A Japanification of China’s economy is a scary prospect

It’s a funny old world, isn’t it? This time last year, we were sitting here musing on one hand over the depth and duration of pending US recession and laughing at the soft landing merchants as deluded optimists whilst casting an eye in the general direction of China which without a doubt would have to play the role of global economic locomotive once the ridiculous lockdown rules had been removed. And where are we now?

Sure, there are incongruities and contradictions in US economic data, but the longer time goes on, the less likely a deep and costly recession appears to look. On the other hand, when China’s President Xi Jinping rather abruptly and not a minute too soon scrapped the entire Covid protocol on 7 December, the expectations were for one huge, consumer-driven rebound in the Chinese economy which was going to drag a faltering West out of whatever mire it might be finding itself in. A year on and the tables have turned.

Federal Reserve Chairman Jay Powell might be talking of the Fed remaining scrupulously vigilant with respect to inflationary pressures and predicting persistently tight monetary policy, but the Street is not taking him too seriously and expectations are for an early and fairly aggressive reduction in the rate of Fed Funds by as much as 250 bps by the end of next year. Mass unemployment is not there, nor is the avalanche of mid-sized bank failures. Inflation goes down not when prices go down but when they stop going up. When the current inflation cycle began, the blame was laid at the door of food and energy, both of which have been driven higher by the invasion of Ukraine and the ensuing sanctions against Putin’s Russia. As the world has begun to learn how to live with the new paradigm, global price pressures have indeed begun to ease and in consequence so had inflation.

As I asked in yesterday’s piece, is it high interest rates that slay inflation or is there a simple self-righting effect which given time will bring the economy back into equilibrium? Turkey and above all Argentina would appear to prove that argument to be wrong although neither of them has a sufficiently integrated economy in which supply gaps can organically be filled. I rather boldly suggested yesterday that the Vietnam War and the NASA moon program in the 1960s probably had more to do with the high inflation of the 1970s than the oil shock of 1973 which I painted as merely the supercharger on an already powerful inflation generator to which one of my more highly regarded US readers overnight commented “V nice explanation of the 1970’s US inflation situation. I had never considered it your way before. Well done.” True praise indeed. That said, I am not in the business of rewriting economic history so I shall desist from digging myself too deep a hole in forecasting the dominant inflationary trajectory for the next year or two. I have, it would now appear, been on the wrong side of the American recession scenario and although I shall dismount from that horse, I shall sit, watch and for a while lick my wounds before grabbing another nag which is cantering in the opposite direction.

If there is one great predictor of something – bear with me – it is the weakness of US dollar. If you’d have expected a strong currency to accompany a stronger than expected economy, think again. The Greenback hit its cyclical high on 3 October 3 when the DXY, the wider dollar index, printed 107.00. It sold off a bit, then when the collective of Fed officials came out insisting inflation was still an issue and a reversal of the currently tight monetary policy stance was here to stay it shot back up to trade on 1 November at 106.88. Then the mood changed and the decline in the dollar has been epic. At the time of writing, it is down at 103.16, its lowest level since the end of August. That said, it remains a decent bit higher than when it briefly dropped below 100.00 on 13 July.  And now the dollar is falling not because the economy is in a death spiral but because it isn’t, and rates are going down because inflation is declining despite high levels of employment and all the other jazz. I last night listened to a podcast interview with a Goldman Sachs economist who drilled down into the universe of econometric minutiae which I have not visited since I left my desk in the City, but who after an hour concluded that the probability of a deep US recession had to be marked down from 30% to 15%.

And there is China which is not doing what it was supposed to do. When working for US banks, which I did do on two occasions during my working life, I was always struck by the American boss’s inability to understand that not all the world follows the same trains of thought as do their fellow countrymen. I caused much mirth when I observed that Americans think of foreigners as nothing other than Americans who talk a different language. If it sells in Georgia, it’ll sell in Germany. And when Covid restrictions are lifted in China, Li SixPack will be out there blowing the lockdown savings in the same way as Joe and Megan SixPack had done at home. Not so.

China’s consumer demand has remained remarkably restrained. It is of course wrong to generalise although it might be fair to say that the Chinese are voracious savers – the lack of a western style social security safety net leaves them no option – and much of those savings have gone into real estate. China has overbuilt and the population is overinvested. The current stress in the property sector is no secret and the names of failed Evergrande and failing Country Garden are rarely far from the front pages of the financial press. Their total collapse would be a PR disaster for the government in general and for President Xi in particular. Elevating oneself to supreme leader, only to then watch the greatest store of citizens’ wealth go to hell is not a good look. The latest move by the Beijing administration is on the banks which it is now urging to offer further unsecured liquidity providing loans to the sector. A list of 50 property developers who are eligible and in need has been drawn up. Yesterday, the People’s Bank of China, the country’s central bank, instructed the commercial banks which had already been strong-armed into lending to companies, many of which are technically bankrupt, to lower the rates of interest charged.

The price at which banks lend to individual industrial sectors is easy to understand. Take the whole sector, evaluate the expected default rate adjusted by the expected recovery rate and add a margin. That gives the basic credit spread applicable to the sector. Lending to individual companies will then be adjusted up or down. The property developers are at the moment a deeply risky bunch and the price of money, even for the better ones, should be high. Now the PBoC pops up, taps the banks on the shoulder and asks them to lend at what is effectively economically the wrong rate. The PBoC’s argument is that the economy is falling into deflation and that therefore lending rates must reflect the same.

A large part of the property development sector is already made up of zombie companies, of dead men walking. China’s savers are shunning property. Why should they not? Who’d want to put a deposit on an off-plan apartment if there is a risk of the developer going under and the money being lost? The PBoC’s bet is that if it can be seen to be engineering the survival of even the most troubled of developers – Country Garden, the largest and also one of the financially most stressed of players is included on the list of 50 – then the public’s fading enthusiasm for real estate might be reignited.

Is that enough? The country’s largest shadow bank, Zhongzhi Enterprise Group, is also up to its neck and last week advised its shareholders that it is insolvent. That has to be the understatement of the year. In its letter it reports liabilities of between CNY 420 billion and CNY 460 billion but that its assets would be worth no more than CNY 200 billion and in the case of a fire sale maybe even less.  As a non-bank, Zhongzhi presents itself as a wealth manager which depends on customer deposits for funding. As Zhongzhi’s business is entirely domestic, its troubles have largely failed to make the news in the West. China’s shadow banks have long been something of an enigma but with the firm’s indication of the critical asset/liability deficit, one cannot but wonder how many other nasties are still hidden under the blanket.  

Comparisons are now widely being drawn between Japan and China, the latter simply following the former with a 20-year time gap. Older readers will remember when in the late 1980s “The Land of the Rising Yen” was being held up to us as the way to go. Endless reports on the TV about the miracles of Japan’s industries with the entire workforce in uniform overalls performing synchronised tai chi in the courtyard before heading indoors in order to out-manufacture the world. The Nikkei225 index hit its all-time high of 38, 915 pts on 29 December 1989. By early 2009, it was back down at just above 7,500 pts and even today, 34 years later, it has not yet regained the old high. At the time of writing, it is marked at 33,408 pts. A Japanification of China is a scary prospect and one which should not be taken too lightly. Economically floundering autocracies – or call them dictatorships if you prefer – are dangerous places, be that in Germany in the 1930s, Argentina in the 1970s or Russia as we speak.  President Xi’s cosying up to the Americans at the APEC conference in San Francisco a couple of weeks ago looked to me to be aimed at buttering up one’s consumer of last resort. If that works, fine. If not….Germany, Argentina, Russia….join up the dots.

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