Via Tiger Tong, Ph.D, CFA of Institutional Equities Research. China does not boast of a good record for smooth transition. The failed attempt to soft land the economy from 4Q10 to 2Q12 has made the gap between funding cost and profit margins of the industrial sector reach a level where making further investment becomes less attractive. If 1998 is a guidance point for future margin squeeze, oil & gas, real estate, and liquor are among the most vulnerable sectors, while electronics and utility are among the most defensive sectors. As real estate sales as a percentage of GDP have increased from 3% in 1998 to 12.4% in 2012, the anticipated the new crash of real estate sector will be more cause for worry than the 1998 scenario.
In the past few months, we have been arguing that secularly (Why China will face more challenges than Japan in the 1970s dated February 22), cyclically (The road is ending dated February 15), politically (Cultural Revolution 2.0? dated February 8), and socially (Xi’s era starts, but markets might suffer dated March 15), China will face a sharp adjustment. The new leadership is on course for making the adjustment (House keeping dated June 21).
However, one has to see whether China could engineer a soft landing. The country’s track record is not good. In fact, China is far from cyclefree. Even during the past thirty years, which can be considered as a single development stage (in contrast to the previous thirty years under Chairman Mao), there are clear ten-year boom-bust cycles. In the late 1980s and late 1990s, China experienced painful economic slowdown, partially due to high inflation (See Figure 1). Although the inflation in the past ten years looked much more benign, the problem is clearly visible in the asset bubbles (mainly housing).
In May 2013, the average property price in 36 cities rose 15.1% YoY despite the economy softening. In some major cities, the absolute price is close to many developed countries, including Tokyo. Increasingly, the divergence between economic growth and building up of asset bubble indicates that soft landing has become elusive.
Divergence between the profit margins of industrial sector and funding costs due to failed soft-landing attempt
There is clear divergence between industrial sector profit margin and rising funding cost. In 1Q 2013, although average interest rates for bank loans was 7.2% (6.1% in 2010), profit margins for industrial sector have dropped to 5.3% from 7.6% in 2010 (See Figure 3). Simultaneously, the reported interest rate charged by banks is normally understated since 2009, as banks will charge the so-called services or consulting fees, which ranges from 1 to 2pps. Thus, the actual gap between industrial sector margin and interest rates of bank loans is even bigger (See Figure 4).
At the same time, for many companies, bank loans are the cheapest funding sources. There are little incentives for the players of the industrial sector to expand their business, thus creating a vicious cycle.
China Printing A Lot Of Money Notes
However, we know China has been printing a lot of money. Therefore, one can question its scarcity of funds. The reason is that in the past few years, China not only depended on an investment-led model and many investment projects were highly leveraged. For example, in 2010 (China started to tighten in 4Q 2010), bank loans accounted for 30% of infrastructure investment (See Figure 5), far higher than the manufacturing and other sectors. This official data is highly understated (China classifies the sources of funds raised for fixed assets investment (FAI) to bank loans, foreign investment, government budgetary funds, self-raised, and others). For example, many working capital loans were used as capex investment. However, those loans were not included in the official figures for the ratio calculation. Further, most of the funds raised by developers were through mortgage loans.
As China is heavily dependent on infrastructure and real estate to power its economic growth, the dependency on credit to grow has been growing sharply in the past few years.
However, since 4Q 2010, China started to engineer a soft landing by tightening credit, especially bank loans. Thus, total incremental bank loans (not limited classified as sources of FAI fund raised) as % of funds raised for FAI dropped sharply from 44% in 2009 to 20.5% in 2012 (See Figure 6). The clumsy sudden loose-then-sudden-tighten mode has made shadow banking an inevitable product. Non-bank lending accounts for about 50% of total credit today.
As many sectors already face over-capacity problems and economic growth is set to decelerate further, we expect profit margin of industrial sector to continue to drop. If we go by the 1998 guidance, the profit margin squeeze has not reached half way yet. In 1998, the profit margin of the industrial sector was 2.3% (See Figure 7) while 1Q 2013 was still more than two times that number.
Figure 8 shows some selected sectors’ profit margin, we can see that the pain of coal sector is only half-way and liquor just at the initial stage of margin squeeze.
Taking 1998 as reference point, oil & gas, real estate, and liquor are three sectors with the biggest margin squeeze ahead, while electronics and utilities will be the most defensive, if history would act as a guidance point (See Figure 9).
Real Estate A Growth Engine?
For real estate, although many view it as a permanent growth engine, it indeed experienced two hard crashes in late 1980s and late 1990s (See Figure 10), as the share of real estate sales as % of GDP increased from 3% in 1998 to 12.4% in 2012 (See Figure 11).
The damage of a fresh real estate crash will be much more painful compared with some of the earlier crashes in late 1990s. In other words, there is high possibility that the forthcoming pain will be even more hurting than the late 1990s.
Consumption is likely to be the only bright spot left in the future. For example, despite the down turn in late 1990s, China’s passenger traffic remained decent while both electricity and cargo traffic suffered a much deeper setback in 1998 (5.8% for passenger, - 0.8% for cargo, and 2.8% for electricity consumption).
The negative passenger traffic is 1989/90 and 2003 was due to political circumstances (Tiananmen Square event) and emergency scenario in the country (SARS break).