China: Q2 Early Look Brief

Second Quarter 2017

By Leland Miller and the staff at China Beige Book

Executive Overview

So far, 2017 has played out as a best-case scenario for China’s economy. The remarkable absence of both domestic (more foolish financial policies) and foreign (Trump tariffs) shocks has created the stable environment corporates need to outperform most expectations, including ours.

This fortuitous run continued for at least one more quarter. China Beige Book’s new Q2 results show an economy that improved again, compared to both last quarter and a year ago, with retail and services each bouncing back from underwhelming Q1 performances. Manufacturing’s rally has now surpassed the one-year mark. Commodities surprised to the upside, despite significant price volatility in April. All this outmatched a slowdown in property and enabled hiring to improve almost across the board.

Three developments are worth extra emphasis. Any worries the leader­ship had about the labor market prior to the Party Congress have likely evaporated, with hiring improving on an already solid Q1 – both nationally and in all the major sectors. Claims of fading Chinese manufacturing turn out to have been premature, and new orders say at least another quarter of solid expansion is coming. And, while it’s only one quarter, it was all accomplished despite the initial signs of deleveraging – interest rates spiked and borrowing edged down. Facing the challenge of a very poor start to 2016, the Party has turned the economy back in the right direction, with time to spare.

Even in Beijing, though, there is no free lunch. Companies across the economy understand that 2017 needs to be a strong year economically and are storing problems away for the future. Literally – inventories hit their highest levels in the history of CBB data, both nationally and in every sector. The same companies who report solid results on most indicators also continue to show cash flow in the red – corporate health has not yet responded to better growth. And property continues to make investors nervous. As we predicted last quarter, the sector as a whole weakened noticeably despite a major turnaround in residential construction.

The credit market is also a source of heartburn. Firms did not report higher borrowing costs in Q1, but they certainly did so in Q2. Either firms expect the spike to be temporary or they are bearing up under the strain temporarily for political reasons. Either way, China has not yet even begun to face the pain from deleveraging, so the commitment to do so remains very much in question. It remains true that either rates have to come plunging back down, as the NDRC recently called for, or the present level of corporate activity is headed for a cliff. Today’s feast may have been bought with tomorrow’s lunch money. But for now, we toast the solid quarter.

Key Themes

Goldilocks Still Skipping Along.

For the economy, this may be as good as it gets for a while, but right now it’s pretty good. Policy support, no foreign shocks, no one wanting to rock the boat ahead of the Party Congress. The economy a year ago was much weaker than commonly thought, so merely on-year gains wouldn’t be impressive. But the economy a quarter ago was fairly active and this quarter is more so, on multiple dimensions. Revenue growth accelerated (though see inventories). Sales price gains eased fears of deflation harming growth. Most important, hiring strengthened again. This might be politically influenced, and thus temporary, but it already constitutes a political success. Moreover, with the labor force shrinking, a drop-off from the current hiring pace wouldn’t be a concern. On the whole, the second quarter is a very nice baseline for Beijing to be working from.

Why Rebalance When You Can Have Both?

The second quarter saw minimal progress in moving away from manufacturing toward services leadership in the economy. This was an excellent failure, however, since services performed well and manufacturing almost as well. Manufacturing tapered but extended its powerful rally since the first half of 2016. Revenue, hiring, and new orders were all higher on-quarter and sharply higher on-year. Still, services outperformed manufacturing in revenue and profits. Hiring in services has been uneven, but Q2 was solid.

Commodities Surprises to the Upside.

Defying early signs of a slowdown, our biggest Q2 surprise was another robust performance in commodities. Make no mistake, the warning signs look like Times Square: the second quarter saw huge across-the-board jumps in inventory, sliding sales price growth in three of four sub-sectors, and rising input costs. Yet, more firms again saw rising sales prices than input cost hikes, sales volumes accelerated, and cash flow moved from red to black, bolstering balance sheets.
Away from Markets’ Gaze, Aluminum Shines.

