Markets likely to head down before a Fall rebound — China’s policy-makers have begun performing the delicate balancing act of reforming the economy and at the same time ensuring growth does not stall says Minggao Shen of Head of Citigroup’s China Research in a new report. He notes that the road to rebalancing growth will be bumpy, borne out by the recent Shibor spike. He therefores expect a choppy 2H13 for the markets within a wide range, darting up on reform hopes and darting down on growth concerns. Amid uncertainties, the markets could fall further before rebounding when clarity on reforms emerges. More from the report focusing on Chinese GDP growth and potential roadblocks along the way.
- Overweight sectors less sensitive to GDP growth — We recommend sectors that have low leverage ratios, resilient earnings growth and those that stand to gain from reforms. We therefore Overweight consumer staples, low-end discretionary sectors, property, and healthcare. Distressed valuations are another reason to long these sectors, but they could go lower before stabilising. We are Neutral on banks and utilities, and Underweight cyclical sectors – energy, materials and telecoms.
- Fear triumphs hope for now — Overcapacity, unsustainable local debt and credit dislocation have spooked investors. Come Oct 2013, China’s decision-making ability and policy moves will come under closer scrutiny. The delicate balance between growth and reform may force the government to switch policies between defending growth and boosting reforms. The economy may test 7% growth in the next 12M if China starts de-leveraging and clamping down on shadow banking.
- Period of adjustment has only just begun — Given the complexity of the coming reforms and the changing global environment (Fed tapering), recent policy and liquidity shocks could just be a prelude to what lies ahead in the reform process. Investment slowdown and local government defaults are major risks alongside possible de-leveraging. Global trends suggest that the investment growth rate could halve once the investment-GDP ratio peaks. China may be near that tipping point.
China’s GDP growth may test 7% in the coming 12 months, attributable to overcapacity, unsustainable local debts, credit dislocation, and possible missteps and slow responses on the policy front. Structural reforms (such as interest-rate liberalization, a clamp-down on shadow banking and elimination of overcapacity) could be rolled out by the Chinese government in coming months in its bid to rebalance the economy, but the near-term impact on growth could be negative.
China Grow And Reforms
Slow growth will precede improvements in its quality. The reform package to be rolled out in October 2013, if decisive, could surprise the market and investors could look beyond any near-term economic impact. However, reforms are likely to be gradual and investors will worry about further weakness in the economy and markets before turning positive. The delicate balance between growth and reform may force policy-makers to switch policies from defending growth to boosting reforms. Growth cannot be too slow and reforms too fast. It also remains unclear whether the coming slowdown will trigger more stimulus or reform. Such uncertainties will leave investors battling between hope and fear, as detailed in our 2013 Road Ahead report.
We Now Expect MSCI China To Finish The Year At 60
The recent liquidity crunch has created some overhangs. The policy shock may have hurt the risk appetite in the market, resulting in a higher risk premium, which has stalled the bond market since late June. Given the complexity of the coming reforms and the changing global environment (Fed tapering), such policy and liquidity shocks could just be the start of many more to come for China. Investment slowdown and local government default are two risks. Global experience suggests that the investment growth rate could halve once the investment-GDP ratio peaks.
China may be near that tipping point. The cost of borrowing for local governments may rise as a result of the clampdown on shadow banking. In our China Road Ahead 2013: A Battle between Hope and Fear, we argued that the market could rebound from its 2012 low due to expected economic recovery.
That rebound was cut short by weaker-than-expected growth. We now expect MSCI China to finish the year at 60, plunging to new post-GFC lows before rising again this Fall. We expect its PE to touch around 7x from the current 8.5x if growth slows down in coming years. Nevertheless, it will be a choppy market, in our view, alternating between growth fears and reform hopes in coming years. If the market returns to 0.5SD below the 2010-12 average level with 9% earnings growth in 2013E, our targets for MSCI China, CSI 3000 and Shanghai A index in 2013 would be 60, 2500 and 2300 respectively. For 2014, the targets would be 69, 2900, 2700, assuming 5% earnings growth and average valuations of 2010-12.
