Global trade relations are currently moving in opposite directions. While US President Donald Trump’s administration is trying to impose new restrictions on its trade with the rest of the world – especially its main partners such as the EU, China and Japan – there are other influential powers with great leverage in trade ties seeking a further liberalization.
The US has recently levied tariffs on imports from China, the EU, Canada and many others, which would have an effect on up to 500 billion US-Dollar of its trade with China alone. Thus, Trump has left other partners facing a difficult choice, either full liberalization of trade or levying of equal tariffs by all parties. During a meeting with the European Commission president, Trump said he would cooperate with Jean – Claude Juncker to work to reduce trade barriers to zero on industrial goods, with the exception of cars. Juncker on his part said, “The US and EU will refrain from imposing any more tariffs during their trade negotiations.” This means reaching no final agreement, in light of the French President Emmanuel Macron’s immediate rejection of the Trump-Juncker agreement. This despite the trade exchange between the EU and the US exceeding 1 trillion US-Dollar annually.
On the other hand, the European Union and Japan signed a free-trade agreement in mid – July and which will come into force in 2019. It will be the world’s largest free trade agreement and cover one-third of the global economy and 600 million people. It in turn deals a blow to the protectionist policy adopted by the US president. However, it is still unknown which side will have scale in its favor. The US is struggling alone against powers such as China, the EU and Japan, which practically constitutes a trade bloc against US tariffs that Trump believes is a legitimate right similar to the tariffs imposed on his country’s exports by the other three. It goes without saying that none of the major powers intends to enter a trade war with the largest economic power, whose market represents a vital outlet for their exports. At the same time, the conditions set by Trump cannot be accepted as they pose a trade and economic challenge to the others and are not welcome even within the US itself, prompting the US administration to allocate 12 billion US-Dollar in the form of subsidies to American formers.
The global trade situation as a whole is in a state of uncertainty, as there are no indications of any understandings on the deputies. This would cause serious damage to global growth as a whole. Let us assume the US has scale in its favor, it would become the undisputed trading power and once again regain control over trade relations that have been shaken by the emergence of China and the European Union as powers that can influence trends. Meanwhile, if matters head the other way and a European – Chinese – Japanese alliance is formed, the US economy would be severely affected and countermeasures would be taken as a result. Both cases would aggravate a trade war that has already entered into force. There remains slim prospect of companies to meet halfway and save the world from the dire consequences. It is in fact being sought by the EU, China and Japan, but faces many complications on the US side. Mainly because of their currently strong economy. Still, the second-quarter US gross domestic product report brings up the question of whether it can be sustained in a way it wasn’t the last time GDP growth was this robust four years ago.
The economy in 2014 had some things going for it that the current economy lacks a federal funds rate firmly anchored at zero and an economy still operating well below its potential, implying more room to grow without inflation being a concern. Yet, an unexpected shock came in the form of the collapse of energy prices that dragged down growth during the next couple of years. The good news in 2018 is it’s hard to see a demand shock lurking out there that might derail things the way energy did four years ago. But the bad news is that with the economy now operating above its potential, we’re going to need some positive surprises if this pace of growth is to be sustained.
The surge in economic growth in the second and third quarters of 2014 was due in large part to a boom in energy investment. In the 1990s, the share of GDP attributable to fixed investment in mining exploration, shafts and wells was 0.2%. That share began to increase in the mid–2000s as the rising price of oil incentivized companies to invest in more energy production. This really took off after the financial crisis as the technology improved, new sources of supply were identified and the price of oil remained high. That same share of GDP due to mining investment peaked at 1.1% in the fourth quarter of 2014. This might sound like a relatively small amount in the context of the vast US economy. Of course, it’s not just the direct impact of that investment that mattered, but the multiplier effects. Industrial companies had to build equipment to support the industry. Trucking and rail companies had higher revenue as machinery and raw materials had to be shipped. In the West Texas shale patch, workers got paid more, which meant they could spend more on consumption. Tax revenue grew.
Companies and countries around the world benefited. But the bust reversed all that and then some. This is because in a bust, investment falls faster than it rose in the boom; it only took six quarters for energy investment as a share of GDP to erase five years of growth. Knock-on effects dented both the supply chain for the industry and the global economy, as the dollar surged and emerging-market economies struggled. By the fourth quarter of 2015, GDP growth was down 0.4% from 5.1% in the second quarter of the prior year.
The good news in 2018 is the energy bust already happened, so that shouldn’t be something that can undermine the economy today. Housing is always an industry people think about when talking about risk of a down-turn. Yet, while land, labor, raw materials and interest rates have all been rising, demand for housing remains robust, with millennial entering their family-forming years and low supply in the marketplace. Muddling through seems like the worst case scenario for housing for now.
The challenge for the economy is how much more room there is for it to grow without inflation accelerating. This remains an unknown. Essentially, there are three frameworks for the state of the US economy right now, and they each say things that to some extent are in conflict.
