China - No Hard Landing (Rise of the Dragon)

This article is to be published by the Boston College Finance Magazine - 2013 Edition

Originally Dated: Mar 07, 2013 by Debashis Das

Introduction

After falling for more than two years, China’s economic growth picked up steam to register a GDP growth of 7.9 percent in quarter four 2012, compared to a year earlier. HSBC Markit Purchasing Managers Index (PMI), a widely followed and important China macroeconomic metric, registered better-than-expected values for both December 2012 and January 2013. Other indicators, including higher electricity consumption, steel production and demand for crude oil, support this uptrend in China’s economy. China is the world’s biggest consumer of iron-ore and copper, and its rising prices in the world market suggests a strengthening Chinese economy. The global macro environment continues to struggle with the European Union (EU) going through near recessionary conditions and the United States registering a barely 1.5-2 percent annual growth rate. U.S. GDP had a contraction of 0.1 percent in Q4 2012 based on preliminary Q4 GDP data from end of January 2013, which was then revised up by 0.1 percent growth for Q4 2012 based on data from end of Feb 2013. The BRIC (Brazil, Russia, India and China) emerging market countries are struggling to live up to their expectations of either double-digit or high-single-digit growth but based on the macroeconomic data from the last couple of months it seems that China has turned the corner and is trying to make a comeback. Economists and analysts who planned to write off China earlier and declared a ‘hard landing’ (a substantial slowdown in economic growth) at the PRC (People’s Republic of China) should take a closer look at the recent economic data out of the country and rethink their strategy.

The economic data and numbers referenced in this article are from the same sources (primarily the People’s Bank of China and the National Bureau of Statistics of China) which are referenced by the financial world. Also it needs to be noted that some of the economic data around Jan. and Feb. tends to be a bit skewed due to the Lunar New Year effect when economic activity tends to be high compared to the rest of the year.

China Economic Indicators – GDP Growth, HSBC Markit PMI

Recent macroeconomic data out of China depicts positive trends. China’s economy rebounded to register a GDP growth of 7.9 percent in Q4 2012 from a year earlier, after decelerating for more than two years and above polled analysts’ estimates of 7.8 percent. For the full year 2012 China registered a GDP growth of 7.8 percent down from 9.3 percent growth in 2011. The Chinese economy has slowed for the last few years due to various factors but primarily due to slowdown of the global economy, which has curbed the demand for its products abroad. After the financial crisis, China’s GDP growth reached a peak of 12.1 percent in Q1 2010 as shown in Figure 1, fueled not only by easy money policy and massive stimulus package by the People’s Bank of China (PBC) but also due to rebuild and repair which was going on in the global economy after a recession. Being the world’s second-largest economy, China’s GDP numbers are widely monitored and followed in the investment community. China is also the center of a lot of estimation and speculation, and China’s GDP numbers moves the global equity and currency markets as well as commodity prices. Beijing had set a targeted growth rate of 7.5 percent for 2012 and 2013, and the new incoming leadership for the next decade of Xi Jinping and Li Keqiang will try to ensure that future growth is in line with those set targets or exceed targets. Other data points, which are not widely followed but also used, include railway freight data and electricity consumption. Both of which have seen positive trends, as depicted in Figure 1. According to the new Premier Li Keqiang, both electricity consumption and railway freight are better indicators of growth than GDP data.

Figure 1. China GDP growth and other economic indicators

Source: Wall Street Journal[1]

HSBC Markit China Manufacturing Purchasing Managers’ Index ^TM (PMI^TM) is another critical indicator which the global investing community looks forward to at the beginning of every month for the prior month’s manufacturing activity in China. In January 2013, the HSBC Markit China PMI index recorded a value of 52.3, up from 51.5 in December 2012 as shown in Figure 2, signaling robust growth in the manufacturing sector and support the boost in the GDP growth. Value above 50 indicates continued strength or expansion in the manufacturing sector, and a value below 50 indicates contraction or recessionary conditions. January marked the third month of growth in the China manufacturing sector, including production and new export orders. The average reading for Q4 2012 was 50.5. That is the strongest since 2011 and above the low average reading of 48.3 from Q3 2012, marking the turnaround for both the PMI as well as the closely correlated GDP growth, which is clearly evident from the plot of PMI and Gross Domestic Product in Figure 2. This plot also depicts the sharp contraction in the PMI measure as well as the GDP growth around Q1 of 2009 due to the financial crisis of 2008-2009.

