[Miller, Scissors] China Isn‘t fixing its flaws

In the runup to China’s twice-a-decade Communist Party Congress, many analysts have turned bullish on the Chinese economy. Some of the optimism is based on an impressive recovery since the quasi-crisis of late 2015 and early 2016, some on hopes that a strengthened President Xi Jinping will emerge from the congress to restart far-reaching reforms. Whatever the cause, though, the giddiness is ill-founded.

In our China Beige Book, we quiz over 3,300 firms across China about the performance of their companies as well as the broader economy. Their responses reveal that much of the exuberance about China today is based on dangerous misconceptions.

The first and most obvious myth is that China is actually deleveraging, as officials claim. Responses from Chinese bankers support the notion that regulators, at least for the moment, have successfully targeted certain forms of shadow financing such as wealth management products. Companies, however, don‘t seem to be feeling much pressure to curb their excesses.

In the second quarter, while firms reported facing moderately higher interest rates and borrowing modestly less, that only slowed the pace of leveraging instead of reversing it. And even that progress has since stalled. Third-quarter loan applications rose, rejections fell and companies borrowed more. Interest rates at both banks and shadow financials slid.

What officials are calling deleveraging -- rolling back excess credit -- still represents more, uneven leveraging. If the restrictions on financials do extend to companies in 2018 and deleveraging actually begins, the process could be much more traumatic for the Chinese economy than most people currently recognize.

The second myth is that the Chinese economy has finally begun to rebalance away from manufacturing and investment to services and consumption. In reality, China’s stronger 2017 performance has depended almost entirely on a revival of the old economy; the improvement in both growth and jobs drew heavily upon commodities, property and, most consistently, manufacturing. Call it “de-balancing.”

Since bottoming out in late 2015, manufacturing revenue growth has improved every quarter, and at a pace quicker than services and retail in most of them. The manufacturing sector has recorded consistent gains in profits and pricing power over the past year, not to mention six straight quarters of expanding workforces. On the other hand, “new” economy sectors such as services and retail have grown in fits and starts. While those sectors are performing adequately, they‘re hardly on a course to displace manufacturing -- far from it.

Finally, and again contrary to government claims, China hasn’t slashed overcapacity in commodities sectors. Xi has incessantly touted what he calls “supply-side reforms,” which would seem to give Chinese companies very strong incentive to report results showing such cuts.

Yet for more than a year, firms have indicated the opposite. While some gross capacity has been taken offline to much fanfare, net capacity has continued to rise. From July through September, hundreds of coal, steel, aluminum and copper companies reported a sixth straight quarter of overall capacity rising, not falling.

This will soon come to a head. For over a year, blistering demand and flows of speculative capital have combined to keep metals prices rising and mask the lack of genuine supply cuts. In the third quarter, though, firms across sub-sectors reported poorer revenue and profit results. Most telling, domestic orders weakened sharply, signaling that there‘s no quick rebound on the way. Unless true supply cuts are imposed, it’s a matter of when, not if, speculative inflows unwind and many investors find themselves running for cover.

All three of these misconceptions have serious implications. Not only will the commodities reversal reignite skepticism over the Chinese economy, the yearlong rally in metals is also seen by many as evidence of global reflation. Should commodities prices suffer a sustained fall, confidence in both the global economy and, relatedly, central banks‘ willingness to raise rates may be affected.

For China itself, many observers have come to believe that the economy has recovered even as it’s rebalanced and undergone at least some deleveraging. But restructuring didn‘t begin in 2017. Rather, the task was delayed yet again in order to serve the Party’s desire for stability and growth ahead of its big meetings.

If Xi and China‘s new leadership actually roll out such an agenda next year, the dislocations will likely be far greater than investors are anticipating. On the other hand, if they don’t act, imbalances will continue to swell, making the pending correction all the more painful.


By Leland Miller and Derek Scissors

Leland Miller is chief executive officer of China Beige Book International and Derek Scissors is chief economist at China Beige Book International, as well as a resident scholar at the American Enterprise Institute. -Ed. 


(Bloomberg)