The First focuses on the unemployment rate and demographics. The jobber’s rate is low, and prospects for labor-force expansion due to population growth are minimal. Therefore, economic growth that puts more downward pressure on the unemployment rate could lead to a faster increase in inflation. Keep in mind that the unemployment rate, now at 4%, is below the Federal Reserve’s estimate of full employment.
A second model focused on the labor force participation makes a very different point. During the past 20 years, wage growth has had a closer correlation with the employment – population ratio than the unemployment rate. With prime-age labor force participation yet to return to its pre-crisis highs, the employment – to – population ratio still has room to grow before wage increases and inflation spiral out of control. So that suggest the economy should still have some room to grow.
A third model essentially says that inflation hasn’t been a problem in so long that we shouldn’t worry about it until it’s here. It’s true that inflation both in the US and around the world has been below the target of central bankers since at least the late 1990s.
It’s also true that for two consecutive economic cycles the Fed has tightened monetary policy too much too fast, leading to recessions. By these reasons, we would be better off waiting until we are absolutely sure inflation is a problem rather than relying too much on models.
The prospects for sustainability of strong economic growth boil down to which model or models you believe. Between the stimulus from the tax bill, a lack of obvious signs of over – investment in the economy, and millennial demographics, it’s possible that demand growth can remain strong for the upcoming months.
It also has become shockingly common this and the previous earning season for companies to report better – than – expected profits only to see their share price fall. There are many explanations but none make much sense, nor do they acknowledge the bright outlook for equities.
First-quarter earnings on average were forecast to rise by an exceptionally 17%, so it might seem reasonable for investors to be disappointed with anything short of perfection. However, earnings were close to a gain of 22%, so that theory did not hold water and strong second-quarter earnings seem to have continued. One might then reasonably infer from the share price declines that future earnings projections are being revised lower. Although Caterpillar Inc. for example did suggest the first quarter might have been the peak for its margins, results were sufficiently strong that analysts revised up their estimates for the balance of 2018 and even 2019. There goes another theory out the window. So to explain the market’s behavior, some analysts are suggesting the problems is that so much of the rise in earnings due to the decline in tax rates, which is obviously nonrecurring, so it should be discounted somehow. This explanation is both wrong and incompetent.
Unlike other periods when a company might see temporary reduction in tax rates that artificially boosts results in one quarter that might be entirely reversed the very next quarter, this time the reduced tax rate is recurring. Moreover, every stock analyst understands this and has built a lower tax rate into their earnings forecasts for 2018, 2019 and beyond. In fact, that’s precisely why earnings were expected to rise about 20% this year, an extremely large gain at this late stage of the business cycle. Yet, an incremental gain of 10% is already expected for next year.
Another explanation suggests that stocks declined because the growth rate of profits will decelerate in 2019, which is another incompetent view. The 2018 tax reform resets the tax rate lower and resets the profit level higher. Another 20% gain on top of this year’s 20% increase was never in any analyst’s projections. Instead, it is impressive that analysts expect an incremental 10% rise in corporate profits in 2019 this late in the business cycle on top of the 20% jump gain projected for 2018.
Another widely expressed view is that stocks are historically expensive, so any retreat just represents more reasonable valuations. It has been repeated so often that it must be true, right? The data show the exact opposite. The S&P 500 Index closed at about 2.800 by beginning of August and 2.660 by beginning of May. According to FactSet, project earnings are 158.78 US-Dollar for the year of 2018 and 174.89 US-Dollar in 2019. These numbers may be revised higher rather than lower after analysts recalibrate following the better – than expected first – and second – quarter earnings seasons in which 79% of firms so far beat estimates of the first-quarter earnings.
The estimates indicate the market is trading at 17 times projected 2018 earnings and around 15times projected 2019 earnings. Those compare with the market’s average multiple of 16.7 times over the past 50 years.
The average multiple was calculated over periods of both low inflation and low interest rates and high inflation and high interest rates. Since prevailing interest rates remain exceptionally low historically, a better comparison would be those periods when inflation was comparable to today’s rate of about 2%.
In those periods, the P/E (profit/earning) multiple for the market average was around 19.5 times. On this basis alone, one should infer stocks are actually about 10-12% cheap and even cheaper based on 2019 earnings estimates. Stocks react to multiple influences at any given time, and it is difficult, bordering on impossible, to assign blame for a sell-off to just one factor. The geopolitical situation remains highly uncertain. We hear about who’s sleeping with whom, or who’s lied to the FBI, or who’s paid off which political or non-political figure on the news almost every evening. That’s distressing.
After a superb 2017, some increase in volatility and retrenchment seemed inevitable. But much of this is just noise to the economics of business. The US economy is looking healthy and is growing, profits are rising nicely and stock valuations are actually on a fair level. Interest rates are rising, so some stock volatility should be expected and, of course, stocks have never been known to be stable. So the best explanation so far might be that’s it mostly noise.
