PAUL KRAKE: China’s deleveraging cycle that wasn’t. Growth to rebound.


China’s deleveraging cycle that wasn’t. Growth to rebound.

(This is the second of our discussion on growth rebounding in the second half of 2018.Part 1 is here. These are excerpts of our June 5 flagship report.)

Chris Balding is an associate professor at Shenzhen University and a regular on the VFTP Expert Series. Chris focuses on Chinese credit, and I think he has an excellent handle on aggregate credit growth trends. Much of what follows comes from our discussion on July 3rd and while many of the conclusions are mine, Chris’ input into this section were valuable. Expect a full report on the outlook for Chinese credit in the next week.

The conventional wisdom regarding the Chinese credit mechanism is that activity should start to slow 6 months after credit growth begins to decline. Post November’s Party Congress, the composition of credit growth began to shift, or should I say accelerate, to a process of transferring credit growth from the off-balance sheet channels and back onto the balance sheets of traditional banking sources. Total Social Financing fell but was more than offset by the expansion of the banking sector. So, while many have argued that Chinese equity weakness has been the result of a deleveraging cycle, a more accurate way to describe all this is that leverage continues to come out of the shadows (pardon the pun) and is much more transparent, and easily regulated by the official banking system.

There is evidence in the last six months that corporate loan growth has slowed and has been replaced by a focus on household lending. The markets are fixated on the decline in corporate lending growth since the start of the year, but the natural flow-on effects that weaken credit i.e. softer growth six months forward don’t seem to be playing out.

If deleveraging started in earnest in November like many bears believed, then why is steel production reaccelerating?

Why are land sales jumping? Maybe credit is not slowing to the extent that many of you think? Maybe the answer is in the liquidity being provided by the PBOC in the form of reverse repo and the Medium-Term Lending Facility or MLF.

The PBOC is adding liquidity aggressively

Since the start of Q2 2018, the PBOC has reversed its stance of removing liquidity from the system by adding copious amounts of new cash via reverse repo and MLF, effectively reversing all the contraction that happened in Q1. On the surface, this is hardly an environment where the PBOC is looking to deleverage the economy at any cost. All this liquidity hasn’t neatly been reflected as an uptick in official lending numbers, I believe this is a clear indication that Chinese bears have credit crunch arguments completely wrong.

The PBOC has been adding liquidity into the system because deposit growth hasn’t been enough to keep up with the increases in lending from banking system. With credit growing at 12.5% annualized and deposit growth running at 6.3%, the uptick in MLF and Reverse Repo is designed to make up the difference.

This reversal in stance from Q1 does certainly go part of the way to explaining why credit sensitive sectors such as steel, coal, and housing have experienced an uptick in activity at precisely the time when conventional wisdom says they should be contracting. Our good friend Robert Ciemniak of Real Estate Foresight observed that Land acquisition by developers in construction areas increased by +2.1% YTD YoY, +3.7% 3M rolling YoY, +14.6% 12M rolling YoY – compared to -2.1%, -2.3% and +13.2% in April, respectively. How is this possible if credit growth was meant to be coming off the boil?

Now one must consider the availability of land banks and the ease of new acquisition, but the facts remain that developers need credit to access land banks and if these acquisitions are growing, then it is naive to believe that the availability of credit is drying up.

Credit growth has slowed at the margin since the start of the year, but China bears will have you believe that it has fallen of the face of a cliff. This is just not correct and if the PBOC continues to ease liquidity conditions like it has since the start of Q2, conventional wisdom says that growth should rebound towards the end of the summer.

Picking a bottom in Chinese stocks is tough but the patient will be rewarded

I am not trying to tell you that this is the point in time when EM equities, led by China, are about to reverse and start to reclaim what has been a quite relentless period of underperformance versus the developed world, especially US stocks. Picking turning points is tough enough in normal times, but in the era of Trump, where policy objectives gyrate with each and every tweet, predicting a turn in sentiment regarding trade rhetoric is impossible. The best we can do is to stick to our guns regarding valuations and technical levels and allow the plan to play out. Over the last week, hedges in both HSCEI and HK property stocks reached our long-held levels and we covered these positions accordingly. This will allow us to be more aggressively long Chinese equity sectors such as technology, banks, healthcare, and property. More importantly, this allowed us to rotate these hedges into both the SPX and Russell, establishing what I believe will be one of the most compelling equity trades over the next 12 months, which is Long China and Short US equity.

With the CSI300 now down 25% from the January peak and Chinese stocks underperforming US tech and small caps by well north of 20% since the start of the year, the entry level for this outperformance trade has never been more compelling. We are seeing growing evidence that a three-pronged stimulus; fiscal, monetary, and currency easing are evolving, and history tells us that the market consequences of this are generally very constructive. I equate this to Q1 2016 and the market’s response to the Shanghai Accord, the coordinated measure between the US, China, Europe, and Japan that allowed for USD and RMB weakness, in order to stoke global demand. While there will be no such policy collaboration this time around, RMB weakness on a trade weighted basis appears to be on the cards. I would focus less on the USDCNY exchange rate and more on the CFETS basket which remains elevated and close to levels not seen since the Shanghai Accord.

The thematic model portfolio has established a position being short the RMB v the CFETS Basket.

The monetary response has always been less important to the fine tuning of the broader Chinese economy than fiscal or currency means. Liquidity management has always been the tool of choice for the PBOC, with adjustments in the official cost of money being rare. I am skeptical about the effectiveness of using tools like the Reserve Requirement Ratio (RRR) for banks, but clearly it is a help at the margin. That said, the announcement of an RRR cut last week to coincide with the pending implementation of US tariff was dismissed by equity markets in China where liquidation remains on the minds of domestic investors. Western pundits are clueless about what drives the whims of Chinese retail investors but what has been proven, time and again, is that the RRR is an ineffectual tool when it comes to changing sentiment. Clearly, on the monetary side of things, we need to see something more.

We have heard from Li Keqiang on several occasions in the past couple of weeks, talking about targeted support regarding loans to small and medium sized companies (SMEs). This exposes the flaws, the contradiction and flat out confusion that the market was when weighing up the short and longer terms goals of Chinese policy makers. Talk, and I stress the talk, of deleveraging, continues to be a prevailing theme, yet I remain incredibly skeptical about the level of implementation regarding stated regulations being implemented. While credit growth has slowed at the margins, the Chinese are playing their typical game which is to announce a series of grandiose measure but the implementation of these new rules, in many cases, generally doesn’t happen.

Chinese activity will rebound in the second half of 2018 and with it, the fortunes of the equity market.


The View