The blog got 54.8m results from Google when it entered the phrase “China GDP” this week. The only problem, seemingly unrecognised by most analysts, is that China’s GDP report is a completely fictitious number, invented by the leadership each quarter to suit its own narrative.
This sounds a bold statement, but it isn’t:
- China is the only country to declare its GDP figure only 2 weeks past the end of the quarter
- It is the only country that never revises its GDP figure
- It is also the only country where all the provinces routinely report GDP numbers higher than the national figure
The blog noted back in December 2010 that Li Keqiang, now China’s premier, had described the figures as “man-made and therefore unreliable”. Now the blog is delighted to see a new book, ‘Myth-busting China’s Numbers’, by Matthew Crabbe, highlights just how fictitious they are. As the Financial Times review notes:
“One of the first and most important points he makes is that in China’s Leninist system all information is political and can be designated a “state secret” at any time if the ruling Communist party decides it does not help to bolster the party’s own legitimacy and power.
“Crabbe also explains why data and statistics are so often manipulated by party cadres whose career advancement relies very heavily on them meeting various top-down targets issued by Beijing. This book is timed very well – just as the crowd of self-proclaimed China hands based all around the world has begun to multiply exponentially.
“The extremely important point he makes repeatedly is that it is impossible to understand what is happening in China by just looking at the data published by the government.”
As Li and Crabbe note, one has to look at data for electricity consumption, bank lending or rail freight volumes to understand the real state of China’s economy. At the moment, given the problems with the shadow banking system, the blog is preferring to focus on electricity consumption as its key metric, as shown in the chart above:
- Electricity consumption is core to any economy, and reflects real-time demand as it cannot be stored
- 2009 data highlights the massive stimulus impact, with consumption up 22% in January-May versus 2008
- More recently, 2012 was up 6% versus 2011; 2013 was then up 5% versus 2012
- So far, 2014 is also up 5% overall, but April/May show a slowing trend versus Q1
This picture of a slowing economy is also confirmed by latest data for China’s oil consumption. Reuters report this was down 0.7% in May versus May 2013. They also note that China is now exporting fuel on a semi-regular basis, also suggesting a slow economy.
“Self-proclaimed China hands” may like to focus on GDP numbers, as it gives them the illusion of knowledge. The rest of us will be much more cautious.
No matter what the official numbers may say, China’s actual GDP growth may well head towards zero in the near future, as the new leadership continues to clean up the mess it was left.
We can all hope that China’s ‘collateral trade’ turns out not to be as big a problem as seems likely. But history shows that this type of problem has a way of escalating once people start investigating more closely.
Thus state-owned Citic revealed yesterday that it has lost $40m in the Qingdao scandal, as half of its alumina is missing. And, of course, this is only what it knows to be missing. We also learnt that local Chinese banks may have Rmb 15bn ($2.4bn) in outstanding loans to Dezheng Resources, the company at the centre of current investigations.
The key issue is that nobody can tell today the depth of the problem:
- Maybe this is just one company, with one set of deals that went wrong?
- Maybe the vast majority of China’s commodity imports have indeed been used to create future income?
- Maybe China’s housing market is not as overvalued as it appears, and may stabilise at today’s levels?
- Maybe the government will reverse course and do another 2008-type stimulus to try and resolve the situation?
But maybe only some, or none, of the above turns out to be true? The Qingdao scandal has now been running since April, when Dezheng’s founder was first detained. And as the Financial Times reports:
“The case has cast a chill over metals trading in China, the world’s largest consumer. Chinese customers and traders are now often unable to find loans for imports as Chinese and international banks pull back from a practice once viewed as safe….
“China’s central bank ordered banks in Shandong province to approve import financing from their provincial offices, rather than their city branches, on the same day that police formally began investigating the multiple claims on the metal.
Day by day, the story refuses to die down. Instead, more and more details emerge to suggest it may get worse.
It therefore seems prudent to adopt the Scout motto of “Be Prepared” and try to identify a ’worst case’. The reason is simple – history shows, as during the sub-prime Crisis, that there is little time to react once the wider market becomes aware of the potential problem.