Overweight Sectors With Low Leverage Ratios
We overweight sectors with low leverage ratios, resilient earnings growth even in a slow-growth environment, and favourable policies (e.g., channeling more liquidity into the private and consumer sectors, hukou reform, and interest-rate liberalization).
We overweight downstream sectors, including property, consumer staples, selected consumer discretionary (autos and home appliances), IT, clean energy, and healthcare. We are neutral on banks and industrials, and underweight materials, energy and telecoms.
Growth Trends Down
7.5% GDP growth target could be missed
The artificial liquidity crunch in June suggests that the Chinese authorities may attempt to address the core problems in the economy at the cost of slower growth. The Chinese leaders could push for de-leveraging going forward, which may drag down GDP growth further from its recent low last year. China has 7.5% as its GDP growth target for this year, but it could miss it for the first time in the past two decades. In our view, China should be able to defend 7% growth in the near term, barring policy missteps.
Traditional growth drivers are facing new constraints
China’s growth momentum continues to weaken. Its year-to-date growth has been mainly driven by strong infrastructure investment, whose growth rate since 2010 has been the strongest thanks to the launch of new projects since late last year (Figure 1). In line with our expectations, the property tightening measures introduced in March have not been fully implemented, supporting the c.20% investment growth in the sector. Export growth has fallen to its lows since the global financial crisis, consistent with the flat growth in global trade in the first five months of the year. None of these growth drivers can sustain
fast growth.
Rising funding cost, investment slowdown and pending reforms may drag down growth
The slowdown is driven by over-capacity, unsustainable debts, and credit dislocation. First, funding costs may rise as China is forced to de-leverage. The infrastructure and property sectors may face credit constraints and rising cost of capital after the recent liquidity shock. Second, over-capacity and credit dislocation have contributed to the investment slowdown. Third, unlike their predecessors, the new leaders are less likely to stimulate the economy. China’s future growth will likely depend on the pace of reform in general and de-leveraging in particular. However, it remains unclear how reforms would be rolled out in coming months; any lack of policy coordination among regulators and ministries could exacerbate the slowdown.
Pace of re-leveraging in the economy is unsustainable
The rapid debt expansion in the past cannot be replicated going forward. China’s non-financial (and non-government) debts increased from 115% of GDP in 2007 to 151% in 2012 (Figure 2). This is even worse if local government debts are included. Due to limited sources of funding, local governments rely heavily on new debt. Local government debts had been expanding in line with the growth rate of infrastructure investments (Figure 3). This raises a critical question about the debt expansion this year, as infrastructure investment is up 21% yoy.
According to Mr Liu Jiayi, Head of China’s Auditing Office, out of 36 audited provinces and provincial capitals, 4 provinces and 8 provincial capitals had debts growing more than 20% between 2010 and 2012. The fastest debt growth rate was 65%. This suggests that the debt control introduced by regulators last year was not effective. Also, 55% of debt payment was promised to be repaid by land sales in 4 provinces and 17 provincial capital cities in 2012, and the principal and interest payments in these regions were already about 1.25 times their disposable land sales revenues. In other words, if existing loans cannot be rolled over when due, these local governments would have already exhausted their funding and no new infrastructure projects would be funded.
More credit has been allocated to sectors that are already highly leveraged, i.e., local governments, inland China and SOEs
The misallocation of credit has further reduced efficient use of credit. More credit is allocated to highly leveraged local governments (vs. manufacturing), non-coastal areas (vs. coastal area), and large firms (vs. SMEs).
- Relative to manufacturing, local governments get more credit. Fixed-asset investment (FAI) is moderating in manufacturing, services and resources sectors (Figure 4). While property sector investment is relatively stable, the only sector that has growth accelerating is the infrastructure sector. In order to support FAI, local governments would have to lever up further from current levels.
