China’s quarterly numbers are in and China’s economic growth decreased to 6.4%. We are reviewing the most recent numbers and examining some inconsistencies. So diving right in, let’s pick up at the most recent quarterly GDP numbers in figure 1. Real growth in GDP by industry shows a decrease from December 2018 from July 2018. However, much of that decrease is due to the downward pressure seen in the tertiary industry. The official increase in the secondary industry from August 2018 is evident but we see little evidence of this looking at more granular data. Whereas, primary and tertiary industries have had clear uptick beginning in May 2018. We believe there are pronounced weak spots in China’s GDP growth and expect to see that downward pressure in the Chinese economy going forward.
Figure 1-Real GDP Growth by Industry
However, when we consider nominal GDP, sectors show a decrease across the board. GDP and secondary are at 8%. Tertiary was just slightly higher at 9%, while primary clocked 3%. The decreases show that the soft underbelly of Chinese economy is becoming more apparent but for a very specific reason. Quarterly nominal GDP growth has dropped from 11.1% to 8.1% from Q4 2017 to Q4 2018. This has two important implications. First, it points to much bigger slowdown in the fourth quarter than the official real GDP data indicates. Second, with neither price nor GDP acceleration expected in 2019, it makes it very unlikely that absent another major slowdown in new lending, China will be able to begin deleveraging.
Figure 2-Quarterly Nominal GDP Growth
When we compare real GDP with nominal GDP, we can see the significant decrease in nominal GDP in contrast to the flat real GDP. The downward pressure on the Chinese economy is clear in figure 3. Given the commodity have nature of the 2017 price spike, we struggle to see a real catalyst that would push prices higher in 2019. With CPI quite subdued, by official and unofficial metrics, the only real channel to push prices higher is commodity producer prices. With commodity prices peaking in 2018, we see no reacceleration of prices in 2019 putting a lot of pressure on nominal GDP in 2019.
Figure 3- Nominal vs. Real GDP
When we shift to look at nominal GDP growth by sector, we can see in figure 4 retail and industry officially continue to grow quite healthily. Construction continued to decrease from a rolling 12 month high in March 2018. Conversely, we see agriculture showing some buoyancy, increasing from June 2018 to 5% growth in September 2018. December GDP numbers for specific industries were not released with headline data in Monday. This is where profound skepticism about Chinese GDP data begins to creep in. As we have covered previously, granular industrial data just does not match this level of GDP robustness. Almost all consumer products growth are growing negatively, flat, or in the low single digits. However, retail and wholesale is growing by 9% strikes us as incongruous. Much of the underlying data in Construction and most industrial sectors do not come close to matching the headline GDP number.
Figure 4-Nominal GDP Growth by Sector
As we have noted before the official NBS reason has major statistical problems by excluding the firms with declining sales or profitability as this essentially only counts the winners and then produces a growth figure. The reality is likely somewhere between the two lines, as the major firms remain in the sample, but distinctly lower than the headline average. The key problem remains however, that the industrial activity data shows falling utilization but rapidly expanding revenue and profit in a year when price growth was rapidly slowing.
In fact, if we look at a broad array of data, it is difficult to see how GDP expanded by the claimed amount. Passenger and freight traffic grew in the low to mid single digits. Conversely, while steel output was supposedly up almost double digits, the average operating rate dropped from 74% in 2017 to 67% in 2018. Most consumption products from food, clothing, and durables were growing only in the low single digits or experiencing negative growth. While Apple and car sales grabbed the headlines, there was broad consumer weakness well outside specific narrow brands or product categories. Even tax revenue is showing broad weakness in the fourth quarter with low to mid single digit growth over the course of the year.
In a widely circulated speech and video, a notable Chinese economist estimated that 2018 GDP growth would be under 2%. Based simply on Chinese data, and reconciling Chinese data where possible, we find the official headline rates implausible. While we may be considered skeptics of official data, we try to actually use official data and see if it is possible to reconcile key data points to other data points only deviating from official or quasi official data where a strong case can be made using official or systematic data. Put another way, we try to start from a position of accepting the data and only rejecting it if there is strong systematic data that is either exogenous or internally contradictory data. Even if we accept official data in individual sectors, we cannot see how retail sales grows 9% and steel had a significant reduction in operating while simultaneously boosting output almost 10%. Even the weight of underlying official data, points to growth in the range of 2-5%. It should be emphasized that this is official data. It is quite likely based upon information we have that unofficial data and anecdote would make that 1.67% number rather plausible.
Finally, it is quite apparent that Q4 GDP is much lower in reality than the official headline data. Two thirds of the way through January, we see no evidence of a bounce back month with anecdotal evidence supporting very weak or contractionary levels of activity. What we continue to be surprised by the the near absent level of economic stimulus. There are regular rumors of various tax cuts, financial easing, or investment but so far we see nothing that we would consider a material change to economic policy to stimulate the economy. We say this because most announcements we know of are already building on existing projects and may boost at the margins over a couple of years but do not add over the next 3-12. We honestly do not understand why there has been effectively no response.
Figure 7-Industrial Revenue and Profit Growth
Key Industrial Figures
Industrial numbers from China show some key areas that underscore how weak the Chinese economy is. The following graphs are offered with little commentary, but the downward pressures on the economic sectors are evident. Of particular is the difference between YoY and YoY YTD numbers. For more insight into industrial numbers as they relate to import/export numbers, click here for our analysis of the latest numbers.
