China Hits A Brick Wall: For First Time Ever, Record Chinese Credit Creation Fails To Stimulate Economy

Submitted by Gordon Johnson of Axiom Capital

We believe that exhibit 1 says a lot: it shows that despite a record level of new credit issued by China’s PBoC YTD through Oct. 2017 (which stands in stark contrast to government authorities continued statements that China is de-levering), China’s economic backdrop is currently experiencing:

• (a) monthly construction new start (commercial + residential + office) growth slowing Y/Y (Ex. 2),


• (b) monthly fixed asset investment growth slowing Y/Y (Ex. 9),


• (c) monthly cement output slowing Y/Y (Ex. 5),


• (d) monthly electricity production slowing Y/Y (Ex. 6),


• (e) monthly M2 money supply growth slowing Y/Y (Ex. 7),


• (f) monthly household loan growth slowing Y/Y (Ex. 8),


• (g) monthly private fixed asset investment growth slowing Y/Y (Ex. 10), and


• (h) monthly home price growth slowing Y/Y (Ex. 12) – in fact, select data points have turned negative Y/Y.

Stated differently, while the lion’s share of our client base continues to tell us, with respect to our bearish views on China… “President Xi Jinping will simply stimulate more if/when things get bad”, we would highlight, again as detailed in Ex. 1 below, China stimulated at a record pace in 2017, yet it did not resonate in improved economic activity (in fact, the exact opposite appears to be unfolding – i.e., economic growth is slowing across a number of data points).

Furthermore, underpinning our view that China’s debt stimulus was targeted specifically at the months preceding the 19^th Party Congress in Oct. 2017 (i.e., when President Xi Jinping consolidated power to become the strongest Chinese leader since Mao Zedong), implying we may see a phase of debt fatigue, we note that in the first 10 months of 2016, incremental credit issued in China on a month-over-month (“M/M”) basis was negative three times (i.e., May, July, and Oct.), and averaged $189 billion on a monthly basis; yet, in the first 10 months of 2017, incremental credit issued on a M/M basis was positive in each month outside of Oct., and averaged $429 billion on a monthly basis (in Oct. 2017, the month the 19^th Party Congress concluded, new credit issued fell by $11.9 billion M/M).

WHAT DOES IT ALL MEAN? The broader point is… when you issue an unprecedented amount of credit targeted at a growing number of negative ROI projects multiple decades, at some point the law of diminishing marginal returns sets in (since 1/1/09, China’s credit has grown by CNY153.9 trillion while GDP has grown by a much more modest CNY 48.5 trillion, or a multiple of 3.17x, meaning a lot of bad investments have stacked up over the years) – keep in mind that China’s $3.6 trillion in credit issued in 2017 YTD through Oct. is more than the entire developed world combined. Put in the simplest of terms, at some point the incremental dollar in new credit created actually does more harm than good.

Ex. 1: China New Credit Created YTD Through Oct.

Note: Credit created = TSF + Local Gov"t Debt.
Source: PBoC; NBS; ChinaBond.

SO WHERE FROM HERE? When considering China hit the afterburners on new credit issuance in 2017, yet the impact seems to be quickly fading, it would appear we may have reached the point of “no return” (while Consensus, at this point, seems completely oblivious to this possibility, the recent sell-off across the Chinese stock markets suggest investors on-the-ground in China may be catching on).

CONCLUSION: In the face of China’s TTM 3Q17 credit as a percentage of GDP coming in at 250%, to “keep the party going”, Xi Jinping would have to force new credit issuance far in excess of $4.0 trillion in 2018 (which could trigger a number of ratings downgrades, as well as a reassessment by the IMF of China’s “market economy” status).

Moreover, given what we’ve seen this year – i.e., 101.7% Y/Y new credit issuance growth YTD through Oct. 2017 – it seems the level of credit necessary to stimulate growth in China could prove elusive at this point (we don’t recall any economist’s forecasts exiting 2016 pointing to China’s new credit issuance more than doubling Y/Y in 2017, yet that’s exactly what’s happened – had this been our base case, we would have expected all economic indicators in China to be moving substantially higher at this point in the cycle). Thus, to the thesis that rests on a view that: “Xi will just stimulate more”, we would argue that the extent of the stimulus necessary may be so high at this point that President Xi Jinping may have lost sight of how much debt he needs to “get things going again”. Should this prove to be the case, China’s economy will continue slowing, putting pressure on bulk commodity prices, and, ultimately, industrial/steel stocks (CAT, URI, FMG, RIO, X, CLF, GATX, and TRN, all of which we have SELL ratings on).

