By John Richardson
THE Wall Street Journal agrees up with my blog: Two months after I warned that a slowdown in lending growth in China was a major threat to the global economy, its 1 May front-page article echoed my warning.
Meanwhile, evidence continues to build that the pace of the credit slowdown is accelerating.
First we saw a decline in total social financing (TSF) in January-February on a year-on-year basis. TSF is a measure of total credit available from both state-owned and private lenders.
Next came the more mixed picture of TSF in March. Lending from the state-owned banks fell quite sharply, but new financing via the highly speculative private, or shadow lenders, surged.
Since March, therefore, a series of measures have been introduced to reduce the scale of shadow lending as China once again picks up the pace of its long-running “whack-a-mole” game.
For example, entrusted investments, a source of $1.7 trillion of financing, are drying up thanks to new regulatory guidelines. These investments, which have helped re-inflate the real estate bubble, represent just one form of many forms of highly speculative and so risky lending that’s at the root of China’s financial-sector problems.
Crucially, also, any official who steps out of line with the reforms risks being investigated as part of the long running anti-corruption campaign.
What Happens Next
Levels of leverage in China are in excess of those in Japan, Southeast Asia, the US and the UK ahead of their financial crises in the 1990s and 2008. So the jury is very much out on whether China can deflate its bubble without triggering a financial crisis that would have major global implications.
Even if Beijing can square the incredibly difficult circle of deflating the bubble without triggering something similar to the Global Financial Crisis, the slowdown in lending will still very likely turn today’s global reflation back to deflation.
Here is why:
- The global economic recovery has had very little to do with a fundamental shift in the underlying growth dynamics in key developed economies such as the US. Until or unless the US and the rest of the West tackles the challenges of ageing populations, a sustainable recovery cannot happen.
- What has instead been behind the recovery, if we can call it that, has been a mini commodities pricing bubble.
- In 2016, commodities prices rose as the Chinese economy boomed on a rapid growth in lending. This was the result of the Populist anti-reform political faction regaining control of China’s economy.
- Global deflation has thus turned to reflation as global manufacturers hedged against higher raw material costs by building-up their inventories of raw materials.
- But as this year’s slowdown in lending demonstrates the Princeling pre-form political faction, led by President Xi Jinping, is back in in control of the Chinese economy.
- Commodities prices, such as iron ore, have a result started to decline as credit conditions in China tighten. We are in the early stages of a destocking process up and down global manufacturing chains.
- Oil prices could also soon start to head down on growing awareness that China’s demand growth for crude – and so its imports – will be lower in 2017 than in 2016. This would of course lead to major destocking up and down all the chemicals and polymers value chains.
The Importance of Purchasing Managers’ Indexes
A lot of the renewed global economic confidence has been derived from stronger manufacturing purchasing managers’ indexes (PMIs) in China and elsewhere.
But visibility on real demand is very weak during periods of sharp acceleration in raw materials costs. What everyone interprets as strong demand on better underlying economic fundamentals can instead be stronger demand on the restocking process that I have just described.
The German and UK manufacturing PMI’s for April were at multi-year highs, which, as I said, suggests to me we are only at the beginning of a global destocking process. In a sign the mood has already started to change in the West, though, the US April manufacturing PMI was lower than had been forecast.
A pointer to the future for the rest of the world could well be China’s Caixin manufacturing PMI. In April, it fell to 50.3 from 51.2 in April, as the chart above indicates. This was the slowest rate of expansion in seven months.
There is a good correlation between iron ore prices and the Caixin PMI, as the above chart also indicates. From July 2016, the Caixin swung into positive territory of more than 50 as the 2016 credit boom really start to take effect. As growth in the Caixin has moderated, iron prices have fallen. Similar patterns can be seen from comparing the Caixin to the rise and fall in other commodities prices.
It all might turn alright in the end, of course. There may be no major shock emanating from China in 2017 if President Xi and his fellow reformers back away from today’s slowdown in credit. Perhaps the economy will be re-stimulated over the next few months.
But this will only delay the inevitable. At some point China has to deal with its excessive leverage, and the longer the delay the greater the scale of the problem.