Is China in Recession? Then It Isn't Deleveraging

Chinese fixed asset investment for May hit a new all-time low in the WTO era. It is consistent with the long-term trend. The key question is: does it represent another rapid deceleration in growth?

Fixed asset investment growth fell from 25 percent in 2011 down to 20 percent in 2012. This was the end of the 2008 stimulus, the top in commodities globally, and the end of a real estate boom cycle. There was some real estate rage in Shanghai in October 2011, the offshore yuan saw a bit of depreciation, but things reverted to normal rather quickly.

In late 2013, another drop in fixed asset investment growth began. Growth decelerated from 20 percent down to 15 percent. Real estate investment growth decelerated far more, from 20 percent to contraction in 2015. Real estate rage showed up again in early 2014 in Hangzhou and later that year Liaoning was in deep trouble. The boom created in the wake of the 2011 mini-crisis had ended, commodity prices fell, the yuan depreciated significantly. Some bubbles were blown in the process, including the stock market bubble that topped in spring 2015. China flooded the economy with liquidity, there was some firming of real estate in Shenzhen, and then China went all in by early 2016. Commodity prices immediately rebounded, home prices were popping, the yuan stabilized by the end of 2016 and all was well again.

There's been a lot of news about defaults in 2018 and comparing it to 2016, but this isn't history rhyming with 2016. It is rhyming with 2014. (Not good since AA+ rated bonds have already run into default trouble.) As 2014-2016 was a much more volatile version of 2011, so this coming wave will be a far larger version of 2016. The final rhyme will be a sharp slowdown in investment. If the dip in FAI continues, we'll have our answer.

As for real estate investment, it slowed at the end of 2017, but has stabilized around 10 percent (for now) and the government is struggling to keep a lid on home prices. China's ham-handed housing regulations may be the only thing keeping investment growth from tumbling off a cliff. Eventually, China will "get in right" in their attempt to limit home prices. If there's a scenario where FAI goes negative, real estate will be involved.

The People's Bank of China is behaving as it did in 2015. It cut the required reserve ratio (RRR) in April. It expanded collateral for the medium-term lending facility (MLF) in June.

China cannot deleverage without first slowing credit growth. If it slows credit growth, it will experience sharp slowdowns in economic growth somewhere. In 2011 the slowdown was modest and officials panicked. In 2013, they let things go much further, but then panicked in late 2015 and early 2016 when the global economy was on the verge of slipping into recession.

After the National Congress in October 2017, when Xi became President For Life if he wants, another deleveraging attempt began. It is even stronger than the 2014 attempt. Heading into that year I had many posts on the gap between Western coverage of China and the official statements in Chinese media. The former expected another stimulus, the latter were saying no stimulus, reform. One More Time: No Stimulus Commodities investors in particular were banking on China saving them. They ended up being right, but only in 2016. There was a lot of pain in between.

We also have to consider Chinese politics at the time. A big story on this blog back then was the Battle for China: China's Corruption Drive Still Clearing the Decks for Reform; Why 2008 Stimulus Will Not Be Repeated. That war is over. Xi Jinping won. While he hasn't reformed as I expected, if reform is coming, now is the time. The past two bailouts after 2011 and 2014 downturns shows reform cannot take place unless it continues through a full economic cycle. China isn't making noises about major reform, but even with no reform, politically it is better positioned to stay the course with deleveraging.

Outside of China, things have only gone from bad to worse. The global economy is doing fine for now, but China missed its golden opportunity for reform. Had it allowed yuan depreciation in 2008 (they had to go back to the peg to prevent depreciation) it would have ignited global panic far beyond what occurred then, but if it coupled it with reform, the world might have hit bottom by 2010 at the latest before resuming growth. China could have also credibly blamed it all on the Untied States. It then missed a chance in 2011 and 2014. With each passing year, global social mood turned more negative. The window was closing on China. I warned there would be trade friction and it came in spades with President Trump's victory in 2016. China could very well be punished by the United States if it tries to reform and let's the yuan depreciate as part of those efforts. If it doesn't let the yuan depreciate, it will suffer a recession. If it does, it ignites a trade war and suffers a recession.