 

Figure 2. HSBC China Manufacturing PMI and PMI versus GDP plotted against time

Source: Markit [2]^,[3]

Commodity Prices – Iron Ore, Copper and Crude Oil

China’s industrial sector and its robust growth are main contributors of demand for commodities including iron ore, copper and crude oil, of which China is the biggest consumer. China demand drives the global prices of metals including copper, steel and commodities like iron ore and coal. This demand in commodities is not only driven by the country’s growing housing sector but also numerous infrastructure projects that the government has undertaken since the crisis of 2008-2009. China sources its commodities mostly from mining and materials rich Australia and Brazil, where most of the giant global miners, like BHP Billiton, Rio Tinto, Xstrata and Vale SA, are based. Prices for these commodities and metals have rebounded in the last few months, signaling the rebound currently going through the Chinese economy.

The iron and steel industry in China is one of the most important and basic industries, and it plays a critical role not only in the country’s economic development but also globally. The growth of the iron and steel industry has kept pace with the rapid industrialization and urbanization in China that led to the development of the economy. Domestic steel consumption, after reaching a peak of 24.6 percent growth, has since come down to around 9 percent annual growth for the last two years due to slowdown in steel-consuming businesses, such as real estate, automobiles, machinery, and household appliances. Demand for steel has fallen for the last few years due to slowdown not only in the domestic economy but also in the global economy worldwide, which has dented demand for Chinese products in the foreign markets.

Iron ore prices are a key indicator of the Chinese domestic demand for steel and its economic condition. Iron ore prices (benchmark iron ore with 62 percent iron content) have jumped 25 percent in December and around 3 percent in January and have come a long way up from the $100 level reached last year. Steel prices in China have stayed high amidst hopes that construction and manufacturing will pick up after the Chinese New Year holiday and is acting as a floor below the iron-ore prices. China is also the biggest consumer of steel-reinforcement bar (rebar) and the rebar futures contract for delivery in May 2013 was priced recently at 4144 yuan ($665), ^[4] which is its highest level since June 2012.

China accounts for 40 percent of global copper demand and is the biggest global consumer of copper. Copper prices were hit hard middle of last year due to economic concerns about a potential hard landing, which China has been able to avoid so far. Copper prices shown in Figure 3 for COMEX Copper Futures, May 2013, have been climbing fueled by the demand, restocking and recovering economic conditions from China, based on positive economic data for the last few months.

Figure 3. COMEX Copper (Cu) Futures (May 2013) Price

China is the world’s second largest global oil consumer and crude oil is the largest component of its import. China’s crude-oil imports for 2012 recorded a growth of 6.8 percent, which was better than 6.1 percent of 2011 but lower than 2010 before a slowdown in the domestic economy ensued. With an expanding economy fueled by urbanization and more and more people moving up in their socio-economic status the demand for imported crude oil will continue to rise and provide a good barometer to the health of the overall Chinese economy.

China Retail Sales

With the global slowdown affecting major economies like the European Union (EU) and United States, China needs to be more self-dependent on its increasing middle-class population, migrating to bigger cities and spending more to stimulate the economy forward through internal consumption. Household consumption drives 70 percent of GDP in the United States whereas in China it is around 35 percent. One large part of that percentage is retail sales, one of China’s key growth drivers. Retail sales hit 15.2 percent in Dec 2012 compared to the same month in the previous year as reported by the National Bureau of Statistics (NBS) of China and depicted in Figure 4. NBS has started publishing the month-on-month growth data from 2011 onwards, also represented in Figure 4. Trends from both YoY and MoM retail sales shows that consumers and businesses are more confident in their spending habits, which is critical to sustaining positive economic development.