Commodities’ unsung hero: aluminum. CBB data show aluminum firms wildly outperforming the current market narrative, seeing broad Q2 gains in revenues, profits, volumes, output, and new orders, as well as cash flow, which jumped into the black for the first time in our survey’s history. The why is less clear than the what, but one obvious possibility is aluminum is the latest recipient of some of China’s excess liquidity. The #moneyball may have struck again.

Property Slows Off its Q1 Peak.

As we forecast last quarter, the property sector weakened, growth slowing in three of five sub-sectors. Transportation construction drove the deterioration with commercial realty and construction piling on. The extent of the pain may have been masked by better results on the residential side. Overall revenues and profits plunged in Tier 1 cities, with the slowdown concentrated primarily in the Beijing and Shanghai regions. Hiring stagnated, while cash flow worsened across the board. It is the credit picture, however, that looks most daunting. Borrowing completely cratered outside of residential construction, as rejections jumped and shadow banks suddenly refused (or were ordered not) to backstop the sector. Reflecting this disfavor, the relatively few property firms that were able to issue bonds this quarter paid through the nose – the highest yields ever seen in the CBB survey.

Inventory Levels Notch All-Time High.

The single most worrisome development is the level of inventories, which hit an all-time CBB high nationwide in the second quarter. The three sectors tracked– manufacturing, retail, and commodities – also each saw all-time highs. Inventories can stay elevated in China’s mixed economy for far longer than market economies, but they still represent either more waste and debt or a painful hangover that will drag down future growth.

No Fun in Shanghai.

Two high-profile regions marked a comeback after several quarters of lackluster performance. Guangdong turned in the strongest revenue and profit result while Beijing posted the largest on-quarter improvement in each. Shanghai missed the dragon boat, turning in the lowest growth figures nationwide. Inland provinces at least matched Q1, with the Center in particular reporting faster revenue growth. Even with its stellar results, though, Guangdong probably isn’t celebrating too loudly: companies in the region are China’s most sophisticated in terms of accounting practices and they report the country’s worst deterioration in cash flow.

The Right Kind of Inflation.

Unlike cash flow, the inflation picture has tilted away from stress toward health. The main reason is retail, which had the largest gains of any major sector in revenue, profits, and hiring. The hiring contributed to the strength economy-wide that pushed up wage payments by firms. In light of stated goals of reducing inequality and boosting consumption, this is a clearly positive development. Another element of good inflation is directly connected to retail: sales price increases continued in Q2, a sharp contrast to the weakness in 2014-15. Retail results show people are still buying despite rising prices. Higher input costs are harder to explain but were concentrated mostly in property. Input cost inflation was mild in retail and services and nearly invisible in manufacturing.

Borrowers Comforted by “Party Congress Put.”

China’s attempt at deleveraging has been discussed to no end, but its implications are not well understood. In Q1, corporate reporting to CBB showed credit tightening was limited to interbank markets. In Q2, it hit firms: bond yields and rates at shadow banks touched the highest levels in the history of our survey, and bank rates their highest since 2014. So why did borrowing not collapse, denting the broader economy? One reason is what we call the “Party Congress Put.” While borrowing did see a mild drop for the third straight quarter, companies’ six-month revenue expectations remain robust in every sector save property. Companies assume deleveraging is transient, likely because they are skeptical the Party will allow economic pain in 2017. It will not be until 2018 when we find out whether deleveraging is genuine – because it won’t be until 2018 that it will actually hurt.

Nothing like this has happened in 323 years
Financial Times columnists pick their charts of the credit crisis on the decade anniversary

 by: Martin Wolf


The Bank of England was founded just over 323 years ago, in July 1694, at the instigation of King William III. It is the second oldest continuously-functioning central bank in the world, after Sweden’s Sveriges Riksbank, founded in 1668.

The Bank of England supported the UK’s public finances and stabilised the British financial system through the wars with Revolutionary and Napoleonic France, two world wars and the Great Depression. Throughout that period, the Bank has made secured overnight loans to commercial banks (under different names).

Prior to January 2009, the Bank had never lowered its lending rate below 2 per cent. But it was then lowered to 1.5 per cent, on its way to 0.5 per cent in March 2009 and 0.25 per cent in August 2016. This ultra-easy policy was further buttressed by a huge expansion of the Bank’s balance sheet, which now contains £435bn in UK government “gilt-edged” securities and £10bn in corporate bonds.