Market psychology can greatly affect stocks in the short run especially with Mr. Trump with his generalized rage about trade is a measure of ignorance about globalization and supply chains. Mr. Trump acts like he still lives in the 1950s. In those days, things were made in one country – usually America – and then sold in another – preferably just about everywhere else. The modern world of bits and pieces, with components and semi-finished products moving to and fro across borders, does not fit the president’s template. Nevertheless, the values are there, and it’s reasonable to expect another leg up for the bull market unless a trade war between the US and the rest of the world escalates or we see another round of balance sheet “optimizations” from one of the big four auditing firms like in South Africa, where UPMG has lost 20 listed audit clients since the start of 2017, or Carillion in the UK or General Electric in the US.
Let us not forget, just a decade ago, as the financial crisis gathered momentum, two giants of the US investment landscape, Goldman Sachs and the insurer American International Group, were locked in an arcane but high-stakes accounting dispute. AIG’s fast-growing, London-based financial products arm had written billions of dollars worth of insurance in the form of credit derivatives against a mountain of the investment bank’s packaged-up mortgage loans. As credit conditions deteriorated in the late 2007 and these mortgage-related securities started to buckle, the value of this insurance policy became central to the financial health of both businesses. The bank wanted to recognize the mushrooming gain it was making on its derivative position, based on a probabilistic estimate of the underlying loans defaulting. By its calculation, AIG owed 5.1 billion US-Dollar on its outstanding swap positions, a large chunk of that to Goldman Sachs. Unsurprisingly, AIG took a very different view. The insurer estimated its liability was no more than 1.5 billion US-Dollar, a sum that helpfully allowed it to continue posting quarterly profits. Both sides sought the acquiescence of their auditors for these treatments. Coincidentally, in this case that meant the same firm: Pricewaterhouse Coopers. And despite the iron logic that one side’s gain in a zero-sum trade should mirror the other’s losses, the same firm allowed these divergent – and mutually beneficial – approaches.
Only months later, with markets still frozen, did PwC toughen its line and force its insurance client to take a substantial writedown. In the event, even this proved wildly insufficient. AIG’s derivative positions ultimately forced it to cough up tens of billions of dollars in 2008 – a sum it could only pay because the US government had bailed it out.
There were few credible market prices at that time, let a lone transactions, to support the key valuations. Speciously precise profits and losses were written, not on the basis of concrete observation, but mathematical calculations derived from computer models. As to the logic of such contradictory valuations, Warren Buffett’s investment partner Charlie Munger spoke for many when he observed in a 2009 interview that they “violated the most elemental principles of common sense”.
From a “Big Eight” auditing firms in 1987, the industry consolidated to a Big Five by 1998. With the collapse of Arthur Andersen in 2002 through another auditing scandal, their number shrunk to four. These firms today entirely dominate the markets for auditing around the world. Many observers including us accept this lack of choice and make the industry difficult to regulate. In our opinion it makes the “Big Four” too big to fail mirroring a similar situation as in the tech industry. But let us move to the balance sheet of the world’s second biggest economy “China”.
China’s Belt and Road Initiative is commonly seen as a program to fund and build infrastructure in some 78 countries around the globe. It is also Beijing’s bid to reshape the world by offering an alternative developmental vision to the US-led world order. In the Chinese context, it is the linch-pin of President Xi Jinping’s grand design to create a “community with a shared future for mankind”. As such, the Belt and Road (BRI) is officially intended to showcase an open, inclusive form of development which benefits all countries that participate.
To criticize BRI, therefore, is to censure a rising China’s proposition to the world. Yet there is growing evidence that the infrastructure projects are falling short of Beijing’s ideals and stirring controversy in the countries they were intended to assist.
Debt sustainability, governance flaws and general opacity are some of the main issues. RWR Advisory Group, a Washington-based consultancy, has found that projects worth 419 billion US-Dollar, or 32% by value of the total in Belt and Road countries since 2013, have run into “trouble” – such as performance delays, public opposition or national security controversies. In Malaysia, about 23 billion US-Dollar in China-backed infrastructure undertakings were suspended as Kuala Lumpur ramped up its investigations into corruption surrounding 1MDB, a scandal-ridden investment fund.
Mahathir Mohammed, the country’s newly-elected prime minister, has pledge to review all Chinese projects and “unequal treaties”.
Pakistan is facing an external debt crises exacerbated by ballooning debts to China incurred as part of a 62 billion US-Dollar injection into the BRI. At the start of June, Islamabad’s central bank had just 10 billion US-Dollar in foreign currency left, considerably short of the 12.7 billion US-Dollar in external repayments due next year.
