What happens if China goes pop? || Macrobusiness

Reproduced with kind permission of David Llewellyn-Smith at Macrobusiness.

Pop

Yesterday, the falling terms of trade prompted a couple of readers to ask for a description of the process of a China bust for Australia (if it were to happen). As well, there was a grossly limited effort to do so at the AFR using the same old dial-a-quote economists, so I thought I’d better bring some balance this morning.

To make sense of the question of what happens in the event of a China accident, you first have to define the pop. I offer three scenarios below.

1. Cyclical crash

This week Glenn Stevens dedicated an entire speech to the argument that Australia could sail through a cyclical China crunch relatively unscathed. I agree, more or less. A brief but deep cyclical downturn in China is manageable. I expect authorities would simply replay a more modest version the 2008/9 stimulus as mines closed, borrowing and consumption fell and unemployment rose.

The key, of course, would be house prices. In the AFR article yesterday, most of the focus was on interest rate cuts preventing rising unemployment from hitting asset values and creating a negative feedback loop. That’s happy-go-lucky drivel in my view. There is no scenario in which a serious China slowdown would not increase bank funding costs. And as the banks increased spreads to the cash rate to preserve profits, the efficacy of rate cuts would decline. At best I reckon the RBA could muscle mortgage rates down to 5%, only 1% down from today. That’s some nice relief but pales next to the relative relief provided in 2008 when mortgage rates fell over 3%.

That means we’d have to see another First home Buyer’s Grant to keep house prices up. The evidence from many recent state programs is that such would still work to entice the vulnerable into supporting the rich. It wouldn’t work as well as 2009 but well enough. The mini-me fiscal spending package would probably be in the vicinity of $30 billion with deficits for three years culminating in a near doubling of the Federal debt stock.

One year out from the bust and unemployment is in the the 7 to 7.5% range.

The real issue is what happens next and that’s where we come back to defining exactly what kind of Chinese bust we’re talking about. If Chinese fixed asset investment growth rebounds in a v-shaped recovery its all hunky dory once more. The real fear is of a structural shift in the Chinese growth model.

2. Structural shift in Chinese growth

It is widely accepted (outside of Australia) that the dependence of Chinese growth on fixed asset investment which drives the commodities boom is unsustainable and, indeed, risks a major and enduring debt crisis ala Japan. There is a quite good feature on this at the AFR today that probably draws upon yesterday’s exceptional debate at MB. It would be nice to receive some acknowledgement but the point of the blog is to prod the MSM into action so I won’t complain (too much!) Back to the subject at hand, it was on the question of Chinese structural adjustment that this week’s IMF report on China made Glenn Stevens speech look like a cheap sales pitch.

Obviously, if we know this so do the Chinese. Michael Pettis thinks that China has begun the process of shifting its growth model towards one of internal consumption. And there are reasons to think so. The local and international risks of not doing so are rapidly becoming larger than doing it. And consider, to date we have seen more weakness than consensus expected in Chinese growth yet much slower monetary stimulus as well. As Michael Pettis describes, not cutting interest rates is a key plank in Chinese rebalancing:

Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.

Of course the process will not be easy. Debt levels have risen so quickly that unless many years of overinvestment are quickly reversed China will face debt problems, and maybe even a debt crisis. The sooner China starts the rebalancing process, in other words, the less painful it will be, but one way or the other it is going to be painful and there are many in China who are going to argue that the rebalancing process must be postponed. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.

The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates.

But these measures will necessarily slow growth. The financial repression tax, especially, is both the major cause of China’s economic imbalance and the major source of China’s spectacular growth, even though in recent years much of this growth has been generated by unnecessary and wasted investment. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.

We have also seen a moderate refilling of the infrastructure pipeline and a weakening in the yuan. This could be interpreted as a three-pronged attempt to support the economy with a modicum of fixed asset investment and modicum of external demand boost as a greater role for consumption drivers is grown. If so, there will not be another large infrastructure stimulus package and if it comes can be seen as a sign of panic.

