CDT Money: Credit Where Credit Is Due

A key measure of Chinese manufacturing activity edged into positive territory last week, as the official Purchasing Managers Index (PMI) rose from a September level of 49.8 to 50.2 for October. The expansionary figure represents a three-month high, and one analyst told BBC News that “the return of the PMI to above 50 suggests economic momentum has indeed picked up”. Even HSBC’s unofficial PMI reading, which draws its data from private small and medium-sized enterprises as opposed to the official SOE-focused survey, hit an eight-month high despite remaining in contractionary territory. As The Wall Street Journal notes, both gauges now tightly straddle the 50 mark that delineates an expansion from a contraction.

But has China’s factory sector really rebounded? Not so fast, according to The Financial Times’ Kate MacKenzie, who breaks down the individual components of the official PMI and sees a mixed underlying story. Input prices have jumped, and both new export orders and employment continue to contract (albeit both more slowly than in September). MacKenzie writes that such details “stand out to us as taking the shine off the overall positive figure”. The Wall Street Journal also scanned the analyst community and found a mixed reaction to the manufacturing data, though some wrote that the readings validated the government’s current approach to policy easing.

As observers continue to debate the direction of the Chinese economy after September and third quarter data also generated cautious optimism, Peking University’s Michael Pettis remains at the center of the debate. The self-proclaimed “China skeptic” has long-highlighted the constraints of China’s growth engine and stressed the likelihood of  a sharp and necessary slowdown as the economy shifts away from an investment and export-led model, and this past week he took on two “China bulls” in separate conversations on the subject.

NPR’s Rachel Martin interviewed Pettis and CLSA’s Andrew Rothman, who took the view that China’s rebalancing process has already commenced thanks to “significant steps” taken by the government:

ROTHMAN: Well, actually one of the reasons why I’m bullish about China is because it is slowing down. It’s very positive that the leadership of China has recognized that the two decades of 10 percent growth are no longer sustainable. And they’ve made a lot of adjustments to slow it down while still keeping income growth high. But it’s always going to be slower, a little bit slower every year for the future.

MARTIN: Michael, I assume you’re not as optimistic as Andy.

PETTIS: Well, China’s economy has been driven primarily by very high investment. Every country that has had very high levels of investment for many years has run into the problems that, at some point, additional investment creates economic activity but it actually destroys wealth. The problem is if you bring investment levels down, you need something else to replace it. And that something else is normally consumption.

But it’s extremely difficult consumption rates up quickly enough to replace declining investment rates. So we’re going to see many years of much, much slower growth as China rebalances away from investment.

With growth already retreating from the double-levels enjoyed before the financial crisis, The Wall Street Journal also asked Pettis and expert Nick Lardy if 7%-8% economic expansion is “the new normal” or if the slowdown will continue. Lardy argued that consumption has already begun to contribute more prominently to GDP, and wrote that he expects incoming leaders Xi Jinping and Li Keqiang to accelerate the pace of reform and stave off any further deterioration in China’s economic performance. Pettis, however, challenged the assumption that household consumption can continue to grow at such a strong clip and instead suggested that overall economic growth “will slow substantially in the next few years”. From Pettis’ response to Lardy:

Global and Chinese conditions are not nearly as good anymore. This means that it will be hard to maintain 7% household consumption growth even in the best-case scenario. But rebalancing in China means by definition that household consumption growth has to outpace GDP growth by at least 3 or 4 percentage points every year for the next decade just to bring Chinese consumptions levels to rates equivalent to the lowest consuming countries in the world.

This is just another way of saying that the growth contribution of investment has to drop so sharply that GDP growth cannot exceed 3% – 4% if China is to rebalance. Any higher GDP growth cannot be consistent with even a minimal rebalancing of the Chinese economy unless there is some way to force much greater growth in household consumption – i.e. much greater growth in household income – in spite of much worse global and Chinese economic conditions.

The arithmetic simply doesn’t work. China must rebalance its economy because its over-reliance on investment has become toxic. For China even to maintain GDP growth rates of even 7% to 8% implicitly requires that household consumption grow by 10% – 12%, something never before achieved even under much better economic conditions. Without a deus ex machine that turbocharges consumption growth, high GDP growth rates are incompatible with rebalancing.

Big Bad Loans

Broader economic data may point to a rebound, but disappointing corporate earnings results have blunted that outlook to an extent. From oil refiners to construction and heavy machinery giants, and from the auto industry to airlines, a number of big names have seen profits slump in the just-completed quarter.

Why? There are plenty of reasons – slumping global demand and rising labor costs, to name a couple. But The Diplomat’s James Parker also writes that China is “addicted to credit”, and notices the sharp increase in accounts receivable (money owed but not yet paid to a company by its customers) on the balance sheets of Chinese companies:

During a slowdown, it is common for payments to be delayed as everyone hangs on to cash. Some companies, though, can be tempted to avoid curtailing production by offering reluctant customers much easier credit to encourage sales, the hope being that the slump will soon end and “natural” demand will pick up again. The trouble of course is that if the slowdown is prolonged, or the recovery weaker than expected, these accounts receivable might turn “un-receivable”, and thus have to be written down as losses. An increase in A/R is expected, but such a large increase suggests that some companies have been staying in operations through this vendor financing.

The Wall Street Journal also reports that China’s state-run banks, despite enjoying double-digit profit growth in the third quarter, are bracing for an uptick in non-performing loans. Even The China Daily admits that bad loans are weighing on China’s biggest lenders, and Forbes contributor Gordon Chang goes so far as to call the Big Four banks “China’s Enrons”:

Whether they cooked the books or not, Chinese bankers have a lot to hide. To avoid the effects of the global downturn, Premier Wen Jiabao, beginning at the end of 2008, made the banks go on a spree by forcing them to abandon lending standards. That permitted China to bulk up on “ghost cities,” towering government offices in rural villages, and magnificent airports in the middle of farmland. Even after central officials supposedly reined in the loan-a-thon in 2010, lending has continued at a fast pace: new loans were up 23.7% in Q3, compared to the same quarter last year.

As a result of this “directed” lending, the banks are now carrying “assets” that cannot, in the normal course of business, be paid back. “The Mother of All Debt Bombs” is how Minxin Pei of Claremont McKenna College characterizes the risky situation. Chanos puts it this way: “Imagine a credit python,” he said. “The U.S. is the pig at the end of the snake, and China and Asia are the pig entering the snake in terms of deleveraging the banks.”

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