HOW’S THE DATA LOOK IN THE FACE OF CHINA’S RECORD 2017 CREDIT “BINGE”? So how do the data points look? Well, here’s a few (we feel the charts say it all)…

Ex. 2: Monthly Construction Starts (Residential + Commercial + Office)

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 3: GDP Growth Internals - China (FAI, Industrial Production, & Retail Sales)

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 4: China Monthly Steel Production by Year

Source: World Steel Association (WSA), National Bureau of Statistics (NBS), Axiom Capital Research.

Ex. 5: China Cement Output

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 6: Y/Y Growth in Electricity Production by Month

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 7: China M2 Money Growth, Y/Y% - Multi Decade Low (bearish)

Source: Peoples" Bank of China (PBOC), Axiom Capital Research.

Ex. 8: 3MMA Household Loan Growth, Y/Y%

Source: Axiom Capital Research, Bloomberg, National Bureau of Statistics.

Ex. 9: Monthly Total Fixed Asset Investment and Y/Y Growth

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 10: Monthly Private Fixed Asset Investment and Y/Y Growth

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 11: Private Investment in Industrial Sector and Y/Y Growth

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 12: Average Price Change of New Residential Buildings, by Tiered-Cities, %Y/Y

Source: National Bureau of Statistics (NBS), Axiom Capital Research.

In short, we feel China could be the “black swan” that ruins the stock market rally party for many in the industrials space. Caveat emptor.

China Manufacturing PMI Jumps To Five Year High

China"s reflation story (on the back of a record amount of debt created last year) was put on display on Friday morning when both the Chinese manufacturing and non-manufacturing PMI rose more than expected, with the Manufacturing PMI rising to a level not seen since April 2012. According to the NBS, China"s Mfg PMI rose from 51.6 to 51.8 in March, the highest in almost five years, and above the 51.7 consensus estimate, while the non-manufacturing PMI also jumped, rising from 54.2 to 55.1, the highest in two years.

The National Bureau of Statistics reported that New Orders rose from 53.0 to 53.3 while new export orders rose to 51, the highest since early 2012. Broken by firm size, the state-measured PMI showed largest enterprises were the strongest at 53.3, followed by medium-sized companies, while small firms remained in contraction at 48.6. Perhaps the most notable internal metric was the employment index, which hit the 50 level for the first time since May 2012, marking the first time the manufacturing sector has not lost jobs in nearly 5 years.

As the chart below shows, the catalyst for the move higher has been the recent surge in producer prices, which have soared as much as 7% Y/Y on the back of soaring commodity prices; both have since peaked and it is expected that in the coming months, China"s inflationary pressures will subside especially given the recent efforst by Beijing to reign in out of control credit, especially shadow, issuance.

A subindex for construction activity rose in March for the first time since the start of the year, hitting 60.5. As a reminder, and as Deutsche Bank explained two weeks ago, the only thing that matters for both China, and the rest of the world, is making sure China"s housing bubble, as explained in "Why The Fate Of The World Economy Is In The Hands Of China"s Housing Bubble," does not burst.

"The first quarter is off to a good start," said Wang Qiufeng, an analyst at China Chengxin International Credit Rating in Beijing, quoted by Bloomberg. "The upbeat momentum may last through the first half of this year, as the government is pushing investment."

“The fact that the real strength is with the non-manufacturing PMI suggests that there’s fundamentally a good story going on here,” said James Laurenceson, deputy director of the Australia-China Relations Institute at the University of Technology in Sydney. “Manufacturing is where you’d expect to see the effects of stimulus showing up.”

So is China worried by the potential inflationary signals carried by today"s PMI prints? Oh yes, which is why the PBOC did not conduct a reverse repo liquidity injection for the sixth consecutive day, saying in a statement that the liquidity level if "relatively high" despite traditional month-end liquidity demands; as a result in the past 6 days, the PBOC has now drained some 320 billion yuan from the banking system.

In recent days this has led to a sharp move higher in various repo tenors, most notably the benchmark 7-Day repo, which on Thursday fell w bps to 2.81%, but has jumped sharply in the past week as interbank funding problems have emerged, leading to the biggest drop in months in the Shanghai composite index overnight. Keep an eye on the the repo market in Friday"s session for any acute liquidity shortages, especially since China"s onshore market is closed on Monday and Tuesday.