Cambodia is also under stress. A surge in imports of capital goods for use mainly on China-funded infrastructure projects has widened Phnom Penh’s trade deficit to 10% of GDP. Sri Lanka already had to transfer ownership of the port of Hambantota to China after it could not afford debt repayments. In several other countries including Myanmar and Montenegro, debt sustainability questions are emerging.
Certainly many Belt and Road projects have met with success. The Greek port Piraeus for example, which was acquired by a Chinese company in 2016, has seen its container throughput grow sharply. A Chinese-built railway between the Kenyan port of Mombasa and Nairobi has halved journey times. A cotton factory in Tajikistan built with Chinese investment has boosted the country’s processing capacity.
All of these investments have taken place far away from the American continent you might think. You will be surprised:
For much of the past decade, the United States has paid little attention to its backyard in the Americas. Instead, it declared a pivot toward Asia, hoping to strengthen economic, military and diplomatic ties as part of the Obama administration’s strategy to constrain China. Since taking office, the Trump administration has retreated from that approach in some fundamental ways, walking away from a free trade pact with Pacific nations, starting a global trade war and complaining about the burden of Washington’s security commitments to its closest allies in Asia and other parts of the world. All the while, China has been discreetly carrying out a far-reaching plan of its own across Latin America. It has vastly expanded trade, bailed out governments, built enormous infrastructure projects, strengthened military ties and locked up tremendous amounts of resources, hitching the fate of several countries in the region to its own.
China made its intentions clear enough back in 2008. In a first-of-its-kind policy paper that drew relatively little notice at the time, Beijing argued that nations in Latin America were “at a similar stage of development” as China, with much to gain on both sides.
In Argentina for example, a nation that had been shut out of international credit markets for defaulting on about 100billion US-Dollar in bonds, China became a godsend for then – President Christina Fernandez de Kirchner. And while it was extending a helping hand, China began the secret negotiations that led to the satellite and space control station. The giant antenna rises from the desert floor like an apparition, a gleaming metal tower jutting 16 stories above an endless wind – whipped stretch of Patagonia. The 450 ton device, with its hulking dish embracing the open skies, is the centerpiece of a 50 million US-Dollar satellite and space mission control station built by the Chinese military. The isolated base is one of the most striking symbols of Beijing’s long push to transform Latin America and shape its future for generations to come – often in ways that directly undermine the United States’ political, economic and strategic power in the region. Until today, Argentine officials say the Chinese have agreed not to use the base for military purposes. But experts contend that the technology on it has many strategic uses.
Trade between China and countries in Latin America and the Caribbean reached 244 billion US-Dollar last year, more than twice what it was a decade earlier, according to Boston University’s Global Development Policy Center. Since 2015, China has been South America’s top trading partner, eclipsing the United States. China so far has issued tens of billions of dollars in commodities-backed loans across the Americas, giving it claim over a large share of the region’s oil-including nearly 90% of Ecuador’s reserves-for years.
China has also made itself indispensable by rescuing embattled governments and vital state-controlled companies in countries like Venezuela and Brazil, willing to make big bets to secure its place in the region.
China’s policy document on Latin America in 2008 already promised governments in the region to “treat each other as equals”, a clear reference to the asymmetric relationship between the United States and its neighbors.
As “our relationship with the United States diminished, our relationship with China grew,” said once Brazil’s former president, Dilma Rousseff, whose ties with the Obama administration suffered after revelations that American officials had spied on her, her inner circle and Brazil’s state-controlled oil company. The new alliance paid off, helping propel Latin America to the kind of growth rates that Europe and the United States envied. Let’s make it short and say, that Latin America won the China lottery. It helped the region to have its largest growth spurt since the 1970s. The bounty came with significant peril. Industries like agriculture and mining are subject to the boom-and-bust cycles of commodity prices, which made relying on them too heavily a big gamble over the long term.
Sure enough, global commodity prices eventually tumbled. In July 2014, as several leftist leaders were presiding over distressed economies, China signaled even more ambitious plans for the region. At a summit meeting in Brazil President Xi Jinping announced that Beijing aspired to raise annual trade with the region to 500 billion US-Dollar within a decade, matching the current trade level with the US.
Soon after, China took a step that startled the Pentagon. In October 2015, China’s Defense Ministry hosted officials from 11 countries in Latin America for a 10-day forum on military logistics titled “Strengthening Mutual Understanding for Win-Win Cooperation.” The meeting built on the ties China had been making with militaries in Latin America, including donating equipment to the Colombian military, Washington’s closest partner in the region.
Borrowing from the global playbook the United States had used, China organized joint training exercises, including unprecedented naval missions off the Brazilian coast in 2013 and the Chilean coast in 2014. Beijing has also invited a growing number of midcareer military officers from Latin America for career development in China. The contacts have pared the way for China to start selling military equipment in Latin America, which had long regarded the United States defense industry as the gold standard.