China can't absorb any negative shock because it needs a Goldilocks scenario where GDP growth offsets slowing credit growth. The economy will slow as credit growth subsides, but even a modest slowdown in credit growth risks a recession as I laid out in 2017: China Can't Deleverage, At Least Not Yet

A test for Chinese deleveraging: is the GDP growth collapsing?

I'm using Steve Keen's simplified debt model to show how we should expect a major slowdown if China deleverages. See: Get ready for an Australian recession by 2017

Assume China's nominal GDP is 80 trillion yuan, and debt is 160 trillion yuan (200 percent of GDP).

If GDP grows 8 percent, that's 86.4 trillion yuan.
If credit grows 12.6 percent, that is 20.2 trillion yuan.

Total nominal demand was 106.6 trillion and 19 percent was credit.

In Year 2 China lowers credit growth to match nominal GDP.

China's GDP was 86.4 trillion. It grows 8 percent to 93.3 trillion.
Credit was 180.2 trillion, it grows 8 percent or 14.4 trillion.

Total nominal demand is 107.7 trillion, growth of 1 percent. Credit drops to 13 percent of total nominal demand.

China can't quickly deleverage and maintain its GDP growth rate. It wants to slow credit, slowly, and then let GDP growth do the work of growing out of the debt.

In the meantime, the PBoC is spending (printing?) resources trying to fight deflationary pressure from the dollar. China will need years to complete this process, but if the U.S. dollar bull market still has a year or two to go, the greatest risk of crisis is still ahead.

In that simplified model, a 4 percent slowdown in credit growth takes China to the bring of recession.

I also referenced an article by Christoper Balding that explained there was no deleveraging in 2017. Here's his latest article in Bloomberg: China’s Banks Are Still in Trouble

By several measures, Chinese banks are strained. Their official loan–to-deposit ratio increased from 65.8 percent in June 2015 to 71.2 percent at the end of March. New deposits peaked in 2015 and have since failed to keep up with lending growth. Last year, new loans amounted to 100.1 percent of new deposits. Through the first five months of this year, they were running at 104 percent.

With matters getting worse, the People's Bank of China has stepped into the breach. Since 2015, the PBOC has boosted lending to banks by more than 300 percent, to $1.5 trillion. Beyond just providing liquidity, it's also pushing banks to change their lending patterns: In particular, by allowing short-term debt to expire and rolling it into loans of longer duration. Since January 2017, medium- and long-term loans have made up 85 percent of all new bank lending.

...That’s because China is pursuing conflicting goals. It wants to slow credit growth but sustain economic growth. It wants to push debt out of the shadow-banking sector and onto formal balance sheets, but the official banking sector is too capacity-constrained to accommodate it -- and thus needs more credit. By lengthening durations and pumping money into the system, the PBOC is hoping to square these circles. But it's really only delaying things.

China is already past the point where it can "safely" deleverage. It needs a roaring global economy that it can lean on for growth. Without it, the risk of recession approaches 100 percent because it will take years of intense management to slow credit growth and maintain GDP growth. China is like a drunk man walking across a tightrope from one ship to another on the ocean. And his ship is on fire. If China doesn't deleverage, inflation (home prices) take off and then you will see real outflow pressure and rising USDCNY.

And if Jeffrey Snider is right and the eurodollar system is the engine pulling this train, then China's deleveraging effort can be seen as a massive attempt at defending the yuan. Deleveraging is dedollarization in that scenario. Reflexivity is doing all the dirty work.

China's ace up its the sleeve is yuan depreciation. China can deleverage at any time by making a large, one-off depreciation in the renminbi. It did it in 1994. It can do it again. There will be lots of pain associated with that move, but it will obviate the need for tough reforms and a long drawn out process. China doesn't want to take that action, and it won't until there's enough pain that it becomes the lesser of two evils. But unless China gets extremely lucky, it's not going to deleverage without serious pain. And the economic data, rising default pressure, PBoC activities, currency events in Turkey, Argentina, Brazil and general social mood around the world all point to the global economy entering another down cycle. If global inflation doesn't rise, if global growth doesn't accelerate, if U.S. dollar credit growth doesn't increase, if the DXY doesn't head for new lows and enter a bear market, then we're headed for a new high in the DXY. Much higher than anyone in the mainstream expects.