Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 1 August 2012

Red Flags Over China

Since doubts surround Chinese economic data, one way to infer the health of the Asian dragon is to look at the impact on its neighbours. This does not provide a very comforting picture of the Chinese economy. Growth across the region is spluttering even as hopes of a gigantic Chinese stimulus remain undimmed.

Naturally part of the slowdown is due to a lacklustre US recovery and the slow-motion implosion of the EU. However, China plays an exceedingly large and important commercial role in the region. It has supplanted USA as the primary export destination for Japan, South Korea and Taiwan, three of the four largest economies in East Asia. A very simplistic model of the global goods supply chain is illustrated below.

As developed world demand fails to regain the growth rates prevailing before the 2007 credit crisis, it impacts demand all through the chain. Moreover, even as demand remains anaemic, continued investment in productive capacity has taken place, especially in China. This necessitates robust consumer demand to achieve profitability. 

Unfortunately, this demand is unlikely to come any time soon from China or the rest of the developing world. They simply do not have the purchasing power that the developed world imagined it had during the credit boom. Hopes pinned on Chinese domestic demand are likely to be disappointed. All such talk about Chinese rebalancing and promotion of domestic consumption is mere rhetoric. In China, a tiny minority has captured a giant’s share of the wealth generated over the past decade. This is evident from the refusal of Chinese authorities to release the Gini Coefficient (a measure of economic inequality) for the last 11 years. Such lopsided distribution of rewards from growth ensures that domestic consumption cannot supplant export demand any time soon. 

Thus as export demand cools, the Chinese economy must either embark on a fresh investment stimulus and create an even more imbalanced economy or reduce imports used in manufacturing export goods. The former has not been forthcoming in any appreciable magnitude so far despite hopium-based belief. The latter implies a lower rate of growth not just for China but its suppliers. It also implies lower commodity prices and deterioration of the manufacturing sector. Recent data from economies of Asian neighbours, heavily dependent on the continued march of the Chinese juggernaut, does provide evidence of this slowdown. Table 1 below, shows the recent economic deterioration in the context of the nation’s dependence on China as an export market.

Table 1: Economic deterioration in economies linked to China
Chinese dependence
· Manufacturing PMIs signalling contraction and “Firms signalled that demand from US, European and Chinese markets weakened.” [Emphasis mine]
Exports to China: 27% of total exports; 41% including HK; approx. 30% of GDP
South Korea
·   Q2 GDP grew 2.4% annualised (a two-year low)
· Manufacturing PMIs signalling contraction and “New orders declined at the fastest pace since December 2011. Moreover, new export business decreased for the second successive month amid reports of a downturn in the international economic climate.” [Emphasis mine]
Exports to China: 28% of total exports (Biggest export partner)
· Manufacturing PMIs signalling contraction and “Japanese manufacturing production declined for a second successive month in July, and at an accelerated rate. The overall reduction in factory output reflected lower levels of incoming new business, according to survey respondents. The pace of reduction in new work was solid, and the steepest since April 2011. New export orders also decreased in July, for the fourth month running, with the rate of reduction the fastest in 15 months. Companies mentioned demand weakness in China, Europe and the United States.” [Emphasis mine]
Exports to China: 19% of total exports (Biggest export partner)
·   Q2 GDP fell 1.1% annualised

The PMI charts are given below.

Graph 1: Taiwan
Source: HSBC, Markit

Graph 2: South Korea
Source: HSBC, Markit

Graph 3: Japan
Source: Cabinet Office, Markit, JMMA

Looking at commodity prices, these also seem to indicate that the great Chinese resource grab is coming to an end. Both copper and oil show a declining trend (Graphs 4 & 5) while coal and iron-ore have plunged to 2½ year lows. 

Graph 4: Brent crude
Source: FT

Graph 5: Copper
Source: FT

Whether a Chinese slowdown turns into a meltdown is open to question. However, it is likely to persist before any recovery occurs. The sharp turnaround in 2009 was because of the combined bank bailout and monetary easing in the US and Europe along with Chinese stimulus. At this juncture if China acts (a big if) then it is likely to be alone and thus the impact will consequently be more muted. This implies further falls in commodities notably copper of which the Chinese have built a gargantuan inventory and which has not fallen in line with the bleak demand picture. 

It also implies a shock to the Australian commodity boom. China is the largest export partner for Australia accounting for 25% of total exports. As an example of Australia’s commodity dependence, 41% of the world’s iron-ore exports are from Australia and it is also home to 57% of the new production coming online. Interestingly new investment has been made assuming a worst-case price of $110 per tonne which is in danger of being breached. A shock to the Aussie economy and consequent RBA cuts are likely to lead to a fall in the Aussie Dollar (AUD). At the moment it is riding high due to the twin advantages of higher yield and perceived safety from the debt detonation of the Eurozone and currency debasement of Ben Bernanke. As yield differentials vanish and safety proves illusory, flows could reverse leading to a sharp drop.

On a micro level, mining and commodity stocks (Rio, BHP) might take a further hit. In addition banks exposed to Asia (HSBC, StanC) might see the souring economy feeding into their balance sheets as the stellar performance of Asian units reverts to mean.  

As the Eurozone differs and dithers into oblivion, China is likely to be the unwitting recipient of the power to dictate global markets and policymakers. Ironic.

Disclaimer: All ideas elucidated above should not be taken as investment recommendations. The reader should perform his/her own analysis before making any investments. 

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