WHAT MIGHT HAPPEN NEXT, IN A WORST-CASE SCENARIO?
First to be hit would likely be the global commodity markets, if they wake up one morning to find that China’s vast ‘collateral trade’ is starting to unwind, perhaps rather suddenly:
- The prices for those metals and other commodities caught up in the trade would be hit first
- Mining company shares would also be hit, as people worried their vast capacity expansions were wishful thinking
- Investors may put 2 and 2 together and worry, as the BBC described in February, that “China Fooled the World”
Next to be hit could be other financial markets. Complacency and low interest rates have encouraged investors to borrow heavily. Each night, therefore, they might start to receive margin calls as prices for their commodity-related investments decline:
- Some investors might decide to sell out, pushing prices further down
- Other investors might need to raise funds by selling non-commodity related investments
- At the same time, buyers might then immediately disappear for anything that appears to be high-risk
A third phase of the downturn could then develop in our globally-linked electronic world:
- These forced sellers might have to sell in more liquid markets to secure the cash they need
- This would mean selling blue-chip shares and high-quality government bonds
- In turn, investors who have borrowed heavily to invest in these markets would then start to receive margin calls
The risk is therefore that major declines could then take place quite suddenly in a number of major financial markets, just as Hyman Minsky would have forecast:
His insight was that a long period of stability eventually leads to major instability
- This is because investors forget that higher reward equals higher risk
- Instead, they believe that a new paradigm has developed
- They therefore take on high levels of debt, in order to finance ever more speculative investments
As in 2008, another ‘Minsky moment’ could thus occur as ‘distress sales’ start to take place.
Let us hope that none of this happens. But what would your company do, if some or all of these events start to take place? That is the key question that we all now need to answer.
CONCLUSION – THE WORLD COULD EASILY BECOME A SCARY PLACE
None of this would have happened if central banks had accepted that ageing populations inevitably lead to low levels of economic growth. The New Old 55+ generation are a replacement society, as they already own most of what they need, and their incomes decline as they enter retirement.
But the central banks didn’t want to do this. Instead, they have provided a fig-leaf behind which politicians could hide, to avoid a difficult debate with the voters about the need for pension age to rise, not fall.
The blog has warned over the past year that the world could become quite scary if it finally becomes clear that the central banks have created a debt-fuelled ‘ring of fire’.
It has long worried that China’s property bubble would prove to be the the epicentre of the global debt bubble. Today’s Qingdao scandal seems to be another, stronger, tremor warning of the potential earthquake to come.
If it is accompanied by even a limited collapse of China’s property market, then it risks opening up the fault-lines that the central banks have created around the world.
Today, the blog launches a major new Research Note in the ‘Your Compass on China’ series, produced in association with leading Hong Kong-based financial advisory firm Polarwide.
Titled ‘Here today and gone tomorrow – a simple guide to China’s world of trade finance’, it is probably the single most important paper it will publish all year – please click here to download a free copy.
The bottom line – China’s vast imports of commodities such as iron and copper have, in reality, often been used to finance today’s property bubble. This is how it worked:
Sardine tins were scarce during World War 2 in the UK, and often became tradable items in their own right. Then one day, a company decided to open some for a celebratory lunch, only to find that the sardines had decayed, and were uneatable. On complaining to their supplier they were told – “That’s not our fault. Those sardines were for buying and selling, not for eating.”
This is perhaps the best analogy to explain what has been happening in China with its so-called ‘collateral trade’ since 2009. The world wanted to believe that China’s rise to consume two-thirds of the world’s iron ore, and 40% of its copper, was due to its superior economic policies and long-term growth prospects. But the truth is somewhat different. A major part of these imports have instead been used as collateral for loans to support its housing bubble.
News agency Reuters has suggested, for example, that 100 million tonnes of iron ore are currently tied up in such financing deals. This would be enough to build 1200 buildings the size of New York’s Empire State building. A wide range of other commodities have also become involved more recently, including polymers such as polyethylene and polypropylene. As the Wall Street Journal reports:
“In mid-2013, authorities limited how much traders could borrow against commodities like iron ore and copper. But that only pushed investors to start using a wider range of collateral, including soybeans and palm oil”.