Figure 4. China Retail Sales (MoM, YoY)

Source: www.tradingeconomics.com[5]

China Trade – Exports, Imports & Trade Surplus

The monthly export data from China is not only a gauge of the Chinese domestic economy but also of the global economic demand and growth. China is the world’s largest exporter having overtaken second-place Germany in 2009. Low cost of labor and land for years have helped China’s exporters keep the prices of their products down as compared to the rest of the world aided by an undervalued yuan (RMB). Strong export numbers is positive both for the domestic markets as well as for the global equities markets, as analysts, economists and others watch the numbers closely to monitor the growth story in China as well as for the rest of the world. Similarly strong import numbers signal big demand for commodities like iron ore, copper, and oil, of which China is their biggest importer. Also, there are often big price movements based on these numbers.

Exports climbed 25 percent in January 2013 after a 14.1 percent rise in December 2012, while imports rose 28.8 percent in January 2013 ahead of the 6 percent increase from December 2012 and both were better than the estimates. The trade surplus was slightly lower at $29.2 billion in January 2013, from $31.6 billion in December and $19.6 billion in November.[6] The data could be impacted by seasonal distortion due to the Chinese Lunar New Year, which falls this year in February as compared to January last year. Nonetheless, it shows robust growth and a sustainable economic momentum. Looking deeper into the recent exports data, trends like exports to U.S. and the E.U. shows signs of improvement and positive growth which is healthy for the Chinese economy.

Figure 5. China Trade Surplus/Deficit data for FY 2012

Consumer Price Index (CPI) – Measure of Inflation

After falling for close to a year the Consumer Price Index, a key measure of inflation climbed back again in December by 2.5 percent YoY, as shown in Figure 6 for Consumer Prices month-on-month and year-on-year comparisons and in the China Inflation Rate graph as well, which has the year-on-year change. Food is a key part of the CPI basket and food prices went up by 4.2 percent and were the biggest contributor while non-food prices went up by only 1.7 percent. Higher consumer prices lowers the purchasing power of households, and as the rising middle class families spent a lot of their income earnings on food, higher food prices can be a cause of social unrest and is closely monitored by the central think-tank in Beijing. Post financial crisis in middle of 2011 the inflation levels went up (6-6.5 percent, food inflation of ~15 percent), close to the levels of 2007 of double-digit food inflation shown in Figure 7. Unlike the European Central Bank (ECB), which closely monitors the inflation rate (2 percent target), or the Federal Reserve Bank, the People’s Bank of China does not have a formal inflation target, although Premier Wen Jiabao had targeted inflation rates of 3.5% percent for 2013. The government had to increase the interest rates in the past to fight the inflation, which has since cooled to manageable levels. Increase in inflation also arrest economic development and negatively affects commodity prices. Hence, there is a keen eye always on China inflation numbers to make sure that the growth story is not derailed by inflationary conditions and so far it has held pretty well.

Figure 6. Consumer Price Index – Month-On-Month and Year-On-Year comparisons

Source: www.stats.gov.cn/english[7]

Figure 7. China Consumer Price Index (CPI) & Food Prices comparison

     Source: The Wall Street Journal [8]