Iron Ore Tumbles As China Steel-Producing Hub Found Lying About Production Cuts

Very much like the self-imposed output cut by OPEC and non-OPEC members which successfully boosted the price of crude over $50 even if global crude inventories "inexplicably" continue to hit new all time highs, one of the main reasons why commodity metal prices have seen a dramatic increase in prices over the past year has been China"s solemn vow to cut back on overcapacity and excess production. In 2016, China’s state council set out plans to eliminate 100 -150 million tonnes of steel capacity in a bid to restructure the economy from one driven by government-led infrastructure investment and exports to a more consumption and services-oriented model. Last January, the hub of China"s steel production -  the northern province of Hebei - announced it would cut output to ease pollution and help curb oversupply. Hebei said it planned to reduce steel output by 8 million metric tons in 2016, its Governor Zhang told local lawmakers, while Iron ore production would be cut by 10 million tons.

More than one year later, it appears that Governor Zhang lied about Hebei"s intentions, and according to a provincial notice by the Chinese province, it has emerged that China"s compliance with its own mandatory production cuts has been "problematic."

A steel factory in Wu"an, Hebei province

According to Reuters, the same Hebei province, China"s biggest steel-producing area, launched a probe into steel overproduction in the city of Tangshan "amid concerns that firms have continued to raise output despite mandatory capacity cuts."

Tangshan is the heartland of Chinese steel production. The city is home to the headquarters of the state-owned Tangsteel Group, which in 2006 merged with other companies to form Hebei Steel Group, the second-largest steel producer in the world. Located around 100 miles east of the capital Beijing, Tangshan is on the frontline of the country"s "war on pollution", and was seventh on the list of China"s ten smoggiest cities in the first two months of this year.

Hebei was ordered by China"s central government to investigate firms in Tangshan that have "restricted but not cut production, restricted production but not actually cut emissions, and cut capacity but actually increased output," the provincial dated March 25 said, and circulated by traders on Monday.

Cited by Reuters, an industry source based in Tangshan confirmed the veracity of the document, but said it was unclear whether the new round of inspections would have any immediate impact on production or prices. The document was issued by a special provincial policy team responsible for restructuring the steel industry. It said Hebei has already established an inspection team and Tangshan must begin its own investigations immediately.

The FT adds, that the notice, sent on Saturday, cites orders from President Xi Jinping and Zhang Gaoli, the vice-premier, for Tangshan to investigate the problem of falsely reported plant closures and rising steel output.

Tangshan produces around 90 million tonnes of steel a year, more than the whole of the United States. While China has pledged to slash steel capacity by between 100 million and 150 million tonnes over the 2016-2020 period to shore up prices and ease sector debts, there have been lingering suspicions that this may have been a ruse to push commodity prices higher, boosting cash flows of overindebted domestic producers, who employs millions of low-skilled workers and whose mass defaults could result in widespread social unrest.

The FT confirms as much:

local authorities have dragged their feet on implementing orders to shut down steel mills because doing so would potentially eliminate hundreds of thousands of jobs.

“The local government will always want to protect its own industries because company officials get promotions based on growth,” says Scott Laprise, the founder of steel research firm LTH Consulting. “No one gets a promotion because they lost jobs and their local economy did poorly.”

In addition to the cuts noted above, at the start of the year, Tangshan promised to shut a further 8.6 million tonnes of annual crude steel capacity in 2017. It pledged to make cuts of 40 million tonnes over the 2013-2017 period and had already shut 31.9 million tonnes by the end of last year. Hebei promised to cut crude steel capacity to less than 200 million tonnes a year in the province by the end of 2020, down from 286 million tonnes in 2013. It aims to shut 15.6 million tonnes in 2017.

However, in light of the recent revelation, it appears that local producers did not take the directives too seriously, and may have simply been stockpiling the excess production.

As Reuters adds, the Ministry of Environmental Protection has routinely named and shamed municipal governments in Hebei for failing to implement pollution rules; so far it has failed to achieve the desired result.

Of course, if one province is reneging on its production cut agreement, why not more?

That may indeed be the case: one month ago, Greenpeace said that China"s active steel capacity actually rose by 35 million tonnes in 2016 after the high-profile closure program focused mainly on shutting plants that had already been idled. Additionally, production of crude steel in 2016 actually rose about 1% from the year before, to 808m tonnes, according to preliminary data from the National Bureau of Statistics.

"The steel industry"s capacity reduction targets need to be upgraded to reductions in actual production - only then will we see real improvements in air quality," said Lauri Myllyvirta, senior global campaigner at Greenpeace East Asia.

The problem is that just like with OPEC, there is no credible way of enforcing capacity cuts.

"Local governments will report back and simply say certain companies eliminated capacity or were closed or went bankrupt,” said LTH Consulting"s Laprise. “No one is checking what is supposedly already closed and what is actually closed.”

Excess production notwithstanding, China"s jawboning alone, and stated commitment to removing overcapacity, has managed to send prices of core commodities such as iron ore soaring as shown in the chart below.

