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October 27, 2016

The China Connection

by Amareos.

Among the slew of Chinese macroeconomic data released last week the one that grabbed most headline coverage was the Q3 GDP numbers showing that for a third consecutive quarter the pace of economic expansion was, at 6.7%, bang in line with the midpoint of the government’s growth target[1]. Despite the release, investor fears over the possibility of a Chinese “hard landing” persist.

One reason why such fears continue is widespread doubt among economists and investors alike regards the reliability of the GDP data in capturing the true trajectory of the Chinese economy. As one media headline noted the 6.7% growth rate shows “uncanny stability”[2]. Such concerns are hardly new, or totally unjustified[3], and various methods and alternative data sources (such as electricity usage) have been used to generate unofficial proxy measures of Chinese economic activity.

For those skeptical about official Chinese GDP data, from the crowd-sourced sentiment data that we track at Amareos we can infer that the demand-side stimulus injected during the 2015 slowdown has contributed to boosting economic growth.

As can be seen in the exhibit below, public perceptions of Chinese economic growth have rebounded sharply from the very negative readings observed last year and are now in positive territory (ie. above the long-run average). This is entirely consistent with strengthening Chinese economic activity and should serve to alleviate concern that the “uncanny stability” in the official GDP data is masking a serious underlying growth deceleration in China.

Exhibit 1. Crowd-Sourced Economic Growth Sentiment – China



That being said, for many investors, even those who do not have major doubts about the reliability of the official GDP statistics, hard landing fears are not just about China’s headline growth rate. They stem from concerns about the unbalanced nature of China’s economy; that is to say, it is more structural than cyclical. As a result, and even though it seems paradoxical, such hard landing fears cannot be eradicated by one GDP number, or even a series of GDP numbers, purportedly showing decent economic growth.

Given the subdued nature of world economic growth in the post Great Recession period, in order to sustain robust rates of economic expansion – certainly by international standards, if not China’s earlier, albeit recent, history – China had to rely increasingly on domestic sources of demand, most notably investment, rather than net trade as was the case previously. Indeed, the demand-side policy response to the 2015 slowdown adopted by the Chinese government was centred on boosting investment via stronger infrastructure spending, real estate spending and easier credit.

Typically, economists consider investment-led (I) domestic demand growth to be superior to consumption-led (C) domestic demand growth. This is because, while both boost aggregate demand (recalling your economics 101 class: GDP = C+I+G+(X-M)), in the case of investment once projects are completed they add to the aggregate supply in the economy thereby raising the potential growth rate[4] – something that does not occur with consumption[5]. This assumes, of course, that investment goes into productive projects; productive in the sense that it generates future returns sufficient to recover the initial capital outlay and pay off accrued interest.

As any Austrian School economist worth their salt would be only to keen to point out, such assumptions do not always hold. This is perhaps especially so when the scale of that investment has been of a magnitude unprecedented in economic history and has resulted in total debt in China surging to more than 230% of nominal GDP – levels that are unnerving not only to investors but also supranational organizations such as the IMF and the BIS[6].

All this serves to fuel apprehension as to how the Chinese economy will transition from its current debt-fuelled investment-led economic growth model to a more balanced, sustainable (read less reliant on debt expansion) growth model. In other words, the key question is whether Chinese policymakers have sacrificed long-run macroeconomic stability in order to maintain short-term stability. Only when this question can be unequivocally answered in the negative will hard landing fears vanish.

Until then they will persist, or given the recent sharp rise in Chinese property prices (some Tier 1 cities have witnessed price increases of over 70% in less than 18 months), even intensify further. After all, as was clearly demonstrated in the US almost a decade ago[7], bursting housing market bubbles have the potential to inflict great damage to an economy.

According to the latest crowd-sourced sentiment data for Chinese real estate, animal spirits in this sector have fallen noticeably of late – both residential and commercial sentiment indicators have dropped into negative territory[8]. Whether this shift in crowd thinking towards Chinese real estate represents a positive pre-emptive cooling (calm heads prevailing), or is evidence that the bubble is in the process of bursting remains to be seen, but it certainly warrants close attention.

Exhibit 2. Real Estate Sentiment – China



However, before “hard-landers” get too excited, they also need to consider what tools remain at the disposal of Chinese policymakers to reverse a very negative economic outcome should it start to manifest – something that is not often considered.

We would agree that continuing to rely solely on additional domestic demand stimulus is futile as it only serves to exacerbate already severe imbalances in the Chinese economy. So what else is at their disposal?

Obviously, one stimulus avenue that is now open to the Chinese is exchange rate devaluation following the surprise relaxation of the longstanding USD peg last August. In fact, the Chinese have already been utilizing this avenue to loosen monetary conditions with the CNY having depreciated more than 10% in trade-weighted terms since the regime shift. That said, there are limits as to how much China can, or would wish to, lean on currency depreciation to boost growth.