So, if this scenario were the one we faced what’s the outcome? It means no cyclical bust in China. Rather it means a managed transition over the next cycle (barring external shocks). It also means iron ore, coal prices and other minerals down some 30-40% within several years, which is where they’d probably settle for good, all things being equal.

This is a very different kind of shock for Australia. If it were to transpire beginning now, the following is my guess at the outcome.

Some time in the next twelve months, mining capex spending peaks and start detracting from growth. The decline is gradual because the big LNG projects are advanced and proceed. But iron ore, coal and other industrial commodities face big busts. The large capex plans of the mineral miners are consigned to history.

Big mining and associated industries begin to shed labour and do so in fits and starts over the next two years. The bust in speculative miners is bigger and faster. Wage pressures ease and income growth contracts. Unemployment grinds higher across the country. Interest rates fall steadily to 2% and mortgage rates to 5%. The Australian Budget never sees a surplus but its efforts to try, enforced by the ratings agencies’s stated need to see a surplus over the cycle, put more pressure on employment. House prices are supported initially by rate cuts but continue to fall in the slow melt unless Melbournians or the negatively geared more widely wake up in a rush. At some point the dollar regains its mojo, maybe on a warning from ratings agencies, and tumbles. The long disdained non-commodity exports of manufacturing and tourism rebound but export earnings still decline significantly as commodity price falls easily outpace volume growth and the old export industries recover only slowly having been “adjusted” in the previous cycle. Productivity leaps as labour hoarding unwinds, as mineral resource projects reach the export phase and as low margin mines close all over. The current account deficit blows out to 6% on a growing trade deficit, driven by LNG spending and some uptick in dwelling construction. Funding pressures remain for banks as markets burst their “Australia bubble”. These pressures are manageable so long as nobody in the falling housing market panics.

The ASX benefits at the margin as the dollar falls. Profits are helped too by the new productivity boom. Stocks are also aided by the global rebalancing that is being driven by China’s rising imports from the US and EU, which boosts markets via a price-earnings multiple expansion on falling imbalances risk. But falling earnings for the ASX8 retard its progress. On balance, it goes sideways.

We face a tough five years as asset prices, income and wages deflate and unemployment rises into the 8+% range. Government debt balloons above 50% of GDP on infrastructure spending and automatic stabilisers. The AAA rating is a distant memory.

Beyond that, export earnings begin to grow again as the big LNG projects come on line, food exports power on and Australia finds itself once again somewhat wage competitive. In seven years we find a new equilibrium with the dollar at 60 cents. A current account deficit of 3%, a housing market that is still expensive but 30% lower in real terms than today. A debt-t0-GDP ratio roughly where it is but with a proportionately lower ratio of household debt and higher ratio of public debt. In effect Australian standards of living haven’t improved in over a decade but we’re more secure.

3. Throw in a housing panic

Obviously all of that assumes no external bust, which we covered I guess, nor an internal one, driven by a housing panic. In that event it all happens a more quickly, the stats get worse, and it involves the nationalisation of the lenders mortgage insurance industry whose ludicrously low capital levels are exposed by a wave of new bank claims. The LMIs are blamed for the housing bubble (with some justification) and characterised as a failed privatisation. Don’t forget that Genworth’s business was originally government owned.

The nationalised LMIs funnel a backdoor bailout to the banks and prevent their balance sheets from imploding, though they will join their international zombie brethren. That ensures the bust rolls on for a long period. It might be shortened if the banks are bought and recapitalised by the Chinese. But what are the odds of that being allowed by Prime Minister Abbott?

Do I think any of these will happen? Dunno. But China must rebalance, either in control or through crisis, sooner or later.

via What happens if China goes pop? | | MacroBusiness.