Throughout this prolonged recent period of ultra-easy monetary policy, the concern has never been one of runaway inflation, but rather of the opposite. This time really has been different.

What does it mean for the future? Nobody knows.

How Fast Can Europe Really Grow?

The eurozone is consistently growing faster than estimates of its potential

By Richard Barley

Change in eurozone domestic product from a year earlier

In the global growth stakes, the eurozone is a plodder, not a sprinter. But importantly, relative to potential it is putting in an impressive turn of speed. The key question is whether the currency bloc can do what it takes to keep up the pace.

Eurozone growth in the second quarter was 0.6% from a quarter earlier, or 2.5% annualized, data released Wednesday showed. The Netherlands led the region with a blistering 1.5% quarter-on-quarter expansion, but growth is also broad-based. Even Italy’s year-over-year growth rate hit 1.5%, the fastest rate of expansion since early 2011.

A 2.5% overall annual clip might not sound that impressive. What is important, however, is that the eurozone is growing well above its potential rate, which can be envisaged as a kind of natural speed limit on the economy, albeit not directly observable. The European Commission pegs potential at 1.2% in 2017, down from precrisis levels. Over the five years leading up to 2007, the estimated rate was 1.8%.

It is natural for an economy to grow above trend following a downturn. If above-trend growth persists, inflation will be the natural result. But it is also possible for potential growth to rise. If it doesn’t, and potential growth is really only around 1%, then that carries risks. Low potential growth harms consumers’ and businesses’ appetite to spend and invest, further embedding low growth: a vicious circle. Low growth also makes it harder to grow out of debt, which for the eurozone is a clear and present danger.

The task of raising potential growth mainly falls to governments. Monetary policy can help—for instance, by creating favorable conditions for growth in investment, which can improve productivity, and allow the economy to grow faster without generating inflation. Lack of investment has been a constraint on the recovery.

Still, the European Central Bank has been consistent in calling on governments to do more. The place to watch right now is France under its new president, Emmanuel Macron. France has the benefit of better demographics than some of its big peers, a good starting point for efforts to get more people into work and boost productivity in the eurozone’s second-biggest economy.

There may be reason for hope. The crisis did spur some reforms in those countries hardest-hit, like Spain and Italy. Calculations by UBS based on purchasing managers index data suggest eurozone potential growth may be around 1.5% now—a welcome pickup. The eurozone is never likely to be the most dynamic spot in the global economy. But it needn’t be a permanent laggard either.

The End of Asia’s Strategic Miracle?

