Within the process of managing portfolios and funds, we use fundamental research, technical analysis, asset class valuations and global liquidity analysis to formulate our view of capital markets and adjust our portfolios to reflect that view. To help us do this, we subscribe to external global research from CrossBorder Capital (CBC) and Gavekal Research (Gavekal). Today I want to share a short synopsis of how these two research companies view liquidity and the fundamentals in China.
Liquidity Conditions in China
CBC measured global liquidity conditions and produced their most recent view in the chart below.
It is clear that global liquidity conditions have deteriorated recently and China’s liquidity slide is creating concern. CBC reports that:
- The People’s Bank of China has fallen seriously ‘behind the curve’ in its monetary accommodation (index 41.7) and looks to be falling more in-line with the US Federal Reserve’s ‘silent tightening’.
- Cross-border financial flows continue to impact China as CBC estimate a whopping net US$140 billion quit China in August alone. Even though this may only be a small percentage of the estimated US$3.6 trillion Chinese forex reserves, China cannot keep this pace up.
- Private sector cash flow generation is also lurching downwards, hitting new index lows in July and August, indicating an ever-weakening real economy.
A Fundamental approach from Gavekal Dragonomics
Gavekal’s research team measures China’s GDP growth according to their in-house GDP Deflator process and two other alternate measures, to challenge the statistical headline reports on GDP growth.
Gavekal communicated a few ‘take-away’ thoughts on their most recent conclusions on China’s GDP growth:
- All three alternate approaches show a more volatile growth trajectory over time, and slower growth recently, than the headline GDP numbers.
- Their GDP deflator also indicates that the gap between Headline Real GDP growth number and the three alternate approaches is no more than a single percentage point most of the time.
- Gavekal’s analysis concludes with their longstanding thesis, that the primary bias in the Chinese statistical system is not to overstate growth, but to understate volatility.
Gavekal also discuss the “two Chinas” phenomenon – the widening disparity between different regions – which is a result of the rebalancing of the Chinese economy, away from investment / heavy industry to consumption / services, and regional disparity in growth is widening. The year-on-year percentage mean GDP growth change for the top six provinces averages 18%, whilst the bottom five provinces saw 0% growth.
Growth disparity is the key to understanding the downside risks in China, according to Gavekal. The risk of corporate bankruptcies and financial distress is not determined by the average growth rate across the country, but by the worst cases – and the worst cases are already suffering grievously.
While they do not see a significant risk of a systemic financial crisis, there is a high likelihood of localized fiscal and financial problems in the more distressed parts of the country.
The end of the housing boom and a declining population in China suggests that it will be difficult for northern China to recover quickly by transforming its growth model. If growth stays weak, local banks will have to recognize more non-performing loans in the next couple of years, further threatening financial stability. Some regional banks will most likely need to be recapitalized. More fiscal transfers from the central government will also be necessary for these provinces to cope with higher unemployment and the associated social problems.
So what can we expect, to counter the liquidity and fundamental challenges in China? CBC concludes that, to address liquidity and the fundamental challenges, we should expect a Chinese ‘QE’ solution – dubbed as ‘CE’; maybe a further 5-10% weakening in the RMB this year; spreading Asian inflation; Western deflation and wild swings in the US Treasury market.
We are certainly monitoring the multitude of messages we read from all our indicators, but nowadays one can easily find reasons to be bearish or bullish on global capital markets and we certainly think it is not wise to ‘bet the farm’ either way!
Two Measures on China - MitonOptimal Group Weekly Comment - Week 39, 2015
