Monday, August 13, 2012

Crouching tiger, hidden profit

I've been pondering the apparent divergence between the Shanghai Composite and commodity-based indicators of Chinese growth. The Shanghai Composite remains in a downtrend. Even though it has staged a recent rally, the intermediate term trend is still down.

On the other hand, commodity-based measures, which are secondary indicators of Chinese growth, appear to be either stabilizing or undergoing a bullish reversal. For the purposes of this analysis, I will not show commodity indices because they are somewhat distorted by the spectacular rally in grain prices, but consider industrial commodities such as Dr. Copper, which has stopped falling and appears to be undergoing a period of sideways consolidation.

Oil prices have staged a bullish reversal after prices cratered in May and June:

Another important indicator of Chinese demand is the AUDCAD exchange rate. Both Australia and Canada are positioned as major commodity exporters, but the Australian economy is more sensitive to Chinese growth while the Canadian economy is more levered to American growth. The AUDCAD cross rate has staged a bullish reversal that is similar to the pattern seen in the oil price.

The question is why?

Growth at any cost?
I wrote before (see Good News: China soft landing, Bad News... and China beyond that hard/soft landing debate) that while the authorities recognized that they needed to re-balance China's growth from infrastructure-based growth to growth based on the consumer, such a move would directly hurt the wealth of party cadres and insiders, who stood to benefit from the profitability of State Owned Enterprises (SOEs). This may be an edict that the leadership leads, but the bureaucracy doesn't go along.

Today, economic data shows that China's growth is slowing. The "correct" response is to continue the path to re-balance growth toward China's household, or consumer. The actual policy response has been more of the same - stimulus via infrastructure growth.

Kate Mackenzie of FT Alphaville highlighted a Nomura study that cast a skeptical eye that growth was re-balancing away from infrastructure growth:

Well, firstly: we can probably maintain scepticism that the economy is rebalancing, at least by inference from the flourishing fixed-asset investment (FAI) rate. Nomura has charted the components of the FAI growth, both for June and for the first half overall, and it’s telling that a lot of the surge in June came from the deceleration in railway investment slowing down:

In a later post, she documented plans by local government to stimulate by further infrastructure growth [emphasis added]:
News that the Chinese city of Changsha, in the central Hunan province, plans to spend Rmb829m, or 150 per cent of its GDP, made waves last month. It’s a fairly small city and one that was reportedly booming just weeks earlier.

We recently made the point that slowing growth was leading the central government to back away from its tentative plans to rebalance the economy, and instead doubling down on imbalances with its push to keep GDP growing through investment, particularly in infrastructure.
The latest policy response doesn't sound much like re-balancing in favor of the consumer, does it? Also Sprach Analyst wrote that China can maintain growth for some time, but there is a cost involved:
If China wants to maintain high growth to eternity, it is possible theoretically even though it is not very realistic, because it requires the government to do things that have been done before, and have been widely regarded as wrong.

Because the government controls the issuance of the currency, there should theoretically be no budgetary constraint. So the government can spend and invest very heavily into eternity either directly or via state-owned enterprises even though there is nothing that China really needs but have not already had. In other words, investment will be done regardless of the expected return. To fund that, the government (including state-owned companies for the purpose of argument) borrow either from state-owned banks (while force banks to lend) or from the bond market (for the purpose of the current discussion, let us just say that both ways of financing are more or less the same). Money supply has to grow at some crazy numbers, and M2 will probably double every 2 or 3 years, and Chinese Yuan will depreciate substantially (there is a running joke among China sceptics that Bernanke is only an amateur when it comes to money printing. After all, Chinese invented paper, printing, and paper money). But because this implies ever more over-capacity in the economy, inflation could be surprisingly low. At the end, GDP will grow by 8% in Chinese Yuan term, and nothing disastrous would seem to have happened to majority of Chinese people (or maybe not).

The price to be paid is profit-less growth:
[I]nvesting in huge amount of money into something with very low return is destroying wealth. Let us say that a state-owned real estate developer invested a huge amount of money into a large-scale residential development. Despite being sold out, most of these flats were not occupied nor let out. These assets are generating no return, thus they are next to worthless. The real estate developer was lucky to have sold them all, but those buyers would have bought something with huge amount of money which turned out to be worthless. This is by no means the only scenario. The real estate developer in question could very well be unable to sell, and being drowned in debt. To speak more formally, if a country is directing resources into investing something that cannot generate return in excess of the cost of funding, the country as a whole will be destroying economic value even though the country is generating GDP.

Because of overcapacity, the private corporate sector will probably not invest and have very low level of profit (if not close to zero as a whole), leaving the state-owned sector and local governments the only agents that will borrow and invest. The process of directing state-owned corporate sector to borrow and invest will generate output or GDP, but they will create even more capacity, leading to ever diminishing return. At the end, corporate profit (state-owned and private sectors combined) will fall to zero, if not negative.
Ahead of changing of the guard in China, the authorities appear to have embarked on a policy of growth at any price, i.e. profit-less growth. So what we have is a case of crouching tiger (growth), but hidden profit (margin squeeze for corporates).

The markets appear to understand that. That's why commodity related indicators, which benefit from infrastructure growth, are either consolidating or staging bullish reversals. On the other hand, Chinese corporates as reflected by the Shanghai Composite Index are falling, because their margins are getting squeezed.

This situation is obviously not sustainable long-term. I do worry about what might happen to China in the next down leg of the global economy. What happens between now and then is anyone's guess.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Larry D. said...

Cam; great post. The lack of hopium in the Shanghai index was perplexing to me. It has not participated in any of the recent bullish rise. I have not seen anyone address this so your article was much appreciated.