Richard N. Haass
. Tokyo Ginza district

TOKYO – It is too soon to know whether and how the challenge posed by North Korea’s nuclear and missile programs will be resolved. But it is not too early to consider what that challenge could mean for a part of the world that has in many ways defied history.
The moniker “Asian Miracle” goes some way toward conveying just how extraordinary the last half-century of economic growth in many Asian countries has been. The first economy to take off was Japan, which, despite a slowdown in recent decades and a relatively small population, remains the world’s third-largest economy.
China’s ascent began a bit later, but is no less impressive: the country achieved over three decades of double-digit average GDP growth, making it the world’s second-largest economy today. India, soon to be the world’s most populous country, has lately been experiencing an impressive 7-8% annual rate of GDP growth. And the ten members of the Association of Southeast Asian Nations averaged some 5% growth in recent years.
But contemporary Asia’s economic miracle rests on a less-discussed strategic miracle: the maintenance of peace and order. Since the end of the Vietnam War in the mid-1970s, Asia has stood out for its lack of major conflicts within or across borders – an achievement that distinguishes it from Africa, Europe, the Middle East, and even Latin America.
This stability is all the more extraordinary because Asia is home to a large number of unresolved disputes. When World War II ended in 1945, Japan and Russia did not sign a peace treaty, owing largely to their competing claims over the Southern Kuril Islands, known in Japan as the Northern Territories. Eight years later, the Korean War also ended without a formal peace treaty, leaving behind a divided and heavily armed peninsula.
Today, competing territorial claims – mostly involving China – continue to stoke tension across Asia. Japan is embroiled in a dispute with China over the Senkaku (Diaoyu) Islands in the East China Sea.
More than half a dozen other Asian countries disagree vehemently with China’s territorial claims in the South China Sea. And India is at loggerheads with China over their long-shared Himalayan border.
Despite all of these tensions, Asia has remained largely at peace, partly because no country has wanted to jeopardize economic growth by initiating a conflict. This perspective is most clearly associated with Deng Xiaoping. In leading China’s process of economic “reform and opening-up” from the late 1970s to the early 1990s, Deng explicitly emphasized the importance of a stable external environment to facilitate internal economic development. The reliance on regional trade ties to support growth and employment has provided yet another incentive to sustain peace.
But economics was probably not the only factor at play. Because most Asian countries are host to relatively homogenous societies with strong national identities, the chance of civil conflicts erupting and spilling over national borders is relatively low. Last but certainly not least, America’s strong military presence in Asia – which underpins its robust regional alliance system – has reduced the need for Asian countries to develop large military programs of their own, and has reinforced a status quo that discourages armed adventurism.
These factors have contributed to peace and stability in Asia, but they cannot be taken for granted. Indeed, they are now coming under increasing pressure – putting the strategic miracle that has facilitated Asia’s economic miracle in jeopardy.
What changed? For one thing, China’s economic rise has allowed it to expand its military capabilities. As China adopts an increasingly assertive foreign policy – exemplified by its border dispute with India and territorial claims in the South China Sea – other countries are increasingly motivated to boost their own military spending. As that happens, it becomes more likely that a disagreement or incident will escalate into a conflict.
Meanwhile, the US – the only power with the capability to offset China – seems to be retreating from its traditional role in Asia. Already, US President Donald Trump’s administration has withdrawn his country from the Trans-Pacific Partnership, and confronted US allies on their defense spending and persistent trade imbalances. More generally, the growing unpredictability of US foreign policy could weaken deterrence and prompt allies to take their security into their own hands.
The most immediate cause of potential instability is North Korea, which now poses not just a conventional military threat to South Korea, but also a nuclear threat to all of Asia, as well as to the US. This could invite a devastating preemptive strike from the US. But, if the US refrains from military action, the results could also be catastrophic, if the North actually does strike.
Even just the threat of such a strike could be destabilizing, if it drives concerned US allies such as South Korea and Japan to increase their military spending and reconsider their non-nuclear postures.
Should any of these scenarios come to pass, the consequences would be far-reaching. Beyond the human costs, they would threaten the economic prosperity of not only Asia, but the entire world. A conflict between the US and China, in particular, could poison the single most important bilateral relationship of the twenty-first century.
The good news is that none of this is inevitable. There is still time for governments to embrace restraint, explore diplomacy, and reconsider policies that threaten to undermine stability.
Unfortunately, we are living in a time of rising nationalism and at times irresponsible leadership. Add to that inadequate regional political-military arrangements, and it is not at all certain that wisdom will triumph over recklessness, or that Asia’s unique decades-long peace will endure.

Guadalcanal: The Battle That Sealed the Pacific War

By George Friedman

About 75 years ago, U.S. Marines landed on the islands of Guadalcanal, Tulagi and Florida in the British Solomon Islands. Their mission was to block the Japanese from building an airfield on the island and, after blocking them, to build their own base to fly from while the Marines drove the remaining Japanese out. The U.S. Navy would land the Marines on the island, block Japanese resupply and reinforcements from landing, and secure the American line of supply from Australia and New Caledonia.

Two months earlier, the Japanese had suffered a strategic defeat at Midway, losing a substantial portion of their fleet in the process. Japan was not without resources, but its primary thinking was now the strategic defensive. It sought to secure its gains by two means: reinforcing the layers of islands it had, and conducting regional offensives in defense of its holdings.