Figure 8-Key Steel Operating Rates
Figure 9- Consumer Durable Output YTD Growth in Percent
Figure 10-Tax Revenue Growth
Figure 11-Passenger Travel
Figure 12-Freight Traffic
China Economic News:
Last Friday word came that China is injecting a record 83 Billion dollars because the central banks said, “banking systems overall liquidity is falling rapidly.” However, according to Natixis the injection is looking to be rather surgical to help private enterprises. Yet, one thing that stands out in the report is how a China’s crackdown on shadow banking is leading to a decrease in liquidity in the real economy. So, in reality, the injection will do little to stave off the downward pressure because, as the report says, “China’s monetary transmission mechanism is simply not working.”
China’s Ministry of Finance implemented a new policy for reducing taxes for small and micro enterprises. For small businesses with monthly sales of less than 100,000 yuan (including the number), they are exempt from value-added tax. One change that could have a big impact on businesses is that venture capital enterprises and the angel investment individual investing in the start-up technology-based enterprise can deduct the taxable income according to 70% of the investment amount. The ability to deduct investment up to a certain amount is a very important change.
Shenzhen’s Mayor Chen Rugui said that Shenzhen’s estimated GDP in 2018 will exceed 2.4 trillion yuan, which is a YoY increase of about 7.5%. However, the economic growth target for 2019 is still about 7%.
The same private sector that China is looking to stimulate is also facing problems of getting real complaints and criticism of the market heard by the CCP. According to the South China Morning Post, Chinese Premier Li Keqiang conceded that “We must allow the people and the market players to ‘complain’, and for the words to be harsh.” However, he was commenting to Jack Ma. If a small business openly complained, the reaction may be quite different.
China Economic Market Notes:
Some interesting work that actually presents a somewhat bearish case for Chinese real estate heading into 2019 and out in 2020. Interesting as much because it comes from a research house that is typically very bullish on all things China. Forecasting a 10% decline in square meter volume sales in 2019 with low single digit price drops, by Chinese real estate standards this is a rather bearish report. Coupled with the fact of the typically bullish writer, and this implies significant pressure. Even though I know the figures quite well it remains shocking to see the relative change of debt over time. From 2007 to September 2018, mortgage debt has grown 823% which even after accounting for nominal GDP and wages is an amazing number. Where the risk really comes in how stretched households are the risk that banks carry. Select cities have household loan to deposit ratios above 100% with an average of high risk cities at 94%. As they note, a primary driver of real estate prices has been the growth of consumer leverage the dominant destination of household borrowing. With wages, by all accounts outside of official channels, growing relatively moderately in the mid-single digits (say 4-6%) then this would imply any slowdown from the roughly 18% growth in household debt in 2018, would have significant impact on home prices. While they understandably argue for a shift away from land sales to fuel government revenue and we believe this is a theoretically sound idea, we remain skeptical of this as a viable political alternative in the near term. This would implicitly tie home values to household cash flows and raise taxes significantly on Chinese households, something Beijing is trying to lower. This has been talked about for so long, maybe we are just skeptical it will ever get done.
Continuing the backwards day trend, a typically bearish research house has forecast 11% increase in Chinese stocks in 2019. In what may be a surprise, we are inclined to say a moderate rise seems like a reasonable forecast. Another 21% drop seems unlikely barring major unforeseen events. Our philosophical bias is to believe in mean reversion so the question becomes, where does the mean lie in this scenario? We believe there are two answers that produce very different outcomes. In the first scenario, assume Beijing opts to take the deleveraging medicine and accept the pain, of which we believe there is a substantial amount waiting, for a variety of reasons from the drain on liquidity to the slower growth, it would not be outlandish to see another not insignificant drop of say 10%. However, in the second scenario assume Beijing wants the market to believe it is serious but doesn’t want the pain and they continue to stimulate enough through various channels just enough to keep any real pain at bay. This does not even require some acceleration, simply not allowing the pain to take hold. Under the scenario, it is not hard to envision a scenario where the mean is set a bit higher and induces high single digit to low double digit gains. Especially if the PBOC moves into the market as predicted, this could stabilize or push the market up. We do not believe they want to be seen as the driver but will nudge the market up. While all economies are semi policy driven, it is fair to say that more than most China is a very policy and window guidance driven market.
2019 is set to see more bond index inclusions of Chinese bonds that by some calculations could prompt inflows of approximately $150 billion. With central banks continuing to increase their RMB reserves by a small amount every year, this should offset China’s expected longer term shift into current account deficit country. Arguably the biggest relief will be public sector debt and specifically local government debt which is seen as having a Beijing guarantee but having a slightly higher yield. Part of what we see happening is that Beijing does not want to officially lower rates but is happy to nudge certain rates down to ease the pressures faced by heavily indebted local governments, firms, and households. Look for this liquidity to ease rate pressures throughout the year.
Number of China notes beginning to realize that the pressure on prices and trade has little to do with the headline trade war and a lot more to do with the fall of in economic activity in China.
Note: We will have a couple of GDP related posts this week as a type of capstone to reviewing 2018 and looking ahead to 2019