China Watch

Doug Nolan


I’ve held the view that Chinese finance has been at the epicenter of international market unease. The U.S./China trade war was not the predominant global risk.

It has had the potential, however, to become a catalyst for Chinese financial instability.

And there remains a high probability for an eruption of Chinese disorder to quickly reverberate through global markets and economies.

To be sure, rapidly deteriorating U.S./China relations were a major contributor to this summer’s global yield collapse and bond market dislocation.

At this point, I’ll assume some “phase 1” deal gets drafted and then signed by Presidents Trump and Xi next month in Chile.

In the grand scheme of things, little will have been resolved.

It appears many of the most critical issues between the world’s two rival superpowers have been excluded from the initial compromise, I’ll assume tabled for some time to come.

Short-term focused markets are content with a “truce,” welcoming a period of reduced risk of a rapid escalation of tensions.

Perhaps near-term financial risks have subsided in China.

A counter argument would point out that Beijing’s push to improve its negotiating position forced officials to once again hit the Credit accelerator.

Did Beijing push its luck too far?

I would point to the $1 TN of additional household (chiefly mortgage) debt accumulated over the past year.

China’s Household borrowings were up 15.9% in one year, 37% in two, 69% in three and 138% in five years.

Importantly, Beijing’s stimulus efforts stoked China’s historic mortgage finance and apartment Bubbles already well into “Terminal Phase” excess.

How deeply have fraud and shenanigans permeated Chinese housing finance?

Similar to P2P and corporate finance?

China’s Total Aggregate Financing (TAF) increased 2.273 TN yuan, or $321 billion during September.

This was almost 20% ahead of estimates – and 5% above September 2018.

After a slower July, Credit growth accelerated to place the quarter’s Credit expansion slightly ahead of comparable 2018. At $2.646 TN, year-to-date TAF expansion was 22% above 2018.

With rough estimates of $600 billion of Q4 TAF growth and a $600 billion 2019 increase in national debt, China’s total system Credit growth will approach $4.0 TN.

At $240 billion, September growth in Bank Loans was 24% ahead of estimates.

Loans grew at the fastest pace since March – and almost 14% above September 2018.

Bank Loans expanded $1.924 TN y-t-d, up about 4% from comparable 2018.

September Consumer Loan growth was only 1% above September 2018, with third quarter expansion down a notable 7.8% y-o-y.

Chinese GDP expanded at a 6.0% y-o-y pace during Q3, slightly below estimates (and the “lowest level since 1992”). According to Bloomberg, “Consumption’s contribution increased to 60.5% from 55.3%; Investment’s contribution slowed to 19.8% from 25.9%.”

That growth continues to slow in the face of 12.5% y-o-y Credit (TAF) growth portends instability ahead.

With surging household debt and inflating housing markets, the ongoing consumption boom comes as no surprise.

Property Investment was up 10.5% y-o-y, continuing the powerful momentum unleashed with Beijing’s 2016 stimulus measures.

Retail sales were up 7.8% y-o-y in September, in line with estimates.

Beyond the acute vulnerability to any weakening of Credit growth, the Chinese Bubble economy is demonstrating obvious signs of imbalances and price distortions.

While the housing boom for the most part is ongoing, auto sales have slowed markedly.

October 12 – Bloomberg: “Chinese auto sales fell in September for the 15th month in 16, extending their unprecedented slump despite government efforts to support the world’s largest car market. Sales of sedans, sport utility vehicles, minivans and multipurpose vehicles dropped 6.6% from a year earlier to 1.81 million units… The only increase since mid-2018 came in June, when dealers offered big discounts to clear inventory.”

Meanwhile, weaker-than-expected trade data point to waning economic momentum.

October 13 – Reuters (Yawen Chen and Gabriel Crossley): “A slide in China’s exports picked up pace in September while imports contracted for a fifth straight month, pointing to further weakness in the economy and underlining the need for more stimulus as the Sino-U.S. trade war drags on… September exports fell 3.2% from a year earlier, the biggest fall since February… Total September imports fell 8.5% after August’s 5.6% decline, the lowest since May, and were expected to fall 5.2%.”