The American fleet wasn’t ready for major operations, nor did the U.S. Air Force yet exist in force, but the U.S. strategy had become obvious. There were two lines of attack available. First, there was a western offensive, running from Australia to New Guinea to the Philippines to Taiwan and Okinawa. Second, there was an offensive from the east: Hawaii-Gilbert Islands-Carolines-Marshalls-Marianas-Bonin-Okinawa. Put in terms of the critical and famous islands, this was an offensive through Tarawa, Saipan and Iwo Jima to Okinawa – and many other brutal but less famous islands.

Two island groups were the key: New Caledonia and Fiji. Together, they made both offensives possible. They were directly on the line of supply to Australia and to the southern flank of any attack on the Gilberts. Adm. Isoroku Yamamoto had considered a direct assault on these islands as an alternative to Midway, but he had hoped to force the U.S. fleet into defending Midway, destroying the fleet and later taking the southern islands. He succeeded in getting Adm. Chester Nimitz to engage his fleet. He didn’t anticipate defeat.

Two months after Midway, the importance of New Caledonia and Fiji to Japan was greater than ever, but its available force had shrunk. The Japanese had to move away from large-scale carrier operations, but they had a solid alternative. On both sides, land-based aircraft based on the small Pacific islands made the movement of naval vessels dangerous. Airfields built on select islands enabled aircraft to block critical passages and make enemy offensives dangerous. American strategy later in the war was to neutralize Japan’s land-based aircraft and take the islands as bases for their own aircraft. The U.S. Navy delivered the firepower and troops who landed on an island, and in many cases the airfield was seized or created, blocking forces for hundreds of miles around. This was the island-hopping strategy the U.S., always on the offensive after Midway, adopted. It was the strategy that Japanese land-based aircraft tried to resist. The naval war undergirded an air war, the bases won by the blood of the infantry.

The Battle Begins

In August 1942, Japan was still on the offensive. It wanted to isolate Australia and then flank the assault on the Gilberts. It wanted to capture New Caledonia and Fiji. But the key to that was Vanuatu, and the only asset the Japanese had to support an offensive was an air base in the Solomon Islands. The ideal spot for an island base was Guadalcanal. If Japan couldn’t mount an invasion on New Caledonia or Fiji, aircraft from Guadalcanal could interdict supplies to Australia by threatening New Caledonia.

Australian coast watchers – plantation owners who stayed behind after the Japanese had landed in the Solomons – observed the movement of ships and noted the construction underway on Guadalcanal. They recognized that Japan was building an airfield there, and they knew that if it were completed, a strategic threat might materialize. They also realized that if they waited until the airfield was finished, an invasion would be incredibly costly, if not impossible.

The Americans weren’t ready for such an operation. The Marines available for it were unseasoned and few in number. Army support was not yet available. The U.S. Navy consisted of cruisers and destroyers and too few aircraft carriers to risk any of them. The only positive was that Japanese intelligence had underestimated the size of the available U.S. force.

Nimitz and Gen. Douglas MacArthur understood the potential significance of the Japanese move, and they understood that they were in no position to launch a counterattack. They also knew that if they waited until they were ready, an invasion would be impossible. Japanese aircraft would devastate the landing force, and no carrier would be able to get close without being sunk.

If Japan established its air base in Guadalcanal, it could launch a massive operation against U.S.-Australian supply lines, forcing the U.S. to abort the future New Guinea attack and exposing the western flank of any future U.S. offensive. Japan would then be able to concentrate on the islands of the Central Pacific, making the eastern offensive problematic for the United States.

Nimitz, in strategic command and a meticulous planner, had to shoot from the hip. He had to launch the first Allied offensive of the Pacific War.

The Invasion

The plan was that the Marines would land nearby on Tulagi and the island of Florida as well as on Guadalcanal. Their mission was to capture the airfield before it was activated by the Japanese. Having done that, Navy construction brigades known as Seabees would land and prepare the base for American aircraft, which would then support the Marines in holding the island and, after reinforcement, project power northward.

The Americans didn’t want to take the island, and they didn’t want to start the offensive here. It was the Japanese that forced the Americans’ hand. The Japanese forces on the island were unequal to the task, but the Marines were in even worse shape. The Marines had a huge advantage, however. Their mission was to take and hold Henderson Field, the name they gave the airfield under construction. Then they would be on the defensive. The Japanese would have to dislodge them, moving through the swamps and elephant grass that could slice a man open. Given the available forces and the tactical and strategic reality, the Marines were in a powerful position.