The concept behind the ‘collateral trade’ was simple, though its various mechanisms are complex. Its aim was to finance speculation in China’s property sector as it reached bubble-like proportions, with central Beijing apartments selling for 34 times average earnings. This is four times the ratio seen at the height of the US sub-prime boom.
Property developers have been offering sky-high returns for short-term loans. And one easy way to participate has been to use imported commodities as collateral for letters of credit issued offshore – often in Hong Kong. Investment bank Goldman Sachs estimate that up to $160bn may have been involved in such schemes.
Now, however, China’s new leadership has begun to steer a new course with the economy. The $10tn lending programme developed since the Crisis began in 2009 is being wound down. Property development, currently almost a quarter of the economy, is being drastically scaled back. As state-owned China Daily has highlighted:
“If the country is to eliminate up to half of its industrial base to make way for business based on the mobile Internet, it will have to keep the credit line really tight for local development projects.”
Thus the ‘collateral trade’ is fighting for survival as China’s government and central bank clamp down. China’s 3rd largest port, Qingdao, was closed in early June, with news reports suggesting that up to $1.6bn of allegedly fraudulent deals were under investigation. Qingdao had already started to see property price declines of 20%-30%, as the government’s new policies hit home. Now, as The Diplomat notes:
Qingdao’s commodity and asset market troubles offer an example of how the decline in the shadow banking and real estate markets is playing out in China. It reveals that interconnected degradation is eminently possible and potentially circular, as one shock reinforces another in turn. It is likely that we will see other similar situations emerge in the near future. Qingdao also shows that after-the-fact policies such as loosening mortgage lending are too small to combat full-on market retrenchment. It is hoped that larger reform policies will stimulate economic growth where defensive economic policies cannot. Much is likely to play out through the end of this year.
Investors and companies are now discovering, the hard way, that a large part of China’s commodity imports have not been used for their proper purpose. Instead, like wartime sardines, they have simply been collateral for buying and selling – this time, in support of a gigantic property bubble.
China’s property market is the epicentre of the global debt bubble discussed yesterday. It has been red-hot since urban residents became free to buy their own home in 1998. Before then, they lived where the state told them. With interest rates held low to boost state-funded infrastructure spending, people had few options for investing their money.
The result is that prices have become totally unaffordable for new buyers. Beijing house prices average 34 times average earnings, and Shanghai sells at 29 times average earnings. Even worse is that property has provided massive opportunity for corrupt officials to feather their nest. 30% of all property is owned by just 1% of the population, and around 2.1 million households own between 40% – 50% of China’s $10.5tn real estate and financial assets.
Now these same officials are selling in a frenzy, panicked by the thought that their property holdings will soon have to be published on the internet, for anyone to see. As China Daily reports:
“Once sky-high priced houses in Hua Qing Jia Yuan, a famous residential district near a key primary school, are witnessing a decline in prices to less than 60,000 yuan per square meter. A homebuyer said properties in that district were being sold at 100,000 yuan per square meter just six months ago, but recently she was shown a 106–square-meter house priced at 6.2 million yuan.”
The downturn is also now beginning to widen, as the government’s efforts to control shadow bank lending have led house prices across China to start falling. Thus the research unit of real estate developer Soufun reported:
“Rising market supply and sharp falls in transactions have put relatively heavy pressure on property developers’ sales, leading some to beef up promotions and adjust their pricing strategy.”
And there will likely be more falls to come, as the government wins its battles with local authorities who have been keen to support prices in order to boost their income from land sales – often their major revenue source.
The size of the earthquake now underway is highlighted in private remarks by Mao Daqing, vice chairman of China’s largest developer, China Vanke. Leaked online, they apparently suggested that China’s land bubble now parallels that of Japan before its crash in 1990:
“Tokyo’s total land value in 1990, prior to the property bust there, was equal to 63% of U.S. GDP in 1990, he said. During the Hong Kong bubble in 1997, land values there reached 66% of U.S. GDP. In 2012, the total land value in Beijing was 62% of U.S. GDP, “which is a scary number”, Mr Mao said”.