Should it be confirmed that China was merely jawboning about removing excess supply then the appreciating commodity complex, a core driver of the global reflation trade which in recent months appears to have plateaued may soon see prices tumbling, in the process launching the latest deflationary wave to emerge out of China, and putting an end to the "global coordinated recovery" as so many analysts have called it in recent months.

It may already be happening: prices of iron ore, the key material used in steel production, tumbled fell 6.7% on Monday as inventories of the commodity at China’s ports rose. The fall brings the price to its lowest since January 10, down nearly 18% from its peak in March.

China Vice Premier: "Those Who Manipulate Economic Data Will Be Punished"

Ask any economist or trader over drinks, or in any other setting, what they think about Chinese economic data or financial reporting and the answer will be one and the same: it"s all fake.

And it"s not just skeptical outsiders who share this view: China has made it all too easy for anyone to be convinced, with reports such as this one "China Threatens Its Economists And Analysts To Only Write Bullish Reports, Or Else", and, of course "Chinese Province Admits It Fabricated Economic Data For Three Years." Apparently, China is also a master when it comes to deadpan humor and/or self-referential irony - or is merely galactically obtuse - because on Thursday China"s Vice Premier, Zhang Gaoli, warned that economic statistics "must not be fabricated" and that those caught manipulating data should be punished and face consequences in their careers.

According to Xinhua, the central government requires authentic and reliable economic data to set policy, and China should have a traceable system to punish those found responsible for faking statistics, Zhang said Wednesday during a visit to the National Bureau of Statistics, the official Xinhua News Agency reported.

Zhang also encouraged local authorities and other agencies to better coordinate their work and enact statistical reforms.

It gets better. 

Following the recent humiliation when in January it was revealed that Liaoning province had faked its fiscal revenue and other statistics from 2011 to 2014, the government was humiliated, not so much that Chinese data was fabricated data - everyone knew that was the case long ago - but that it was caught. And since the genie was officially out of the bottle, Beijing had no choice but to show a bold facade and signal that China"s leaders are "attaching greater importance to data accuracy", to demonstrate to the world just how serious it is in cracking down against data manipulators.

Meanwhile, Bloomberg reported last month that the central government has planned steps that will "improve" the independence of data collection and reduce the influence of local governments. In other words, Beijing is trying to scapegoat provinces and regional governments, for engaging in what it itself does.

And since the data rigging will not end for the economy which always comes within 0.1% - and usually just above - of the "consensus" GDP number, we wonder if the Chinese government will be as quick to "punish" its own members once more data manipulation cases are exposed following the crackdown on "regionally" fabricated data. We doubt it.

Chinese Province Admits It Fabricated Economic Data For Three Years

While it will hardly come as a surprise to China watchers who have for years mocked China"s cooked "data", overnight the state-run People"s Daily reported that the severely impacted by the commodity crunch of the past 2 years rust-belt province of Liaoning fabricated fiscal numbers from 2011 to 2014, raising fresh doubts about the accuracy of China’s economic data just two days ahead of the release of China"s GDP report.

The city of Shenyang in Liaoning province of China

City and county governments in the northwestern region committed fiscal data fraud in the period, Governor Chen Qiufa said at a meeting with provincial lawmakers Tuesday, Bloomberg adds. Not surprisingly, the fabricated economic data was meant to show a state of economic strenght with fiscal revenues inflated by at least 20%, and some other economic data were also false, the paper said, without specifying categories.

Why paint a rosier picture? The same reason as alwasy: Chen said the data were made up "because officials wanted to advance their careers." The fraud misled the central government’s judgment of Liaoning’s economic status, he said, citing a report from the National Audit Office in 2016.

The admission of fraud comes now because with growth now moderating, officials have "sought to improve the credibility of economic data" as diffusing financial risks becomes a key policy consideration, along with keeping growth ticking along at a rapid clip.

And while the outgoing Obama administration is cracking down on "fake news", Ning Jizhe, head of the National Bureau of Statistics, has said China is focusing on preventing "fake economic data" as well as increasing the quality of its statistics. Naturally, incidents such as this one will make China watchers that much more skeptical.

Fake economic data may be the least of Liaoning"s worries which in recent years has seen an unprecedented purge of more than 500 deputies from its legislature Bloomberg reports. The deputies were implicated in vote buying and bribery in the first provincial-level case of its kind in the Communist Party’s almost seven-decade rule, according to the official Xinhua News Agency. Former provincial party chief Wang Min, who led Liaoning from 2009 until 2015, was earlier expelled following corruption allegations by China’s top anti-graft watchdog.

As China"s debt-fueled economic impulse continues, if only for a few more months, we wxpect more such instances of fake data to swim to the surface.