Venezuela has spent hundreds of millions on Chinese arms and matériel in recent years. Bolivia has bought tens of millions of dollars’ worth of Chinese aircraft. Argentina and Peru have signed smaller deals.
In our opinion it might be possible that the Chinese had also probably pursued cooperation relationships with Latin American nations, with an eye toward any possible confrontation with the United States. Let us put it this way: “China is positioning itself in a world that is safe for the rise of China”. If you are talking about the 2049 world, from the perspective of Latin America, China will have unquestionably surpassed the United States on absolute power and size. Frankly, if it was a matter of sustained conflict, you reach a point where you can’t deny the possibility of Chinese forces even operating from bases in the region.
But China to be able to continue this strategy – no matter if it is Latin America or BRI-, their own economy has to perform well to provide them with enough liquidity. So let us take an insight on China’s current economical situation.
“If something can’t go on forever, it will stop”. That is going to be true for China, too. What we do not know is when and how it will end. Will it be sooner or later? Will it be easy to cope with or will it be devastating?
The manageability of China’s enormous domestic debts will be of great importance, not just for China, but for the many economies whose exports depend on it. We cannot yet know how the debt surge will end, but we do know how it started. The trigger was the global financial crisis. Between early 2004 and late 2008, Chinese gross debt was stable at between 170 and 180% of gross domestic product. This was higher than in other emerging countries but not much higher. This seemed manageable.
Then, in 2008, came the meltdown of the western financial system and subsequent deep recession in high-income countries. China responded with a huge investment program amounting to some 12.5% of GDP, probably the biggest ever peacetime stimulus. The challenge confronting Beijing was to offset the impact on demand of a fall in China’s net exports of 6% of GDP between 2007 and 2011. In 2007, net exports had been close to 9% of GDP. Since, this was neither economically nor politically sustainable, the fall was permanent. Such a decline in net external demand needed a permanent offset. Given the structure of the economy and the levers in the hands of the authorities, only investment could be increased quickly enough and on a large enough scale. As a result the share of gross investment in GDP soared from an already extremely high 41% of GDP in 2007 to 48% in 2010. This huge investment boom maintained measured growth at close to 10% after the crisis. It also led to a huge and sustained surge in debt, predominantly to non-financial corporations, including off-balance sheet local government financing vehicles. But ominously, far from raising China’s underlying rate of growth, a marked slowdown followed. In the longer term, China’s raised investment rate has delivered the disturbing combination of more debt and slower growth. According to the Institute for International Finance, between the fourth quarter of 2008 and the first quarter of 2018 China’s gross debt exploded from 171 to 299% of GDP. A simple measure of the efficiency of the investment is the incremental capital output ratio (ICOR), which measures the ratio of the investment rate to the growth rate. Until the crisis, the ICOR had not exceeded four any sustained period. Ever since 2011, it has been close to six. It was as though the high-income countries had passed the credit baton to China. For Beijing, this response to the financial crisis had an additional drawback – distracting it away from a necessary rebalancing of its economy.
In 2007, then premier Wen Jiabao declared that China’s growth was “unstable, unbalanced, uncoordinated and unsustainable”. In that year, net exports were 9% of GDP, up from 2% in 2000, investment was 41% of GDP, up from 34% in 2000, public and private consumption were a mere 50% of GPD, down from 63% in 2000, and gross debt was 174% of GDP, up from 146% in late 2000. By 2017, net exports were back down to 2% of GDP: that did represent a rebalancing. But investment was still higher than in 2007, at 44% of GDP, private and public consumption was still only 54% of GDP and debt had soared to three times GDP. In sum, the rebalancing of China’s external accounts came at the cost of still greater domestic imbalances.
So what happens now? How long can China still continue?
There are four conceivable possibilities: a crisis, followed by lower growth; a crisis, not followed by lower growth; no crisis, but reduced growth; and no crisis and no reduction in growth. In a paper published in 2010 of the Free University Berlin and of the University of California argued that “credit growth is powerful predictor of financial crisis.” This finding was from a database of 14 high-income countries. Yet a paper by Sally Chen and Joong Shik Kang of the IMF, published this year, argues that the evidence also applies to China, saying: “China’s credit boom is one of the largest and longest in history. Historical precedents of “safe” credit booms of such magnitude and speed are few and far from comforting”.
This analysis suggests that a crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all this features. Among other things, China has a shadow banking sector, though a study by the Bank for International Settlements argues that “securitization and market-based instruments still play only a limited role”. It is, in all, less complex and more directly connected to the banks than the US system was.
Over the past 18motnhs, regulators have unleashed a “windstorm” against Chinese banks, with rules to prevent out-of-control lending growth and risky funding practices that are especially prevalent among regional players. The forcefulness of the campaign, which has inflicted significant pain on weak corporate borrowers by denying them access to credit, reflects policymakers’ concerns that if left unchecked, problems at regional bank could spark contagion across the financial system.
