chinese economy, Chinese investors, or foreign investors,” with the market still largely driven by a small pool of speculative investors in China.
But this week, Mr. Dalio said he was particularly alarmed about the psychological damage of the stock-market decline. While prices remain above their levels from two years ago, many ordinary investors are sitting on losses because they piled in more recently, he said.
“Even those who haven’t lost money in stocks will be affected psychologically by events, and those effects will have a depressive effect on economic activity,” Mr. Dalio wrote.
To put those remarks into context, you have to understand Ray Dalio`s framework of analysis, which was revealed in his "beautiful deleveraging" thesis. In the wake of the Great Financial Crisis, Dalio believed that there are three broad possible policy responses: government austerity, financial restructuring, aka debt writeoffs, and quantitative easing, aka money printing. You can see him outlining his thoughts on this issue in writing here and in the video below.
If I were to add to Dalio`s analytical framework, I believe that we can describe the global economy as undergoing a process of deleveraging, which can take years and possibly over a decade to accomplish. In big picture terms, the US is the furthest along (and undergoing the "beautiful deleveraging" that Dalio described). Europe is still struggling and they are in the middle of the deleveraging process. China is just beginning the process after experiencing an unprecedented period of credit driven growth.
So back to the Bridgewater note. Initially, Dalio believed that China could achieve a soft landing:
Our views about China have changed as a result of recent developments in the stock market. We previously conveyed our thinking about the debt and economic restructurings as being negative for growth over the near term and positive for growth in the long term - i.e., that it is a necessary and delicate operation that can be well managed.No more. The bubble is bursting. Economic restructuring, real estate and stock market bubbles are all unraveling at the same time (emphasis added):
While we had previously considered developments in the stock market to be supportive to growth, recent developments have led us to expect them to be negative for growth. While we would ordinarily consider the impact of the stock market bubble bursting to be a rather small net negative because the percentage of population that is invested in the stock market and the percentage of household savings invested in stocks are both small, it appears that the repercussions of the stock market`s declines will probably be greater. Because the forces on growth are coming from debt restructurings, economic restructurings, and real estate and stock market bubbles bursting all at the same time, we are now seeing mutually reinforcing negative forces on growth. While at this stage it is too early to assess how strongly the stock market`s decline will pass through negatively to credit and economic growth, we will soon have indications of this. We will be watching our short-term indicators of Chinese credit and economic growth carefully to see what the pass through to the economy of these developments is lie, and we will continue to share our thought about what is happening. Since the linkages in China are broadly analogous to those in other countries that we do have good perspectives on, it is worthwhile to look at the dynamic with this perspective in mind. This is the same perspective as we have taken in looking at China`s debts and economic situation.Their back of the envelope estimates of the stock market crash is 1.3% of GDP, but the concern is the psychological impact on growth:
The negative effects of the stock market declines will come from both the direct shifts in wealth and the psychological effects of the stock market bubble popping. Though stock prices are significantly higher than they were two years ago, the average investor in the stock market has lost money because more stocks were bought at higher prices that were bought at lower prices. We now estimate stock market losses in the household sector to be significantly -- i.e., about 2.2% of household sector income and 1.3% of GDP. However, these losses appear to be heavily concentrated in a small percentage of the population as only 8.8% of the population owns stocks. These are rough estimates. We don't know who is experiencing what losses. Such information usually surfaces in the days and weeks after the plunge. Even more important than the direct financial effects will be the psychological effects. Even those who haven't lost money in stocks will be affected psychologically by events, and those effects will have a depressive effects on economic activity.They looked at past cases of bubbles bursting. Any way you look at it, the effects aren't pretty:
A 2012 study by Pierre-Olivier Gourinchas and Maurice Obstfeld revealed that the combination of high debt (check) and high real exchange rates (check) proved to be particularly toxic. Here is a summary:
In recent research (Gourinchas and Obstfeld 2012), we have tried to understand the divergent behaviour of mature and emerging economies by comparing the 2007–09 crisis to earlier episodes of banking, currency, and sovereign debt distress throughout the world. Drawing on earlier chronologies, and adding a bit of our own judgement and primary research, we develop a database of the various types of financial crisis events that occurred between 1973 and the early 2000s.2 We then rely on an event-study methodology to inspect the antecedents and aftermaths of crises, focusing our analysis on a limited set of variables that earlier researchers have identified as important empirical or theoretical indicators of impending financial stress.
Our primary goal is to see if there are commonalities in the prologues to past crises as between advanced and emerging countries, and if the relative fortunes of different global regions differed in the recent recession because of significantly different policy choices or financial-market developments. In turn, such information could aid in predicting future crises.
What are the ‘smoking guns’?
Our event-study analysis points to:
- Escalating leverage as one of the key ‘smoking guns’ in the run-up to both banking and currency crises.
