China’s reported real 2Q GDP growth unchanged at 6.7%, but more importantly showed a modest acceleration in nominal GDP. If maintained, this acceleration will result in a stabilization or better of asset turns by the end of the year. This would imply a reversal of the long-term fall in return on assets which has been the central economic fact of the last decade. To complement this, the 12m to June saw a near-stabilization of monetary velocity (GDP/M2), suggesting that the deterioration in the allocation of China’s savings is also bottoming out. In addition, any recovery in topline growth is likely to improve profitability very sharply, since even in the subdued markets of 1H2016, China’s industrial operating margins have started to record.
The normal response to these circumstances is a quickening of investment spending. But in China’s case, all the gains in quarterly and monthly data are undercut by a slowdown in private investment spending so severe that by June there was no yoy growth at all. Whilst the central authorities have responded by sending out inspection teams to harry local governments into more investor-friendly initiatives, it is Xi Jinping’s anti-corruption which is the most likely factor currently deterring private investment. If corruption in China is endemic throughout its government system - and China ranks 83rd out of a global 167 on Transparency International’s 2016 Corruption Perception Index - any enthusiastically pursued anti-corruption campaign must generate tremendous investor uncertainty.
Meanwhile, the 6.7% yoy real GDP growth of 2Q was unchanged from 1Q, but this statis hid a modest but useful quickening in nominal GDP growth, to 9.5% yoy from 7.1% in 1Q. This modest acceleration included the first acceleration above 3yr trend since end-2011, and, if maintained, puts nominal GDP growth on a double-digit trajectory for 2016 as a whole. This is a significant development, since this the net growth of China’s capital stock is now slowing very sharply, and is unlikely to be more than 10% this year. As a result, we are entering a period of China’s growth in which asset turns are likely to start rising for the first time since 2007, raising returns on capital in the process.
Looking at how this acceleration of nominal GDP growth is being generated: three things are noticeable:
i) The trade surplus is no longer a significant driver of growth, or contributor to it. In dollar terms, 2Q’s trade surplus rose only 2.5% yoy to US$143.6bn. In Rmb terms, however, the rise was 9.9% yoy, and it accounted for 5.2% of GDP, but only 0.51pps of the 9.5% yoy growth, and only 0.36pps of ‘real’ GDP growth.
ii) Fiscal stimulus continues: the fiscal deficit for 2Q came to Rm459bn, equivalent to 2.5% of GDP (vs a deficit of just only 0.8% in 2Q15). The expansion of the deficit was equivalent to 20.7% of the yoy growth in nominal GDP, suggesting it accounted for approximately 2 percentage points of the 9.5% yoy growth, and/or 1.4 percentage points of real growth.
iii) Excluding the direct first-level contributions of the trade surplus and the fiscal deficit still leaves a modest expansion of private sector nominal domestic demand, with growth accelerating to 7.5% yoy from 5.1% in 1Q, and, as with total GDP, showing the first sustained gains against 3yr trends since 2011.
These results suggests that the mix of policies China is deploying in order to avert a hard landing are beginning to work. There are both similarities and differences between what is happening now and what happened the great credit splurge rescue of early 2009. One way of seeing this is by looking at how money is working in China’s economy, using both liquidity preference (M1/M2) and monetary velocity (GDP/M2) indicators. Liquidity preference shows what proportion of money assets are being kept in cash, reflecting shifts in transactional and/or speculative demand for money, which in turn might be early indicators for recovering demand for goods and services or for investments (though note, this would also include preparations for capital flight). As the chart shows, the sharp recovery in liquidity preference since mid-2015 looks similar to the rise in liquidity preference seen in 2009 in response to the credit splurge.
But there is no similarity between what is happening to monetary velocity now and what happened in 2009: rather in the 12m to 2Q, the decline in monetary velocity has almost stopped, whilst in 2009 it was in vertiginous decline. Current consensus expectations that China’s M2 growth will be sustained at around 12% throughout the rest of the year are extremely vulnerable - such an outcome would demand a new and more vigorous round of monetary loosening during 2H. It is more likely that M2 growth will continue to slow, probably to high single-digits during 2H. One result is that monetary velocity is likely to be in modest recovery. This possible outcome would, of course, be the financial sector complement to the possible rise in asset turns and return on capital which we see hoving on the horizon.
Meanwhile, the monthly data for June showed a sharp expansion in financing, amplified by continuing rises in liquidity preference, which in turn resulted in stronger-than-expected gains in retail sales and industrial production. Combined with modestly positive export momentum, the result has been to restore 6m momentum trends for both domestic demand and industry to 5yr trend levels.
However, these gains found no echo in investment spending: growth in private sector investment spending has ground to a halt, and consequently, there is no real sign yet that the deterioration in labour market conditions has reversed.
The strongest surprise in June’s monetary data was the 24.6% yoy jump in China’s M1, which was achieved with a monthly gain 1.1SDs above historic seasonal trends. This was the fastest yoy growth since December 2010, and with M2 rising only 11.8% yoy, liquidity preference rose 0.8pps to 29.8%, the highest since Dec 2013. M1 was shown an underlying sharp acceleration since May 2015, and as yet this acceleration shows no sign of abating, although the increasingly steep base of comparison will probably cut the yoy gains to around 14%-15% in 2H. Historically, such surges in M1 have been associated with sharp economic recoveries but also inflationary pressures:
the surge in M1 past 20% in 2010 was followed by inflation peaking at 6.7% in mid-2011;
the 20%+ growth in M2 during 2007 was followed by inflation peaking at 8.6% yoy in mid-April 2008;
the c20% growth in M1 sustained for 18 months around 2003 pushed inflation to more than 5% by the middle of 2004.
Currently, no early repeat of such inflationary threats seems plausible: June’s CPI rose only 1.9% yoy, and although there is positive momentum, this is only modest, implying CPI staying around 1.8%-2% during the second half of the year.
M2 money growth of 11.8% yoy only fractionally outperformed trend, and the yoy will struggle to stay in double digits during 2H. This was despite Rmb1,380bn of new yuan bank lending, which was 0.5SDs above historic seasonal trends and resulted in a 14.3% yoy growth of the loan book. It also provided the bulk of the Rmb1,630bn in aggregate new financing recorded in June.
It seems the extra financing is showing up in household, rather than corporate, spending. Retail sales rose 10.6% yoy with a monthly gain 0.7SDs above historic seasonal trends. The details suggest consumers are concentrating on improving home-life rather than more outwardly-obvious symbols of consumption: construction materials rose 14.2% yoy, furniture rose 13.4% and household electronics rose 12.3%, whilst jewellery sales rose only 1.2% and clothing rose only 7.5%.
Investment spending provided the biggest shock, however, with Jan-June urban investment spending rising only 9% yoy, implying growth of only 7.3% yoy in June. June’s growth, however, was wholly the work of the public sector, who’s investment spending rose 20.4% yoy whilst private sector investment showed no growth at all in yoy terms. Not surprisingly, public sector priorities dominated where the spending was made: water production rose 27.1% ytd, public facilities rose 26.6% and power & heat rose 25.4%.
The stand-still in private investment defies improving industrial data: industrial output rose 6.2% yoy in June, with monthly gains 0.6SDs above historic seasonal trends. Exports also showed modestly positive momentum, falling 6.1% yoy in dollar terms, but up 0.2SDs on historic seasonal trends; and flat yoy in Rmb terms, again rising 0.2SDs on historic trends. Any recovery of topline momentum is likely to be felt very positively on the bottom line, since even as topline growth has slowed, operating margins have shown modest but sustained recovery this year (we have the data to May).