Hong Kong & China

The Hang Seng dropped 3 percent Monday, testing medium-term support at 19000. Failure of support would warn of a decline to 16000*. 63-Day Twiggs Momentum below zero already suggests a primary down-trend. Breach of primary support at 18000 would confirm.

Hang Seng Index

* Target calculation: 18000 – ( 20000 – 18000 ) = 16000

With the Shanghai Composite in a primary down-trend, all we need is for the Shenzhen Index to break support at 880 to complete the trifecta. A peak below zero on 63-day Twiggs Momentum already warns of a primary down-trend.

Shenzhen Composite Index

* Target calculation: 900 – ( 1000 – 900 ) = 800

Asia: China, Japan bearish

Japan’s Nikkei 225 index is headed for another test of long-term support at 8000/8200 on the monthly chart. The latest peak below zero on 13-week Twiggs Money Flow warns of strong selling pressure. Failure of support would signal another test of the 2008/2009 lows at 7000.

Nikkei 225 Index

China’s Shanghai Composite Index is testing its 2011 low at 2150 on the weekly chart. Failure would indicate a decline to 1800*. 63-Day Twiggs Momentum below zero continues to warn of a primary down-trend. Recovery above 2250 remains unlikely, but would suggest another rally to 2500.

Shanghai Composite Index

* Target calculation: 2150 – ( 2500 – 2150 ) = 1800

India’s Sensex is retracing to test support on the weekly chart. Respect of 17000 would indicate a rally to 18500, but 63-day Twiggs Momentum oscillating in a narrow range around zero suggests a ranging market and another test of primary support at 15800/16000 remains as likely.

Sensex Index

Singapore’s Straits Times Index is testing resistance at 3040. Recovery of 63-day Twiggs Momentum above zero suggests that the primary up-trend is intact, and breakout would signal an advance to 3300*, but a ranging market is more likely.

Singapore Straits Times Index

* Target calculation: 3000 + ( 3000 – 2700 ) = 3300

Asia: India bullish while China, Japan bearish

Japan’s Nikkei 225 index formed a peak below zero on 13-week Twiggs Money Flow, indicating strong selling pressure. Failure of primary support at 8200 would signal another test of the 2008/2009 lows at 7000.

Nikkei 225 Index

China’s Shanghai Composite Index is testing its 2011 low of 2150 after breaking  primary support at 2250. Breach of the new support level would indicate a decline to 1800*. Reversal of 13-week Twiggs Money Flow below zero would strengthen the bear signal. Recovery above 2250 is unlikely, but would suggest another rally to 2500.

Shanghai Composite Index

* Target calculation: 2150 – ( 2500 – 2150 ) = 1800

India’s Sensex: Bullish divergence on 13-week Twiggs Money Flow indicates reversal to a primary up-trend; a trough above the zero line would signal strong buying pressure. Respect of support at 17000 by the latest retracement would indicate a rally to 18500, while breakout above 18500 would confirm the primary up-trend.

Sensex Index

* Target calculation: 18500 + ( 18500 – 16000 ) = 21000

Singapore’s Straits Times Index is testing resistance at 3030. Recovery of 63-day Twiggs Momentum above zero suggests that the primary up-trend is intact. Breakout above 3030 would signal a primary advance to 3300*.

Singapore Straits Times Index

* Target calculation: 3000 + ( 3000 – 2700 ) = 3300

Labor Shortage May Help China Adjust to Slower Growth – WSJ.com

Reflecting the tight labor market, wage income for urban households rose 13% year-on-year in the first half, and average monthly income for migrant workers rose 14.9%, according to data from China’s National Bureau of Statistics…… At current rates, China’s private-sector manufacturing wages will double from their 2011 levels by 2015, and triple by 2017, eroding competitiveness and denting the exports that have played a key part in China’s early growth.

via Labor Shortage May Help China Adjust to Slower Growth – WSJ.com.

Comment:~ It makes you question official inflation figures of just 2.2 percent when wage increases are significantly higher.