The connection between weak regional economies and local banks has also drawn the attention of investors like hedge funds that have placed a bearish bet on Bank of Shengjng and other publicly traded regional lenders like Black Snow Capital, a New York based hedge fund.
In our opinion, if and when China’s economic growth begins to sputter, problems will surface first in the set of small banks with fragile balance sheets and lending exposure to anemic regional economies.
Several regional banks have already gone bankrupt in all but name before being bailed out and restructured by local authorities. Others have become piggy banks for local governments or politically – connected tycoons with an outsized influence over local banks. These lenders are largely not permitted to operate outside their home territory and are therefore highly dependent on local governments, state enterprises and entrepreneurs to support their businesses. An institution that refuses to lend to a local champion, even if doing so is risky, could find itself shut off from other, more profitable, projects. “The further out towards the fail you go, the sketchier it looks.”
Problems at small banks matter because their role in China’s financial system is growing. The country last year surpassed the euro zone to become the world’s largest banking system by assets. Meanwhile, small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43% in the past decade. And their role is set to grow further. Some 17 regional lenders are seeking approval for initial public offerings on the Shanghai or Shenzhen exchanges.
When we look at balance sheets of the region’s banks, we have a feeling of déjà vu. In 2008, as traders of bank shares we witnessed firsthand how banking crisis unfold. For us and other observers, the risk posed by regional lenders comes not only from their exposure to weak companies but also from the way these banks obtain funding to make these loans. Traditional banks rely on deposits from households and companies to fund lending. Banks in which deposits comprise a large share of total liabilities are viewed as safe because deposits are unusually “sticky”. As an investor, you would love to see a bank that is completely deposit-funded. Once you see banks levering up through non-deposit sources, the cost of funds increases and you develop the potential for an interest rate shock or a liquidity shock. In China, regional banks struggle to attract deposits because regulators rarely allow them to open branches outside their home provinces. Yet they have displayed a voracious appetite for growth. In a country where licenses for tightly – regulated sectors like banking are a scarce commodity, entrepreneurial managers of regional banks viewed their upgrade as a golden ticket.
“To rise from a small local lender to achieve the size and stature we are today – it took incredibly hard work. You can’t even believe the challenges we’ve overcome”, says an executive at a regional lender in north-east China. With modest deposit growth unable to satisfy their appetites for balance sheet expansion, small banks turned to volatile, wholesale borrowing from other banks. The share of deposits in total liabilities at regional banks fell from 73% to 64% between 2013 and 2017, according to data from 244 Chinese lenders.
For the institution that has grown most aggressively, the share of deposit funding is even lower. At Bank of Shengjing, it was 48% at the end of 2017, while the Bank of Jinzhou, another Hong Kong – listed bank in Liaoning, it was 52%. Bank of Jinzhou said in an emailed statement that it’s “risks are controllable”. At wells Fargo, the largest pure commercial bank in the US, deposits were 77% of total liabilities last year.
“A lot of regional banks only care about short-term profits. They just grab what is right in front of them but don’t consider a long-term development strategy”, says one analyst.
In addition to exposure to weak regional economies and reliance on volatile funding sources, the use of complex financial engineering and creative accounting to expand lending beyond regulatory limits, has a further complicated the picture. A decade ago, much as bank liabilities were mostly customer deposits; banks’ asset portfolios were also simple and transparent, comprised mainly of corporate loans and home mortgages. But breakneck growth pushed banks up against central bank lending limits. In order to keep loans flowing without directly violation those quotas or rules on capital adequacy and loan-loss provisioning, regional banks resorted to financial innovation. By partnering with non-bank financial institutions like trusts, securities companies, and fund managers, they were able to transform loans into assets recorded on their balance sheets as “investment receivables”.
“If my assets are increasing by Rmb 17 billion US-Dollar 2.5 billion in a year, but my loans are only allowed to grow by Rmb 8 billion US-Dollar 1.17 billion then I have no choice but to move the rest of those loans into another category on my reports “says the north-east China bank executive. “So we shift them over into the investment receivables item.” Disguised loans took the form of financial products with exotic names such as “trust beneficiary rights” and “targeted asset management plans”. These products are loans in all but name, but they allowed banks to abide by formal loan quotas and lower risk-weighted assets, which are used to measure capital adequacy.
At Bank of Shengjing, former loans comprised only 26% of total assets at the end of last year, while shadow lending was 54%. At Bank of Jinzhou, shadow loans are 56% of total assets. “These banks are quite vague and blurry when it comes to investment receivables”, says a private fund manager that specializes in banks. “There’s so much massaging of the balance sheet, and they won’t tell you about their internal maneuverings”. Despite the tremendous risks, most analysts do not expect problems at small banks to erupt into a systemic crisis. The central government has the financial resources and technocratic expertise to extinguish small fires before they blaze out of control, and several small banks have been quietly bailed out with minimal systemic impact or even public awareness.