An unofficial report of the speech by JL Warren Capital highlights the core problems:
“Mao singles out three major trends in the Chinese real estate sector in 2014:
- Tier 2 and Tier 3 cities: Supply exceeds demand, by a lot
- Tier 1 cities: Continue to see robust demand; however, land prices have gone up more than Actual Selling Price for projects
- Credit has tightened.
“China’s anti-corruption campaign has had a greater impact on high-end property projects than most have realized. Investigations are ongoing into owners of property priced around 40K-50K RMB/sqm, ($6.5 – $8k/sq metre) not to mention more expensive properties. The increased scrutiny surrounding the anti-corruption campaign has caused demand to fall off in the high-end property market.
“The second-hand housing market has been even more impacted by the anti-corruption campaign. New listings for sale surged to 10-12 units per day, twice as many as before.
“Many owners are trying to get rid of high-priced houses as soon as possible, even at the cost of deep discount, because many corrupted officers have illegally accumulated several or more houses through bribery or embezzlement. As a result, ordinary people who want to sell homes in the secondary market must face deep price cuts….
“Most cities have witnessed an increase in inventory-sale ratios for residential buildings. Among the 27 key cities we surveyed, more than 21 cities have Days Sale of Inventory (DSI) exceeding 12 months, among which 9 have DSI greater than 24 months….
“The second critical issue is the demographics in China. Our research shows that by 2033, the total population aged 60 and above will reach 400 million, as well as an additional 270 million people living on social welfare. That is, by the end of 2033, there will be approximately 670 million people, or 50% of the Chinese population, will be living on social welfare”.
The detail behind the remarks makes it clear this was not a ‘top of the head’ speech, but carefully considered. Mao, along with China’s leadership, seems to recognise that there comes a point where the can cannot be kicked down the road any more, as it is likely instead to end up over a cliff.
Total housing activity totalled nearly a quarter of China’s GDP last year, according to Moody’s. So as China’s Academy of Social Sciences has warned, “we’ve got to let the growth rate go down”.
The fault lines from this earthquake thus run very deep indeed.
To assume, as they say is “to make an ass out of u and me”. That was certainly the case last week, when financial markets assumed that China’s slightly better PMI index was a sign that its domestic economy was stabilising. They had temporarily forgotten the key message of February’s Research Note, namely that the government would aim to preserve growth levels and jobs by boosting exports.
This is a critical distinction. The leadership is giving no sign of intending to do any kind of major stimulus programme. It knows that domestic growth will inevitably head towards zero as it tackles the property bubble. But at the same time, China does need to preserve jobs. And the only possible means, on the scale required, is via exports.
China’s PTA market provides a good example of what is happening, as the chart of the blog’s benchmark prices shows:
- Slowing domestic demand combined with increasing capacity has taken prices down 12% this year (red line)
- ICIS suggests that June’s operating rates will be a further 10% below today’s 76% level as demand slows
- This slowdown is destroying import demand – yet until recently China was the world’s largest PTA importer
- Imports were just 500kt in January-April versus 2MT in 2012, according to Global Trade Information Services data
- Instead an export surge is underway, with 127kt exported in the same period – the first time this has ever happened
This change of strategy is most advanced in PVC. China used to be a major importer when its construction boom was at its peak, buying 255kt in January-April 2012. This year, its trade is balanced, with exports matching imports at 300kt.
China’s new strategy makes great sense – it aims to close down low-margin polluting businesses and instead expand higher-value exports. Thus it is investing heavily to create a technologically sophisticated auto industry, and car exports are poised to take off as the domestic market weakens:
- China’s gas deal with Russia rightly grabbed the headlines last week
- But Russia’s railway is now also ramping up its connections between China and Germany/Central Europe
- Links to India, Thailand, Vietnam and Indonesia are also planned for the next 2 – 3 years
- The aim is to create a ‘through route’ for China’s cars to key export markets
And whilst it is fashionable to mock the quality of China’s domestic car production, JD Power analysis shows manufacturers moving rapidly up the learning curve:
“Chinese domestic brands achieved tremendous improvement in vehicle quality in 2013, with four domestic brands—GAC Motor, Venucia, Roewe and Luxgen —performing above industry average. We have seen the gap with international brands continually narrow during the past 14 years.”