- More credit is allocated to non-coastal areas. In 2012, the central and west provinces had loan growth about 5ppts faster than their peers in the coastal areas (Figure 5). This is partly driven by more infrastructure investment in inland China. Historically, inland China is more indebted than the coastal region.
- More credit has been allocated to SOEs. FAI by SMEs has dropped to the lowest level since 2007 and ditto for foreign funded enterprises (Figure 6). Meanwhile, investment by SOEs has continued to pick up since 2012. Among A-share listed non-financial enterprises, the debt-to-equity ratio is 87.3% for SOEs and 62.2% for non-SOEs.
Local governments, non-coastal areas and SOEs are sectors with relatively high leverage ratios. Compared with their benchmark sectors, one unit of credit allocated to these sectors produces less investment dollars and thus reduces the efficiency of credit allocation. China needs to exit the liquidity dilemma, i.e., deteriorating investment efficiency, requesting for more liquidity support, and thus further releveraging lifting the low-quality economic growth. Together with double-counting of financial data, this explains why loose money fails is unlikely to lift growth this year.
Loose liquidity conditions can no longer lift the economy
Amid an economic slowdown, commercial banks are hesitant to fund real economic activities. Instead, they do so through the shadow banking sector based on incorrect pricing of risk. The shadow banking sector has boomed partly because of regulated deposit rates and partly because of low risk premium in a market where defaults are prohibited. As a result, loans for FAI has been consistently weaker than overall loan growth since 2012 (Figure 7). Moreover, due to a margin squeeze, existing projects have been unable to expand in recent years and therefore the share of new projects in FAI has remained high since the overheating in 2007 (Figure 8).
China’s growth in coming years will be determined by the balance between growth and reform. In our view, 6% growth or so is more appropriate to maintain some unemployment pressure and thus trigger economic reform and painful rebalancing. But there is a limit to it as the unemployment rate may start to rise if the economy weakens further from 7% and the risk of PPI deflation spreads to consumer prices. To defend a higher level of growth will likely leave little room for reforms.
Our conversations with Chinese officials indicate that the government would still hope to defend 7% growth in coming years to avoid fast job market contraction. Some policy support is possible if the 7% growth rate is tested. The credit crunch recently exacerbated the downside risk to the economy. The bond market would stay shut before the Shibor normalizes. Infrastructure investments, the property sector and SMEs would be hurt if the Chinese authorities aim at clamping down shadow banking. So the PBOC would have to step in and maintain accommodative liquidity conditions for the rest of the year. This is why we believed that the high Shibor would be short-lived. The overnight Shibor fell to below 4% in the first week of July, back to its normal range of 2-4%.
Stimulus is still possible if the economy slows far below 7% yoy this year and next. Unlike the one introduced in Nov 2008, future stimulus would be enough to only defend 7% growth. Instruments exist to defend growth: 1) More infrastructure investment could be launched and funded by supportive monetary policy (including interest-rate cuts); 2) China could also stem rising NPLs by establishing some rescue facilities; 3) Debt restructuring through securitization; 4) More investment could be generated by opening up the infrastructure and services sectors to private investors.
Possible Market Shocks
Possible shocks include policy missteps, liquidity crunch, investment slowdown and local government defaults
In the next 3-5 years, the Chinese economy will likely slow first before stabilizing in a range of 6-8% if reforms succeed. While a smooth transition is desirable, it’s not easy to achieve. The Chinese economy and market may face policy shocks, a liquidity crunch, a sharp investment slowdown, and local government defaults.
Policy shocks could come from forced reforms and policy lags
Policy shocks cannot be ruled out. If reforms are planned to tackle core issues in the economy, they may support market sentiment. But more likely than not reforms will be forced and thus may create some shocks to the economy and the market in the initial stages. While reform measures could be effective to address concerns on over-capacity, rising leverage ratios and credit dislocations, they may hurt growth momentum further before boosting it. The pace of reforms is thus critical. A summary of recent and future policy initiatives is in Figure 9.