First and foremost, with economic growth subdued in many parts of the globe, political sensitivity to “competitive devaluations” (currency wars in its more salacious form) is extremely high. Hence, it is hard to envisage that other leading nations would sit back and allow China to attempt to reverse a hard landing via a substantial depreciation of the CNY.

Second, there are domestic reasons why China would not wish to drive its currency sharply lower. In the months immediately following last August’s FX regime change there was widespread expectation that the CNY would continue to depreciate – crowd-sourced sentiment towards the CNY slumped (see exhibit below) – which triggered capital flight. Eventually the pace of these outflows was such that the PBoC was forced to step in and support the CNY by selling-down foreign exchange reserves.

Exhibit 3. Crowd-Sourced Sentiment – CNY



This is something the Chinese clearly wish to avoid repeating not only because of the negative connotations associated with capital flight but because they are keen to see the CNY become a major reserve currency. Indeed, just this month the CNY was formally adopted into the IMF’s composite reserve currency – the SDR – with a weight of 11% (higher than for the JPY or GBP). And, while reserve currencies are not typically held for “trading profit maximization” motives, a substantial devaluation would hardly be good optics for a fledgling reserve currency.

The only remaining policy tool for Chinese policymakers, therefore, is to tackle the underlying issue – an unbalanced economy – via structural reform. Such an approach has long been talked about, but implementing structural reforms is never easy – just ask ECB governor Draghi about his experiences in the Euro zone! As we have noted on previous occasions, the payoffs are often far into the future and hence beyond the incentive horizons of most politicians. That said, China is renowned for its long-term policy planning.

One area where there is sign of progress on this front is the diversification of the Chinese economy away from manufacturing towards higher-value service sector production[9]. It is clear from comments from China’s political leaders that a key part of this process is developing its tech industry[10]. What’s more these words are being translated into action.

This week saw the start of a three-week test period for the new Shenzhen-Hong Kong Stock Connect scheme which will allow cross-border trading between the two cities’ stock exchanges. Specifically, it provides international investors with access to trade 880 Chinese companies listed on the Shenzhen exchange and mainland Chinese investors access to 417 Hong Kong listed stocks. Assuming the trial period goes smoothly over the next couple of weeks, it will go live on 21 November.

This venture represents a broadening in the financial interconnectedness of Hong Kong and mainland China – Hong Kong and Shanghai launched the same initiative back in 2014 – and it will help open up China’s capital markets to the rest of the world[11].

Also, importantly, the extension of the Connect scheme to Shenzhen will provide international investors with easier access to Chinese tech companies because with a weight of 20% this is the second largest industry sector in the Shenzhen exchange, unlike the financials-heavy Shanghai exchange where tech accounts for only 4%.

So, not only does the soon-to-be introduced Shenzhen-Hong Kong Connect scheme provide overseas investors with potentially attractive cross-border investment opportunities in China’s thriving tech sector, but it will also serve to facilitate the much-needed rebalancing of China’s economy. And, as we have discussed this is key to maintaining it future economic success and, finally, eradicating concerns about “hard landings”.

Sentiment Analytics are based on MarketPsych indices

[1] It was also bang in line with consensus forecasts, but this is hardly a strong validation of economic forecasting given how incredibly stable Chinese GDP growth rates have been in recent years (more on that in the next paragraph).

[2] See:

[3] Of all the major economies the Chinese statistics bureau is one of the fastest to publish macroeconomic data i.e. the lag between the reference period and the release date is one of the shortest. For a country of such a size and with a vast population this speed naturally raises doubts as to the data’s reliability.

[4] Potential growth rate being the rate of economic expansion that maintains equilibrium between aggregate demand and supply ie. non-inflationary.

[5] Indeed, as Keynesian policymakers and investors are beginning to appreciate, boosting consumption can, via its intertemporal substitution effects, actually hamper future potential growth rates. We discussed this in greater detail in an earlier BSEC research note available to Amareos subscribers on request.

[6] The BIS estimate credit gaps, defined as the difference between the credit-to-GDP ratio and its long-term trend, for individual economies. On their latest estimate, China’s credit gap stands at 30%. This is not only the highest of all the 40-odd countries where estimates are published (see: but is a level that has preceded painful deleveraging episodes in other countries in the past, including Japan, Spain and Thailand. In addition, the IMF is concerned about the efficiency of additional investment given the GDP lift from new credit has been declining over the past decade – see:

[7] Seems like only yesterday – time flies!

[8] We should note that the declines in Chinese real estate sentiment is largely reflective of the changing tone of mainstream media. Social media, by contrast, shows less negativity. To compare the differences between the two media please visit our website or download our App available on the Eikon Studio.

[9] Services now account for more than 50% of Chinese GDP, up from 44% in 2011 – a significant shift. It has the additional, but not insignificant, benefit of being greener economic activity than the type of mining and manufacturing to which China has traditionally been associated with.

[10] See:

[11] Supporting China’s aim of having the CNY become a major reserve currency.

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