China: Time's Up for Credit Squeeze - Upward Inflection Mid-2019

The race to pass judgement on China’s economy peaks four times a year, when China releases its quarterly GDP estimates. It involves a spectacular suspension of disbelief: does anyone really believe it is possible to measure an economy as large, complex and opaque as China’s to within a tenth of a percentage point?

There is little sensible to be said, therefore, about last week’s news that 3Q GDP growth slowed to 6.5% from 6.7% in 2Q.

But there are two conclusions one can draw about the structure of China’s economy, and its likely medium-term trajectory.

The first is that time’s up for the credit squeeze. The determination to improve the discipline of credit allocation was well-founded - back in 2011 every 100 yuan in new aggregate financing was associated with approximately 60 yuan in extra nominal GDP; but by 1Q16 this addition to GDP had fallen to just 26 yuan. From an economic point of view, credit creation was running into the sands.

However, two years into the attempt to discipline the allocation of credit the question China’s authorities have to face is this: does the efficiency of finances continue to rise, or has the negative economic impact of restraining credit growth led to an overall deterioration in financial efficiency?

Between 1Q16 and 2Q18 the credit crunch undoubtedly produced positive results in terms of the impact of extra finance upon nominal GDP: in the 12m to 1Q16, 100 yuan of extra aggregate financing was associated with only 26 yuan of extra nominal GDP; but by 2Q18 this had risen to 47 yuan. These sorts of gains are destined to be more difficult in the second year of a credit crunch as the easy gains have been made, the improvised sources of extra financing will already have been mobilized, and more companies will be hitting the wall. This is now showing in the 12m to 3Q, with the amount of extra GDP associated with 100 yuan of extra aggregate financing falling to 45.5 yuan.

And that, I think, accurately indicates the point at which maximum pressure for a policy loosening is felt, for not only is the pain of continued stringency now laid bare, but in addition, it becomes obvious to banks and monetary policymakers that the erosion of credit quality will itself tend to constrain further credit growth beyond what had been initially envisaged. We are now past that point.

financial efficiency.jpg

Now that we have now entered the phase where policies are set to limit the unforeseen/unexpected damage done by the previous credit restriction, what results can be expected from the current and likely ongoing policy relaxation?

I construct a monetary conditions indicator for China monitoring monetary growth (M1 and M2), changes in real interest rates and yield curves, and the size and historic volatility of changes in the SDR value of the Rmb. Significant changes in that indicator (on a 12ma basis) have in the past been associated with similar changes in the growth of private nominal domestic demand nine months later.

mci pri domestic demand.jpg

This chart suggests three things:

First: even on a 12m basis, China’s monetary conditions are now being loosened, quite aggressively, with 3Q18 being the upward inflection point.

Second: although the slowdown in growth of private domestic demand is moderating, it still has a further six to nine months before we should see a convincing upward inflection point. We can expect good news as a result of policy loosening . . . but not just yet

Third: each time monetary conditions have been loosened, dramatically, the positive impact on nominal GDP growth has weakened. The very sharp upswing seen in 2008 topped out at 26.1% yoy; in 2010 and 2011 it topped out at around 21%; in 2013 a similar loosening resulted only in nominal private sector domestic demand growth topping out at 13.8%. The positive upturn to be expected in 2H19 will probably be weaker still. If so, the upturn in 2019 may seem more like mere stabilization.