- Real exchange rates tend also to be strong, relative to tranquil periods, before all types of crisis.
Managing the fallout
Faced with the twin problems of a teetering property market and a cratering stock market, the key question will be, who pays for the damage? Here is David Cui of BoAML on the fallout stock market losses (via FT Alphaville, emphasis added):
Unless the government is prepared to shoulder the ultimate stock-market related losses by itself, via CSFC or other vehicles, various financial products funding the leverage may suffer from trillions of Rmb losses when the dust finally settles, by our estimate. Given the particularly-thin capital base of the front line FIs, including brokers, trusts and TAMCs, we suspect that it’s a matter of time before banks may have to face the music – bank WMP is by far the largest indirect leverage provider. Banks can decide, voluntarily or forced by the potential of social unrest, to take the losses on their book, which means their capital base would suffer severely. If they decide to pass on the losses to WMP buyers, we expect the shadow banking sector to wobble. We believe that the natural reaction of WMP buyers is to stop buying, given that they have been buying based on implicit guarantees and have little visibility as to which products are supported given the low transparency in the financial system. That effectively would be a bank-run in China’s shadow banking sector because bank WMP is by far the largest “depositor” in the shadow bank.Here is Credit Suisse on the catalysts for a hard landing from the real estate bubble (via FT Alphaville):
It’s possible that banks may take the losses on their books without explicitly acknowledging it, i.e. not marking to the market. In this case, we expect them to be much more cautious granting loans going forward as they would know their balance sheets are weak – that’s how the Japanese banks behaved post the bust of the property bubble.
Whichever way we look at this, what just happened in the A-share market will likely have profound impact on China’s economy and financial system one way or another, by our assessment.
If house prices fall by 15% or more, then we think that we are likely to get a hard landing and the authorities risk running out of fiscal firepower. We suspect that if house prices fell by that much, then the LTV threshold would be absorbed. Moreover, with housing contributing to a third of local government revenue, 56% of banks’ collateral and around a fifth of GDP, the knock-on impacts could be immense.I have seen comments in the past that "the government" is large and rich and it can afford to pay for these losses. Recognize that "the government" is just a transfer mechanism between different sectors of the economy. In this case, should "the government" socialize the losses, it will be ultimately be the household sector that bears the burden of adjustment. In that case, what happens to the the objective of re-balancing to the consumer and the path of future economic growth?
Twice in the past, NPLs have risen above 20%. If this were to happen again, on the current credit-to-GDP ratio, the cost of recapitalising the banks could easily be 50% of GDP, not to mention the deterioration in the fiscal position on account of the loss of fiscal revenue. At that point, most of fiscal flexibility would be used up; however, the authorities would still have the ability to expand monetary policy, cut rates and RRR.
The second catalyst we see for a hard landing would be if deposit growth at banks stopped [now the lowest on record at just 6% with external liquidity in the form of FX flows drying up], as this would essentially limit the ability of banks to roll over loans to SOEs, in our opinion.
A recent Quartz article highlighted a disturbing divergence spotted by Wei Yao of Société Générale. He found that bank loans are falling. But how does bank credit decline in the face of 7% GDP growth?
We can argue that Chinese statistics are made up, but to characterize them as just "made up" is wrong. "Distorted" might be a better description. In the end, the figures have to balance.
Those data were from the National Bureau of Statistics. Weirdly, central-bank data show overall bank lending rising at a much faster clip than growth in financing for FAI projects:
“Given the rise in credit and the fall in actual investment, you have to really wonder where these loans are going,” says Balding. “China hasn’t grown enough Silicon Valleys [meaning, high-growth sectors] to change the entire financial landscape in a year. This indicates a large number of bad loans, and liquidity problems.”In other words, China is turning to the Japanese solution of corporate zombification:
To unpack what Balding means, a company that can’t pay back a loan has a few options. It can fire workers and sell off assets, file for bankruptcy, borrow from someone else to cover the debt, convince the bank to extend the loan for another year or so, or get the bank to lend it even more money. Why would a bank manager do the latter two options? Insolvent loans put bank managers in a tough spot. Cut off the money, and when that customer defaults the bank has to write that money off. That could cost the manager her job.
This is why these companies are dubbed “zombies”—keeping them on a steady drip of financial life-support prevents the dead from truly dying.
The gap between credit and investment suggests this is happening. The reason banks are so hungry for more money is because, quite simply, they’re not being paid back. This is potentially a big problem for China’s growth outlook; bank loans account for three-quarter of China’s total financing. That compounds itself—slower growth makes it even less likely that banks will eventually get paid back. As more and more money shifts toward keeping “zombie” companies alive, there’s less and less that can go to entrepreneurs and households that could really use it.Once the Zombie Apocalypse grips the economy, it gradually rots away and cannabalizes growth potential:
But the horror movie analogies don’t stop there. When debt hits a certain level, an economy starts to cannibalize itself, devouring its own potential. Credit that could support good companies goes to postpone defaults. Corporate profits go to pay off debt, and aren’t reinvested in expansion. Shriveling demand drags down prices.