The Japanese understood as much. They realized that if they lost the airfield, the situation in the Solomons would reverse, New Caledonia would be secure, and any hope of isolating Australia would be lost. They had to reinforce Guadalcanal and keep sending supplies to it. The U.S. had to do the same. This was a naval problem, and the Japanese navy had the cruisers and destroyers to protect supply ships. The Americans focused on cutting off Japan’s supply route.

During the invasion, the Americans and Australians sent in cruisers and destroyers. The U.S. also sent in an aircraft carrier to provide air support for the Marines. But the commander withdrew the carrier, afraid to lose it. He was bitterly chastised by the Marines, who felt abandoned, but in my view he did what was strategically necessary. It would be almost a year before a large number of carriers were available. The U.S. could not afford to lose any, lest Yamamoto take another shot at the Central Pacific. But though he was right, the decision left only surface vessels and some submarines to maintain the U.S. lines of supply and to sever the Japanese line of supply.

The U.S. Navy aircraft carrier USS Wasp (CV-7) burning and listing after she was torpedoed by the Japanese submarine I-19, on Sept. 15, 1942, while operating in the Southwestern Pacific in support of forces on Guadalcanal. U.S. NAVY

Most of the attention around Guadalcanal focuses on the Marines, but it was fundamentally a naval battle. This is because the Japanese had concentrated on naval technology before the war. They had a torpedo with a much greater range than American torpedoes. They also had flashless powder. When the U.S. fired, the Japanese could count the guns and the range. When the Japanese fired, the Americans couldn’t see them. The water off Guadalcanal was nicknamed Iron Bottom Sound because of the number of ships sunk.

In spite of all this, the supplies, from bullets to aviation fuel, made it in. The Marines pushed forward toward Japanese lines, with or without air support. They moved to tactical defensive positions during the night and absorbed countless Japanese attacks, slowly winning a war of attrition. The Japanese sent replacements, but the U.S. Navy and aircraft slowly choked the Japanese supply effort. Finally, the Japanese evacuated the island of surviving tropos.
The Beginning of the End

This ended Japanese strategic operations, which were already sparse after Midway. The U.S. no longer had to defend the line of supply to Australia, and American troops surged to Australian bases. As important, the U.S. had its first taste of amphibious warfare on any scale. The lessons learned about the need for air superiority and massive naval support, as well as the importance of not getting bogged down in attritional warfare, were all carried forward.

This was the moment that Japan might have sought out truce terms. It’s possible they would have gotten them. Guadalcanal made clear that the Japanese, even in defeat, could exact an enormous price – and the Japanese lines of defense hadn’t been pierced yet. There would be almost three years of war yet, and in 1942 the Americans could reasonably think there would be many more. The U.S. dreaded a separate peace between Russia and Germany and eagerly wanted to create a second front in Europe and lend-lease for the Russians.

For Japan, however, it was unthinkable – culturally and conceptually – to seek a truce. The Japanese had lost a battle on a Godforsaken island. Far from the Japanese leadership’s mind was any notion that Midway had closed to door to victory or that Guadalcanal had locked it.

The war went on for two and a half years. The United States never lost the initiative. Japanese forces were scattered on small islands, and the Japanese navy could not sortie to their defense. Having turned amphibious warfare into a replicable model, the U.S. chose which island to assault and never withdrew forces after it had landed. From this point on, the Japanese were simply waiting for the end, with many on both sides waiting to die.

Midway and Guadalcanal, in retrospect, ended the Pacific War, if not the death or the fear on both sides. Those battles would give the United States control of the Pacific, a control that has been in place for the past 70 years or so. And they would lead, in the circuitous path of history, to North Korea today. Whatever fears we have in 2017, they would have been very different had the battles of so many decades ago gone differently. That is the measure of the importance of these battles.

1942 was the year the outcome of World War II was defined. Two more battles, El Alamein and Stalingrad, came later in the year but not in importance.