“I’m not worried about systemic risk. Right now the system is safer than it has been since 2010 because of the competence of the regulatory authorities”, says one of our business partners in China.” The processes around management of contagion risks are extremely good in China.”
Still, small banks are expected to face significant turmoil as they adapt to new regulations intended to curb their risky behavior. Banks lobbied fiercely to dilute a draft framework, published in last November, that would limit their ability to transform loans into “investments”, but the final version was largely unchanged apart from extending the phase-in period to the end of 2020.
Another problem China is facing is that the younger generations are consumers who have rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans – used to buy cars, holidays, household renovations and other household goods – grew nearly 40% last year to Rmb 6.8 trillion US-Dollar 1 trillion according to the Chinese investment bank CICC. Combined with a rapid growth in mortgage lending, which makes up most of China’s household debt, consumer loans pushed household borrowing to Rmb 33 trillion US-Dollar 4.8 trillion by the end of 2017, equivalent to 40% of gross domestic product. The ratio has more than doubled since 2011.
Some economists already fear the build-up of household debt will hurt long-run consumption growth as consumers divert larger portions of income to repayments. Large-scale defaults by consumers would put pressure on the solvency of lenders, potentially triggering a financial crisis. While borrowing restrictions make widespread mortgage defaults unlikely, high interest consumer loans are more risky. A study of 54 economies by the Bank for International Settlement found household debt can have negative long-run effects on consumption, which intensify when borrowing exceeds 60% of GDP. China’s ratio is higher than most developing countries peers but still below EU and US levels of 60 and 80% of GDP respectively. But the differential in our opinion could narrow quickly if left unchecked.
The surge in consumer credit has so far helped Beijing to achieve its aim of making consumption the main driver of economic growth. As Beijing pushed the corporate sector to deleverage, households became the largest recipients of new credit in China’s banking system for the first time last year. “It became harder to depend on the corporate sector to maintain growth. So the government thought it could use household leverage,” said Kaji Chen, an economist at Emory University in the US.
Consumer loan growth has been accelerated by the emergence of hundreds of online peer – to – peer lenders who collect money from retail investors and dispense small loans to consumers without collateral. Banks have been reluctant to issue such loans because of the difficulties assessing the credit worthiness of individuals. Outstanding loans on P2P platforms rose 50% last year to total Rmb 1.2 trillion US-Dollar 175 billion, according to the industry monitoring service Diyi Wangdoi. Interest rates can be up to 37% p.a., with additional charges for late payment. Consumers in their twenties have been the core customers. “They feel peer pressure and the importance of investing in themselves… It could be English classes, vocational training, weddings, travel, or buying the latest iPhone”, said Benny Li, chief executive of the platform Huaxia Finance.
Aside from a central bank database, that provides limited information, China lacks credit data on consumers. While the average US consumers’ credit history dates back 14 years, in China you can be lucky to have a few months. In China in regards to credit history we are today probably similar to the 70s or 80s in the US when Sears and JC Penny were issuing credit cards. China’s first unified private personal credit information service, Baihang, only launched in February and has signed up 15 platforms, but most still perform their own checks.
Non-performing loans reported by listed Chinese P2P platforms are about 8% on average – four times the official figure for the banking sector.
The NPL (none performing loan) ratio for the P2P sector as a whole could be as high as 15%. The proportion of overdue loans was even higher, at about 50%, often due to fraud. We would estimate China’s household debt burden was equal to 80% of total disposable income – consumption would collapse if household tried to repay all their debt at once.
With average mortgage maturity about 16 years, a more realistic worry, say analysts, is that mortgage repayments will crimp consumption. Households use nearly 17% of monthly income to repay debt, according to the China Household Finance Survey, up from 11% in 2013. For low income households, it is even 47%. That burden in our opinion could constrain other forms of consumer discretionary spending and enfeeble authorities’ efforts to pivot the economy towards consumption – led growth. There are signs this is already happening. Retail sales growth for example slowed to 8% this year, down from 12% in 2013. Yet annual income growth in recent years has averaged 7%, meaning many households will double their incomes in the next decade. Total household leverage is low, relative to bank deposits and other liquid assets, which are about Rmb 147 trillion US-Dollar 21 trillion or 180% of GDP, according to CICC.
P2P lenders hope their young borrowers can avoid default by earning higher wages. Let us just hope that there are no other problems, so that the young borrowers will reach the shore as investors who had lost money in the recent collapse of P2P platforms had already organized a protest in Beijing. Over the past two months a wave of defaults shocked families who believed their investments were safe. In July alone, 221 platforms experienced “problems”, compared with 217 such cases in all of 2017, according to Online Lending House, a research group.