Is China sliding towards deflation? | beyondbrics

Robert Cookson: Chinese policy makers spend a lot of their time worrying about inflation. But the growing risk now appears to be deflation….

The PPI index has already turned negative [and] year-on-year growth in money supply has plunged to a level that in the past been consistent with CPI of between zero and 1 per cent…..

via Is China sliding towards deflation? | beyondbrics.

Asian markets: India bullish while China weakens

Japan’s Nikkei 225 index is testing medium-term resistance at 9000/9100. Breakout would test 10000. Troughs below zero on 13-week Twiggs Money Flow indicate weakness.

Nikkei 225 Index

China’s Shanghai Composite Index is retracing to test resistance at 2250. Respect would confirm a primary down-trend — already signaled by 63-day Twiggs Momentum below zero.

Shanghai Composite Index

* Target calculation: 2250 – ( 2500 – 2250 ) = 2000

Wait for confirmation from a Shenzhen Composite index reversal below 880/900. A 63-day Twiggs Momentum peak below zero would strengthen the signal.

Shenzhen Composite Index

Singapore Straits Times Index broke through medium-term resistance at 2900, headed for a test of 3050. Recovery of 63-day Twiggs Momentum above zero suggests that the primary up-trend is intact.

Singapore Straits Times Index

* Target calculation: 3050 + ( 3050 – 2900 ) = 3200

India’s Sensex displays a healthy bullish divergence on 13-week Twiggs Money Flow, indicating reversal to a primary up-trend. Breakout above 17000 suggests another test of 18500. And breach of 18500 would confirm the primary up-trend.

Sensex Index

* Target calculation: 18500 + ( 18500 – 16000 ) = 21000

China’s failed gamble for growth

Zarathustra: The idea of this gamble is simple. With the financial crisis in 2008 hitting the developed world, it naturally affected external demand. The Chinese knew these. At the end of 2007, trade surplus accounted for more than 7.5% of GDP. Currently, the same number is at its low single digit, probably 2% or so. No longer is China’s growth driven by trade. It is now driven largely by domestic demand.

And this is where the gamble lies. The massive stimulus was meant to stimulate domestic demand for a few years, in hope that perhaps the rest of the world will recover, and hence external demand would have recovered. Or else, in hope that domestic demand will become strong enough and sustainable so that the economy no longer depends on the health of the rest of the world…..

via China’s failed gamble for growth.

China and Hong Kong

China’s Shanghai Composite Index broke support at 2250, signaling resumption of the primary down-trend. Declining 63-day Twiggs Momentum (below zero) strengthens the signal.

Shanghai Composite Index

* Target calculation: 2250 – ( 2500 – 2250 ) = 2000

Wait for a break below 880 on the Shenzhen Composite Index to confirm the Shanghai signal. Reversal of  13-week Twiggs Money Flow below zero would indicate selling pressure.

Shenzhen Composite Index

Hong Kong’s Hang Seng Index respected resistance at 20000. Reversal below 18000 would indicate a decline to 16000*. A peak below zero on 63-day Twiggs Momentum would strengthen the bear signal.

Hang Seng Index

* Target calculation: 18000 – ( 20000 – 18000 ) = 16000

Westpac: China credit supply outstrips demand

Phat Dragon is placing the most value on new information regarding credit demand and supply. It is credit growth that tells us more about the shape of activity later this year than any other macro indicator……the supply side of the credit equation is moving decisively higher (greater policy emphasis, increased willingness to lend) but ……sluggish demand for loans is holding the system back. Indeed, the June quarter observation for “loan demand” (bankers’ assessment) fell to 12% below average, lower even than the Dec-2008 reading, even as the “lending attitude of banks” (corporate assessment) rose for a second straight quarter and the ‘easiness’ of the monetary policy stance (bankers’ assessment) rose to 21% above average.

via Westpac: Phat Dragon – a weekly chronicle of the Chinese economy.