Price data (i.e. CPI at six-year high and PPI at three-year low) also support the view of monetary disorder and an imbalanced economy:

October 14 – Market Watch (Grace Zhu): “Rising pork prices pushed China's consumer inflation to its highest level in nearly six years in September… The consumer price index rose 3% in September from a year earlier compared with the 2.8% expansion recorded August… The government aims to keep consumer inflation under roughly 3% for 2019. In the first nine months of the year China's CPI rose 2.5% from the same period a year earlier… Food prices in September surged 11.2% on year to set the strongest pace in nearly eight years and extend August's 10.0% gain.”

October 14 – Reuters (Yawen Chen and Gabriel Crossley): “China’s factory gate prices declined at their fastest pace in more than three years in September, reinforcing the case for Beijing to unveil further stimulus as manufacturing cools on weak demand and U.S. trade pressures. The producer price index (PPI), considered a key barometer of corporate profitability, dropped 1.2% year-on-year in September…”

The Shanghai Composite dropped 1.3% Friday, the largest decline since September 17th – giving back about half of last’s week’s gain.

According to Bloomberg, Chinese defaults this week reached an annual all-time high, with more than two months to spare.

There must also be some system stress smoldering below the surface.

October 16 – Financial Times (Don Weinland and Sherry Fei Ju): “China’s central bank made an unexpected Rmb200bn ($28bn) injection into the banking system on Wednesday, highlighting policymakers’ concerns over liquidity levels as economic growth falls to a 30-year low. Policymakers have worried that liquidity constraints over the past year have made banks less willing to lend to companies at a time when the Sino-US trade dispute is also proving a drag on economic activity. ‘It suggests that the [People’s Bank of China] feels the interbank market needs more liquidity,’ said Julian Evans-Pritchard, senior China economist at Capital Economics. ‘Whether or not the goal is to push down interbank rates or simply to keep them broadly stable is unclear at this stage.’”

I have suggested it was no coincidence China’s August money market instability was followed some weeks later by U.S. “repo” market tumult. I

t was interesting to see both the PBOC and Federal Reserve actively adding liquidity this week. A “phase 1” deal is at hand, while quarter-end funding issues have subsided.

Why then does pressure persist in both funding markets?

October 18 – Wall Street Journal (Michael S. Derby): “The Federal Reserve injected both temporary and permanent liquidity into the financial system Friday. The permanent addition came by way of $7.501 billion in Treasury bill purchases, which are aimed at growing the Fed’s nearly $4 trillion in holdings… The New York Fed also on Friday added $56.65 billion in short-term liquidity to financial markets. In a repurchase agreement operation that will expire on Monday, the Fed took in $47.95 billion in Treasurys, $500 million in agency securities, and $8.2 billion in mortgage-backed securities. The Fed’s operations on Friday are part of an effort to help tame volatility in short-term rate markets with temporary and permanent injections of liquidity… On Thursday, the Fed added $104.15 billion in temporary liquidity.”

Fed funds futures price in an 88% probability of a third Fed rate cut on October 30th.

Those sure seem like rather short odds considering the backdrop, including an easing of trade tensions and near-record stock prices.

There will be a number of dissents if the FOMC accommodates market expectations.

Shouldn’t the Fed’s restart of balance sheet expansion support the case for holding off for now on an additional rate cut?

Some bond selling on a rate cut announcement wouldn’t be all that surprising.

Curiously, a Friday evening announcement from the ECB: “ECB Policy Makers Don’t Expect More Easing in Coming Months.”

October 18 – Bloomberg (Piotr Skolimowski, Jill Ward and Paul Gordon): “European Central Bank policy makers don’t expect any more monetary easing in coming months despite a likely downgrade in their economic forecasts in December, according to euro-area officials. The interest-rate cuts and quantitative easing pushed through by President Mario Draghi in September are enough to see the euro-zone economy through its slowdown unless it’s hit by shocks such as escalating trade tensions or a no-deal Brexit, the officials said, speaking on condition of anonymity. The vehement opposition by some governors to those measures dampens the chance of more action any time soon, they added.”

October 18 – Bloomberg (Jeff Kearns): “The International Monetary Fund warned that global economic risks have risen as central banks reduce borrowing costs and that stronger oversight is needed to ease threats to an already shaky expansion… ‘The search for yield in a prolonged low-interest-rate environment has led to stretched valuations in risky asset markets around the globe, raising the possibility of sharp, sudden adjustments in financial conditions,’ the fund said. ‘Such sharp tightening could have significant macroeconomic implications, especially in countries with elevated financial vulnerabilities.’”

The entire world these days has “elevated financial vulnerabilities,” certainly including China.

Saturday's Brexit vote will be fascinating.

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