The Real Surprise of China's August Data

The most important surprise in China's August data was the recovery of M2 growth, which was far stronger than was suggested by credit growth. This strength shores up the foundations of a recovery in profits which is already emerging, and is likely to be a major feature of the coming year. 

Although almost all of the August data China has released records gathering strength it is difficult to ignore, one of the major factors driving China’s business cycle dynamics continues to be underestimated. From the beginning of the year, it seemed likely that despite the immediately quite gloomy economic data China’s return on capital was likely to inflect upwards this year for the first time since 2007. That upturn was a predictable consequence of the economy finally managing to digest the binge-investing China undertook between 2003 and 2009/10 - an unprecedented investment-frenzy which resulted in a growth of capital stock which even an average nominal GDP growth of 16.6% pa was unable to match. As a result, asset turns and return on capital fell. The likelihood that 2016 was the year when this would finally reverse held the promise of a ‘surprise’ recovery in Chinese profitability.

 

That this is now happening - industrial profits rose 11% yoy in July despite revenue growth of just 3.6% yoy - owes practically nothing to the recovery of August’s domestic and industrial data which arrived in August. Rather, this data shows 12m margins bottoming out at the beginning of the year, and by July rising to the highest level since the beginning of 2015.

Nevertheless, that strength is worth recording briefly:

In aggregate, August’s domestic demand data showed the strongest gain against trend since holiday-affected March:
Retail sales rose 10.6% yoy, with a monthly gain which was 0.4SDs above historic seasonal trends
Car sales rose 21.8% yoy, with a monthly gain which was 0.3SDs above historic seasonal trends;
The CFLP manufacturing PMI employment subindex rose 0.2pts to 48.4, which showed the joint-mildest monthly decline since Dec 2013, although it was still 0.3SDs below the 5yr average of 48.7.
Although urban fixed asset investment rose only 8.2% yoy in August, this was as rebound from 3.8% in July, with the monthly movt 0.6SDs above historic seasonal trends. 

The monthly movements in China’s August trade and industry was no better (and no worse) than modestly positive, as it has been since May: 
Industrial output rose 6.3% yoy, with a monthly movements which was 0.3SDs below historic seasonal trends;
Electricity generation, however, rose 9% yoy, with a monthly gain which was 0.3SDs above historic seasonal trends
Exports fell 3.2% yoy in dollar terms, with the monthly gain 0.4SDs above trend; in Rmb terms, exports rose 1.8% yoy and were 0.2SDs above trend; and in volume terms they fell 1.4% yoy and were 0.4SDs above trend. 

These results were good enough to confirm the 6m trends for both domestic demand and the industrial economy are now mildly improving. The encouragement of a sustained loosening in monetary conditions (includes fx rates, monetary growth, real bond yields and yield curve) is likely to help keep them in positive territory in the short and medium term.

Rather, the most significant piece of data was monetary: M2 growth rose 11.4% yoy, accelerating from 10.2% yoy recorded in July.  This doesn’t immediately sound dramatic, but in fact it is: 

  • First, it was generated by a 1.3% mom rise in broad money which was fully 1.1SDs above historic seasonal trends.  Narrow money M1 rose 2.6% mom and 25.3% yoy, with the monthly movement 0.8SDs above trend. But in addition, Rmb bank deposits rose by 10.8% yoy (vs 9.5% yoy in July), with a 1.2% mom gain which was 0.8SDs above trend.
  • Second: the easiest way to generate a rise in bank deposits is, of course, to raise lending. However, in August whilst bank deposits grew by Rmb 1.77tr mom, bank lending rose only Rmb950bn, with the banks having a net deposit inflow of Rmb 820bn during a month when they can normally expect an outflow of Rmb200-300bn. As far as financial system is concerned, this looks like an ‘exogenous’ recovery in deposit growth, reflecting a combination of declining covert capital outflows into foreign currency and/or a recovering willingness to keep financial rather than real assets. 

In other words, this was not merely a big move, it was generated by more than merely monetary stimulus. 

But there is a third reason why the recovery in M2 matters: it lifts the longstanding threat of a significant slowdown in M2 yoy growth in the coming year which had seemed mathematically very likely.  Rather, it is now reasonable to expect M2 growth of a robust 11%-12% to persist over the coming year. 

In turn that means that unless we see a sharpening of the long-term downturn in monetary velocity (GDP/M2), we can expect to see nominal GDP growth approaching double digits in the 12m to June 2017 for the first time since 2012, and compared to 7.2% yoy in the 12m to June 2016.  

Unremarkable as these numbers may sound, they are good enough to underpin the recovery in profits currently emerging. If one depreciates nominal gross fixed capital formation over 10 years, my best estimate is that in 2015 China’s stock of fixed capital was growing just over 10%. This estimate assumes investment spending growth is maintained this year - an estimate which looks unrealistically generous. But even if this assumption is maintained throughout 2016 and 2017, growth of capital stock will still slow to around 9% in 2017. 

In these circumstances, nominal GDP growth will outpace the growth of capital stock, so asset turns will rise, almost certainly resulting in a rise in return on capital and profitability. In fact, I believe this dynamic is already beginning to show up in China’s data (not surprising given the private sector investment-strike (which is almost certainly exacerbated by the risks to investors posed by China’s anti-corruption campaign). The strength of August’s M2 growth, in excess of what was to be expected from credit growth, firms the foundations of those profits expectations for the rest of 2016 and into 2017.