China Monetary and Economic Policy Analysis

The People’s Bank of China (PBC) is the central bank, and similar to United States’ Federal Reserve Bank (‘Fed’) it conducts various open market operations to maintain and boost liquidity in the banking system. It also promotes credit and lending to small businesses, farmers and for agricultural purposes in the rural areas, government projects and various other reasons. One such open market operation is the cut in the reserve requirement ratio (called the ‘RRR’) to boost liquidity so that easy lending can occur and the PBC has done that few times during 2012, following a 0.5 percent cut in December 2011. It needs to be noted that a raise in the RRR would produce an opposite effect by absorbing the liquidity from the system. The first RRR cut last year of 0.5 percent was in February 2012 followed by another 0.5 percent cut in May 2012 to ensure adequate liquidity in the system. Another operation that PBC undertook was to cut the benchmark deposit and lending rates successively on June 8 and July 6^, 2012.[9] Upon completion of this operation, the one-year benchmark deposit rate was lowered to 3.00 percent and the one-year lending rate was lowered to 6.00 percent. Additionally, PBC adjusted the floating bands of deposit and lending rates. The upper ceiling of deposit rate was raised and the floor of the lending rate was lowered to promote borrowing by lowering the cost of borrowing for companies.

Chinese government announced a massive stimulus package of 1 trillion yuan ($156 billion) on Sep. 7, 2012, after the economy cooled to around 7.6 percent GDP growth for Q2 2012. The stimulus package consists of plans to build highways, waterways, urban rail and subway projects, and waste-water treatment plants to stimulate growth and prevent a halt in the economic expansion. Although this package is much smaller than the 4 trillion yuan ($631 billion) which was injected into the economy between 2009 and 2010, both the infrastructure spending stimulus and the open market operations point to the fact that PBC is ready to take action whenever necessary to promote and inject liquidity in the system, thereby boosting the overall domestic economy.

China Equity Market Analysis

A comparison of the Shanghai Stock Exchange Composite Index [Bloomberg Index: SHCOMP, Figure 8] (from mainland China) and Hang Seng Index [Bloomberg Index: HSI, Figure 9] (from Hong Kong), both of which are good representative of the China equity markets, is presented along with their short term (20-day), medium term (50-day) and long term (100-day) simple moving averages (MA) for the last year. Both the charts paint a bullish picture of the current state of the Chinese stock markets. The SHCOMP index has been moving gradually up from the lows of November end. All retracements until now for this index have bounced from the short term 20-day moving average, which is very bullish. Similarly the HSI index has been moving up steadily from early June and all retracements until now have bounced from the 50-day moving average, which is also overall very bullish. Looking at the longer term (five years) trends in the Chinese equity markets, it can be seen that the market descent that began around August 2009 [Bloomberg Index: SHCOMP, Figure 10] and ended around end of November 2012 may have played out and the markets are ready to move up and in the process of doing that currently. This is also positively confirmed from the long term (five years) chart of the closely related HSI index [Bloomberg Index: HSI, Figure 11].

Figure 8. Shanghai Stock Exchange Composite Index performance chart for 1yr. □ – 20 day SMA □ – 50 day SMA □ – 100 day SMA

Figure 9. Hang Seng Index performance chart for 1yr.  □ – 20 day SMA □ – 50 day SMA □ – 100 day SMA

Figure 10. Shanghai Stock Exchange Composite Index performance chart for 5 yr

Figure 11. Hang Seng Index performance chart for 5 yr

Conclusion

The macroeconomic data from the month of January and initial data from February continues to be impressive pointing to the fact that there are further gains stored in the Chinese equity markets ahead in 2013. After an almost 43 percent correction in the Shanghai Stock Exchange Composite Index (Bloomberg Index: SHCOMP) from August 2009 to November 2012, Chinese financial markets have shot back up around 23 percent from December 2012 to mid-February and continue to be one of the global equity market leaders in 2013. According to the words of Jim O’Neill, from Goldman Sachs Asset Management (GSAM), who continues to be optimistic on China even after a decade when he first published his views on the BRIC economies, “While so many people still always seem to be looking for the worse in China, and so many believe that you can’t make money out of the story even if the economy continues to steam along, I find it amongst the more stable things to think about.” [10]

On Sep. 17, 2012, China released its 12^th five-year plan for financial sector development and reform. This plan is going to herald a new phase in the growth of China with the country moving from export and investment led growth to more of an internal consumption-based growth driven by the 1.3 billion Chinese consumers. As global growth across most of the major economies slows, China is focusing more inwards to fuel its next phase of growth. Premier Wen Jiabao in his final report to the congress said, “We should unswervingly take expanding domestic demand as our long-term strategy for domestic development,”[11] stressing the importance of China to drive its growth based on the demand from its domestic consumption. The 12^th five-year plan with its emphasis in boosting employment, raising wages and promoting more spending – as compared to saving – will help to continue support the growth trajectory. This is also supported by the fact that there is a huge migration going on in China, with people moving from rural to urban areas with income in urban areas more than three times that of rural areas.       

