There is still no respite for the Chinese stock market (or, for that matter, of any of the other global stock markets). On Thursday the SSE composite fell more or less in a straight line, losing 72 points, or 3.3%, rising a single point on Friday to close at 2079. We are now less than 4% away from 2000, yet another barrier that may not prove to be much of a barrier.
There is no lack of bad news on the economy to drive the stock market down. Thursday saw the release by the PBoC and the National Bureau of Statistics of another big batch of data, and it seems pretty clear that the economy is slowing, and perhaps very rapidly.
Industrial output grew by 12.8% year on year in August, versus 14.7% in July, and 17.5% last August. There was weakness in almost every sector, with iron and automobile production actually contracting versus one year ago. Clearly the industrial sector is slowing, and this puts all the more pressure on rising consumer demand to keep the economy strong.
At first glance consumers seemed to be doing their job. Retail sales, the main measure of Chinese consumer spending, grew by 23.2% year on year in August, slightly less than July’s 23.3% but substantially better than last August’s 17.1%. This growth, however, may have more to do with Olympics spending than with long-term trends, and we will probably need to see September and October numbers to get a real sense of how consumers are responding, although I suspect these will be excessively low because at least part of July and August’s robust growth in consumption probably consisted of anticipated spending for the Olympics.
Loan and M2 growth were also slightly weaker than expected. Given the existence of the large informal lending market I am not sure what that means for total loans in the system, and given the complications imposed by a rapidly changing society and a very inefficient financial system, I am not sure how valuable M2 or any of the other monetary aggregates are in explaining money supply. Sill, I would argue that the continued rapid growth of foreign currency reserves at the PBoC is probably being countered by the sharp fall in real estate and stock prices to represent money growth below what we would have expected (and I wonder if we will soon begin to see hot money outflows). The fact that loans in the banking system – much cheaper than loans available in the informal sector – grew by less than they could have under the loan caps, suggests that either companies are reluctant to borrow and invest because of concerns about the slowing economy, or that banks are reluctant to lend because of credit fears.
Neither of these explanations is very comforting. Morgan Stanly just released a report saying the real estate sector is on the point of an imminent collapse, which suggests even that perhaps both explanations might be true. Needless to say a collapse in the real estate sector is one of the biggest risks in China. Not only would it cause havoc in the banks’ loan portfolios, causing a sharp rise in NPLs, but it would contract one of the main pillars of Chinese growth, real estate development. The one piece of good news is that I have heard anecdotal evidence that developers that reduce prices have seen very strong subsequent demand for apartments and offices, so perhaps the problem is as much one of high prices (which can be fairly easily fixed) as of oversupply (which cannot).
One of the questions I have been getting a lot from my investor meetings in New York concerns the sharp split between rising PPI inflation and declining CPI inflation. What does this indicate about inflation and financial conditions in China?
I have already indicated my puzzlement in my entry of two days ago that CPI inflation has come down so quickly, and I worry that we may not be capturing all the inflation correctly. But aside from that, if you assume that PPI inflation is a proxy for rising input prices among corporations, and CPI inflation is a proxy for rising output prices, the tremendous gap between them suggests that corporate profits are going to be killed. This already seems to be happening, with corporate profits down and most analysts expecting them to decline further.
How do corporations react? I think there are two ways they can react. First, if they are able, they will raise prices, and so PPI inflation will then cause a subsequent surge in CPI inflation to bring the two back into line. This is what I always thought would happen, but now I confess I am not so sure. If the economy is slowing, capacity rising, and demand falling off (although we have not yet seen the third condition), companies will have great difficulty in raising prices. In that case we may see a sharp drop in profitability and even a rise in bankruptcies, to the extent that the banking system is forced to contract.
One way or the other the system has to adjust to the tremendous monetary expansion of previous years, and there are two ways it can do so. We can see high inflation, which brings nominal demand and nominal supply back into balance by adjusting prices. Or we can see an equivalent contraction in the money supply because of a contraction in banking.
Neither of these is a good outcome, but excess money expansion – as we are seeing, by the way, in the US – must eventually cause something to adjust, and the adjustment is rarely benign. Historically it almost always consists either of rising prices inflating away the growth in money supply or of a sharply contracting banking system reversing the earlier money contraction through debt deflation. The key determinant of which path this takes, I think, is the fragility of the banking system and the response of the central banks.
I can’t rally predict which outcome we will see in China. On the one hand I have been notoriously bearish on the quality of the banking system for so long – and, I suspect, to the annoyance of many of my colleagues in the market – that it seems to me very reasonable to me to expect real problems in the banks that lead to loan contractions and the hoarding of liquidity. By the way, reducing minimum reserve requirements will have little effect on lending if banks don’t want to lend, borrowers don’t want to borrow, or if informal banks have acted to undermine the impact of lending constraints, which I believe has happened in China.
On the other hand it is always easy to inflate your way out of trouble, and this tends to be the politicians’ preferred response to a banking contraction, especially in systems with limited central bank independence. I suspect that in China we may see concerns about unemployment in the short term trump concerns about inflation in the long term. The point is that if I am right in having argued for so long that we have seen out-of-control money growth in the past few years, we will inevitably have to see an adjustment that is as likely to be a sharp rise in inflation or a sudden debt deflation. As Robert Frost might put it:
Some say the world will end in fire
Some say in ice
I hate to sound so apocalyptical, but this week in New York everyone around me seems to have been filled with dread, and I – no stranger to worried pessimism, as all my blog readers surely know – am also being infected by the mood.