- Growth-negative reforms: De-capacity, de-leveraging, tackling the credit dislocation problem (e.g., tightening activities in the shadow banking sector), interest rate and capital account liberalization, and SOE reforms, which are unlikely until SOEs lose money or credit is constrained.
- Growth-positive reforms: Abolishing the one-child policy, reforming the hukou system, monetizing the farmland, channeling credit to sectors with low leverage ratios (e.g., consumer-finance companies, privately-owned banks), fiscal reform and debt restructuring.
Policy consensus may not be achieved before it is too late. The government may favor de-leveraging and reforms, but further economic slowdown could trigger stimulus not a reform. Chinese policy-makers may have not prepared for an extended period of economic weakness and its unintended consequences, e.g., over-capacity, slow fiscal revenue growth, rising non-performing loans, and growing unemployment. More importantly, policy-makers are not always good at managing market expectations and communicating effectively with markets. In order to engineer a relatively smooth transition, China needs to improve decision-making and adopt a combination of cyclical and structural policy measures to address the short- and longer-term challenges. The cyclical policy is to mitigate the downside risk to the economy, while the structural measures are to create new growth drivers and improve the economic and market outlook.
China could well be hit by another liquidity crunch if orderly changes to deleveraging do not take place in coming quarters. The liquidity risk would rise if China continues to rely on investment in the already leveraged sectors. Capital flight is possible if China’s capital-account liberalization overlaps with the Fed’s exit and a weak domestic economy. This may take place with RMB depreciation against the dollar. Another cause for panic could be NPLs slowing the economy.
The liquidity crunch since June shows that authorities are against speculation in the financial sector and warn of liquidity risk in the shadow banking sector. This would likely hurt key borrowers in the market, namely local governments and property developers. According to an estimate by a trust expert, about 40% of trust products (excluding those run through the banking sector) go to property developers, 20% to local governments, 20% to industrial and commercial activities, and 20% to bill financing, art collection and so on. The bond markets and lending activities will likely slow or shut down before money-market rates normalize. Due to the liquidity squeeze, bond issuance has dropped to Rmb543.9bn, almost half of Rmb921.2bn in May. (Figure 11).
Investment growth could drop to a single digit and GDP to 6%
Investment slowdown could be dramatic once de-leveraging begins. High moneymarket rates can force de-leveraging but at the cost of growth. Based on global trends, investment growth tends to fall off the cliff when the investment-GDP ratio peaks (Figure 12). In the US and Japan, investment growth rates fell by more than half, while in Korea, Taiwan and Thailand, it dropped by around 1/3 to half the first 5 years after the ratio peaked.
In China, the peak is near and there is a good chance of the investment growth rate halving in the coming five years, i.e. a drop to around 10%. This could slow GDP growth rates by around 2ppts, to around 6%. The government has initiated a new policy to open up the financial sector to consumer-finance companies and privately owned banks. This is an attempt to channel credit to the private and consumer sectors, which have lower leverage ratios. But results will take time to show up.
Risk of local government defaults, and thus NPLs could rise
Local government defaults are likely to drive up NPLs in the banking sector, so will the leveraged property developers. As the economy slows, the gap between government revenue and spending will widen (Figure 13). Revenue to the central government was flattish in the first 5 months of this year. If it continues, this will likely affect the fiscal transfer by the central government. It would add more pressure on the non-coastal areas whose spending power depends on central government transfer.
In 2012, the share of fiscal transfer as a percentage of local revenue was 26% for coastal areas, 34% for central China and 40% for the west provinces. Liquidity crunch and possible interest-rate liberalization would also increase the cost of local government borrowings and thus increase the risk of defaults. The central government may bail out some of those debts and local governments will have to use securitization and be forced to liquidate some of its assets. NPLs may rise because of 1) defaults by local governments and property developers, 2) SME defaults due to an export slowdown, and 3) de-capacity and deleveraging (Figure 14).