Downside risks still exist in the Chinese economy, with inflation alone having the potential to stall the growth. Inflation has been identified as one of the top 10 major issues that must to be addressed in the years ahead as part of the 12^th five-year plan. If inflation starts picking up beyond a threshold, China needs to enact more monetary tightening policies and higher interest rates to fight the inflation. Rising wages may also have some effect. Although rising wages is seen beneficial in terms of driving more internal consumption based growth, but in the global markets it dampens the demand for Chinese manufactured goods. The hukou – which is China’s system of resident permits – is a big obstacle to raising incomes and driving consumption. Some of the cities are trying different measures to overhaul this old system so that approximately 200 million rural migrant workers can settle in the city they work and have access to social benefits, including education in public schools for their children.

Property prices in China have also been a major cause of headache amongst many, including China’s leadership. After staying flat for a while, property prices in major Chinese cities have started climbing again. Property prices in Shanghai were up 41 percent from a year earlier for the first two months of this year, according to the data from real-estate agency Soufun.[12]  China’s leadership has tried different tightening measures in the past to ensure less participation of speculators in its bubbly property market, but at the same time ensuring affordability for the middle class. In its latest attempt policy makers have proposed implementation of a 20 percent capital gains tax on profits from sales of homes. Additionally it is planning to implement measures including increasing down payment requirement and higher mortgage rates by banks that would make it difficult for second-home buyers to participate and speculate in the real estate market. All of these have the potential to dampen the domestic growth scenario.       

Although we are far from the double-digit annual growth that was normal in the last couple of decades, it is evident that the new regime in China would not allow the hard landing (GDP growth below 5 percent), which many in the world have feared. The new normal growth will be around the 7-8 percent range to avoid a slowdown or hard landing and China is going to make sure through their various economic and monetary policies that it stays around that level with the country moving towards more consumption led growth as opposed to previously investment led growth.

Notes

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[1] Tom Orlik, “Charting China’s Economy: The Fourth Quarter”, The Wall Street Journal, January 18, 2013.

[2] HSBC China Manufacturing PMI, February 1, 2013: http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=10652 (accessed March 31, 2013)

[3] Manufacturing PMI starts 2013 on two-year high, January 24, 2013: http://www.markit.com

[4] “Rebar Climbs to Seven-Month High as China Manufacturing Expands,” January 31, 2013: http://www.bloomberg.com/news/2013-02-01/rebar-climbs-to-seven-month-high-as-china-manufacturing-expands.html (accessed March 31, 2013)

[5] China Retail Sales. http://www.tradingeconomics.com/ (accessed March 31, 2013)

[6] Aaron Back, “China Exports Elevates Trade Surplus”, The Wall Street Journal, January 10, 2013.

[7] National Bureau of Statistics of China: www.stats.gov.cn/english (accessed March 31, 2013)

[8] Tom Orlik, “Charting China’s Economy,” The Wall Street Journal, January 18, 2013.

[9] China Monetary Policy Report, Quarter Two: http://www.pbc.gov.cn/publish/english/3667/index.html , 10 (accessed March 31, 2013)

[10] Goldman Sachs Asset Management (GSAM), “Viewpoints from Chairman Jim O’Neill”, February 11, 2013: http://www.goldmansachs.com/gsam/worldwide/index.html (accessed March 31, 2013)

[11] Tom Orlik, Bob Davis and Esther Fung, “China Moves to Temper Growth – Property Bubble Is a Key Concern,” The Wall Street Journal, March 5, 2013

[12] Ibid.