Soft on the inside, hard on the outside
To summarize. Ray Dalio believes that China has hit the tipping point and its stock market crash is the trigger for a debt unwind. Under such circumstances, the natural reaction of the fiscal and monetary authorities is to try to prevent a Russia, Lehman or Creditanstalt Crisis style meltdown of the financial markets. Beijing seems to be well down that path and they appear to be adopting the Japanese solution of corporate zombification.
Such a course of action would imply that the household sector would bear the most of the burden of any adjustment. Economic growth would therefore have to decelerate sharply. The same-old-same-old model of debt financed infrastructure spending is broken. The economy will be unable to shift to the Third Plenum objective of re-balancing to the consumer because the consumer will have to bear the cost of all these bad debts, either in the form of further financial repression, higher taxes, or other measures.
Despite all these problems, China should be able to achieve a soft landing.
I have also heard the comment that describes a Chinese landing as “hard on the outside and soft on the inside“. China will achieve a soft landing (inside the country). On the outside, however, the countries and companies doing business with China will not be so fortunate (hard landing for outsiders).
Already, we are seeing signs of the hard landing on the outside:
- Taiwan is seeing its manufacturing outlook darken.
- The Singaporean economy flipped to contraction in 2Q..
- Emerging markets are caught by the double whammy of slowing Chinese growth and Fed tightening.
China's Asian trading partners will get hit hard in any slowdown. In addition, Germany is a also a major exporter of capital goods to China and falling Chinese growth will hit the eurozone economy hard. Resource based economies, such as Australia (bulk commodities), New Zealand (milk), South Africa (mining), Brazil (mining) and Canada (energy and mining) will also feel the brunt of a "hard on the outside" effects of a China hard landing. Already, this chart shows that global merchandise trade is slowing:
In the US, latest earning season warned of disappointing corporate developments in China. Numerous companies as diverse as CAT, UTX (capital goods), COH, YUM and GM (consumer) will be affected should Chinese growth nosedive. Despite the upbeat AAPL earnings call message about China, BI recently highlighted a Cowen research note indicating that Chinese iPhone demand was light. Longer term, however, slowing growth is likely to result in an American Renaissance as cheaper input costs from lower commodity prices and an onshoring revival sparks US growth (see my previous post How inequality may evolve in the next decade).
Over the next few quarters, however, the markets will likely focus more on the negative effects of this transition. Spreadsheets will have to get revised with lower growth projections and risk premiums ill rise (and PE ratios will fall).
That is, of course, assuming that you accept the Bridgewater thesis that China is unraveling and the Chinese economy is getting hit with THE BIG ONE.
The canary in the coalmine
One quick-and-dirty key indicator I am watching is the art market. CNBC featured a report about how the Chinese could crash the art market:
The canary in the coalmine
One quick-and-dirty key indicator I am watching is the art market. CNBC featured a report about how the Chinese could crash the art market:
"I think there will definitely be an impact," said Ken Yeh, director at Acquavella Galleries and former chairman of Christie's Asia. "Chinese collectors have become a very important part of the market."The art market warning did come with caveats, though:
Even before China's recent stock-market slide, there were signs that some Chinese collectors were paring back their spending. According to Artnet, total art sales in China and Hong Kong fell 30 percent in the first half of 2015 to $1.5 billion from $2.2 billion.
During the spring sales in Hong Kong, "I heard many dealers talking about how weak the sales were. It's definitely down," Yeh said.
While some market watchers are drawing comparisons to the Japan-led art boom of the late 1980s, which crashed with the Japanese property market in 1990, others say today's art market is far more diverse and durable. Even if the Chinese collectors put down their bidding paddles, buyers from the U.S., Middle East and Europe will step up in their place.
"In the late 1980s, the market was so much smaller," Gyorgy said. "The Japanese were just about the only ones buying. Now we're working with collectors in Asia, Latin America, the U.S., Europe and so if one segment goes away, another segment comes back."
Yes, but what if the deflationary effects of a slowdown in the Chinese economy spreads globally?If you want the real-time market reaction to any possible China slowdown, watch this chart of Sotheby`s.
Yet the big test for the market will be in October and November, during the fall sales in Hong Kong and New York. Last fall, Sotheby's and Christie's sold $1.78 billion worth of art, with many of the bids coming from Chinese buyers.
Gyorgy said all it takes is one weak auction to damage the already fragile confidence of Chinese buyers.
"Everyone is going to be watching this very closely," she said. "Art is as much a psychological market as a financial one. If there is one sale that isn't strong, people get spooked."