Meanwhile, as the chart also shows, an ominous calm has fallen in other Benchmark product markets. They have hardly moved in months.
But the blog is keeping a close eye on benzene, its favourite indicator (green line). its prices have suddenly weakened, as Asian demand disappoints. As we move into the seasonally weak Q3 period, this could prove an early warning sign that a new downturn lies ahead.
Certainly performance since New Year supports the blog’s own argument that the Demographic Scenario is far more likely to occur than policymakers’ Recovery Scenario. And even they are now warning of potential trouble ahead. Germany’s chancellor Merkel warned of “deceptive calm”, whilst as Bloomberg reports:
“24 hours of warnings where led by New York Fed chairman William Dudley’s acknowledgement that the slide in market volatility “makes me a little nervous”. Bank of England deputy governor Charles Bean said conditions were eerily reminiscent of the pre-Crisis era, whilst Bundesbank borad member Anreas Dombret said “we do see risks despite the fact the markets are calm“.
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
PTA China, down 12%. “Several producers are planning to shut their units in June because of squeezed margins, and slower off-take in the downstream markets”
Benzene, Europe, down 4%. “Ample import volumes arriving in Europe.”
US$: yen, down 3%
Brent crude oil, flat
S&P 500 stock market index, up 4%
Naphtha Europe, up 5%. “A recent spike in exports to Asia has been followed by a sharp drop”
HDPE US export, up 7%. “Globally, buyers are buying mostly on an as-needed basis, not wanting to build inventories on the assumption that prices will decline”
The above chart is the blog’s simple guide to forecasting China’s auto sales. We know from all the data that most Chinese are far too poor to afford to buy a car out of their income. Average per capita consumer spending in the towns is just $2600/year, after all. While rural incomes are only a third of urban ones.
Thus money spent on cars normally has to come from loans. And cars are quite expensive. So the loans depend on the wealth effect created by China’s property bubble. The chart highlights how it works:
- In 2008, before the crisis, lending averaged Rmb 400bn/month ($65bn) and car sales averaged 560k/month (purple number)
- In 2009, lending doubled to Rmb 800bn/month and car sales to 850k/month (blue)
- Then 2010-12′s red-hot property market meant car sales averaged 1150/month, even with lending lower at Rmb 650bn/month, as players used the windfall house price gains to finance high-value purchases (black)
- But 2013 saw lending’s role return, as loans jumped to Rmb 750bn/month and car sales to 1300/month (green)
So far in 2014, lending has averaged Rmb 950bn and car sales 1500/month (brown).
But Q1 is always somewhat special, as the banks like to lend as much of their quota as early as possible in the year. And in recent weeks, there have been clear signs that they government is turning off the loan tap, with new rules to restrict lending being introduced all the time.
Of course, the government may change its mind and allow lending to jump again. This is what most analysts still expect. But this would make solving China’s debt burden even worse, and it would also increase pollution in the major cities to even more dangerous levels.
And lets not forget that President Xi opened November’s economic policy conference, the 3rd Plenum, by announcing:
“The good meat is all gone; all that is left are hard bones to chew”
These do not sound like the words of a man who intends to maintain ‘business as usual’ in terms of China’s economic policy. The bad loan ratio of China’s banks is already rising, as the squeeze continues on the property sector.
Equally important is that sentiment is turning against property developers in financial markets – the junk bond market is now effectively closed to them, and shadow banking rates have reached 10% – 12%.
A prudent Base Case Scenario for the rest of the year would therefore be:
- Once the government has the shadow banking sector under control, it will no doubt feel confident enough to cut official lending quite sharply
- This could be as early as H2, given that the leadership needs to resolve its problem before 2017, before its reappointment is due in March 2018.
We could therefore start to see China’s car sales fall quite sharply later in the year, as the lending and housing bubbles start to be burst.