Now the big question remains – what comes next?
No one likes to predict recession but the global economy in our opinion is likely to experience a significant slow-down before the end of 2019, and the slowdown may be necessary to relieve upward pressure on commodity prices, especially on oil prices.
In its latest World Economic Outlook, the International Monetary Fund forecasts the global economy will expand at 3.9% both this year and next, slightly faster than the 3.7% achieved in 2017. But beneath the sanguine headline numbers, the outlook provides a long list of downside risk factors, including as already mentioned mounting trade tensions, rising interest rates, political uncertainty and complacent financial markets. “Growth generally remains strong in advanced economies, but it has slowed in many of them, including countries in the euro area, Japan, and the United Kingdom,” the IMF admits. “Even US growth is projected to decelerate over the next few years, however, as the long cyclical recovery run its course and the effects of temporary fiscal stimulus wane.”
The broad global expansion that began about two years ago has plateaued and become less balanced, according to the IMF. The principal economies are still growingly rapidly, with high levels of business and consumer confidence, and contributing to optimism among investors, but there are signs and indications of a potential future slowdown. Global trade volumes are still increasing but the growth rate has slowed significantly since the second half of 2017 Leading economic indicators monitored by the OECD have weakened since the start of the year and point to slower expansion over the next six to nine months. The OECD says that growth momentum is stable in the United States and Japan but is easing in the United Kingdom, Germany, France, Italy and Canada. At global level, the expansion is exhibiting increasing signs of maturity, with commodity prices and interest rates rising and capacity constraints emerging in some sectors. For example, aircraft manufacturers Boeing and Airbus are struggling to deliver orders on time as they strive to expand production and their supply chain. US trucking firms are complaining about the lack of qualified drivers and airlines are preparing to cut their schedules in response to rising fuel costs. Growth remains currently strong in the US, but expansion now shows unmistakable signs of being at a late stage.
The US economy has been expanding for more than nine years, according to the Business Cycle Dating Committee of the National Bureau of Economic Research. The current expansion is already the second-longest on record and will overtake the long boom in the 1990s if the economy is still growing in July 2019. Unemployment is close to its lowest level for 50 years and at or below the levels at the height of previous booms. Industrial production is growing at some of the fastest rates for 20 years.
The Institute for Supply Management’s composite index shows one of the broadest increases in manufacturing activity in the past 70 years. And the University of Michigan’s consumer sentiment index shows household confidence close to multi-decade highs. But consumer prices are rising at the fastest rate since early 2012. Canceling out hourly wage growth, despite a strong economy.
The yield curve for US government securities shows also signs of inverting, which has often been a harbinger of previous economic slowdowns. All these indicators show strong cyclical behavior; in every case, they point to an expansion fast approaching the top of the cycle. The global economy is rapidly running out of spare capacity and nowhere is that more obvious than in the oil market.
The oil market’s unused production capacity has fallen to multi-decade lows as a result of strong consumption growth and a series of output disruptions in Venezuela, Libya and elsewhere. Iran’s upcoming sanctions threaten to reduce spare capacity even further from the start of November, pushing it down to the lowest level since the oil shocks of 1973-74 and 1979-80. Global oil consumption has surged by an average of 1.7 million barrels per day in each of the past three years, and is forecast to rise by a similar amount in 2018 and 2019. The result is that the global oil industry is being “stretched to the limit”, according to the International Energy Agency.
Oil prices have already climbed by more than 70% over the past 18 months, putting upward pressure on global inflation, though they have subsequently eased back slightly in recent weeks. In the past, the final stages of an economic expansion have usually coincided with a sharp escalation in oil prices, with prices dropping back during the subsequent economic contraction. The causality between economic growth and oil prices runs in both directions, with economic growth as a key driver of oil consumption and prices, and oil prices acting as a check on expansion.
US recessions in 1973-74, 1981-82, 1990-91, 2001 and 2007-09 all helped to cool previous rapid increases in oil prices by cutting consumption growth. With oil market running out of capacity, commodity prices rising and interest rates turning higher, it seems increasingly likely the global economy will experience a slowdown within the next 18 months.
The coming slowdown need not be as wrenching as the recession that accompanied the financial crisis in 2008-09. In fact, it probably won’t be. The last downturn was exceptional in terms of its length and severity. Most of the business cycle contractions since 1945 have been much shorter and shallower.
Like several previous slowdowns, the next one in our opinion might be marked by a “pause” in growth rather than an actual decline in economic activity. And it need not be global in scale as India for example with a moderate oil price has still lot of potential to grow further. Some slowdowns were confined to a subset to economies, such as the East Asian financial crisis of 1997-98, while others continue expanding. But the global economy and the oil market appear to be on an unsustainable trajectory, and the only way to resolve the growing contradictions in our opinion is likely to be a slowdown in the next 18 months.
