Ominous Clouds Forming in China's Economic Data (w/ Leland Miller)
LELAND MILLER: I'm Leland Miller. I'm CEO of China Beige Book and we are the only large scale private data on the Chinese economy. We track growth trends, we track inflation, we track the jobs market. Most interestingly, we track the credit environment, which is not just formal banks, but also the shadow banking system. We track who's accessing capital, what they're paying for that capital, and what they do with that capital once they get it. These are some of the most interesting lenses into the Chinese economy beyond simply aggregate gross data. We're the only large scale independent data. All these other leading indicators you see, data troves that people present to you, they're all derivatives of official data, which means their derivatives of the story that Beijing tells you and wants you to know. Now, Beijing has an economic narrative, but they also have a political narrative, which dictates how they term everything. If you're only looking at official data, one, you're getting very lagging information. You're not getting real time data the way we present it, but you're also not getting the real story. The Chinese are very invested in having stability. They don't like big dips. They don't even like big accelerations, because that means they have to acknowledge the dip in the first place. It's very important to have things outside of Beijing's talking points in order to understand what's going on and how to forecast potential problems and busts. Well, we have a nationwide data collection platform. We have, in the last several years, ensured that this is entirely electronic. We track thousands of businesses over 3300 Chinese firms. We track across the entire geographic expanse of China, broken down in eight regions. We track seven major sectors. We track 34 discrete sub sectors. Then we take and slice and dice that data by private state, by firm size, so micro, small, medium, large. We track Hong Kong owned versus Chinese owned versus American owned companies and we just get every different shade of the company so we're able to know exactly where growth is, and where it may not be. The third quarter was the worst quarter of 2019. In our data, and it wasn't even close. We saw almost all our headline metrics fall. We saw almost all our key sectors fall. Manufacturing was the worst of these. You saw revenue and profits and pretty much everything that had been going relatively stable for a while, fall the third quarter. You also saw some even scarier trends. Borrowing in the sector, borrowing the manufacturing sector is at absolutely sky high and unsustainable level. We started to see it pick up in 2018. Its accelerated through 2019. Now, we're at a level which over 30% of manufacturing firms are borrowing every quarter. The way we break that down is that either you've got, over the course of three quarters in 2019, every firm and manufacturing has borrowed, or you've got 30% of firms borrowing every single quarter. Now, they're both bad news. It's very problematic to look at this because this is a sector that should be getting less capital that should be slowing down. That's something that the Chinese are very, very worried about. There is an enormous amount of policy support being pushed into the sector, which we can see through our credit metrics. Let's go back a year. About a year ago, we were saying a Chinese economy in 2018 which is doing better than people thought, partly because tariffs were coming and people were frontloading purchases. In the third quarter at our flash data, we saw export orders and domestic orders, but new orders just crash. We saw some real struggles in manufacturing. Manufacturing sector in the third quarter of last year looked really weak, the rest of the economy looked okay, but the fourth quarter, manufacturing took everything down with it. You saw every sector worse off, every region in China worse off, every headline metric worse off. It was the worst data that we've seen, other than the end of 2015 in the history of China Beige Book. I think at that point, there was a decision made in Beijing to push an economy at all costs, that they could not divine President Trump's intentions on the trade war, but they couldn't take any chances. They needed to unleash some of the credit that they've been holding back. You saw that going right into 2019. The first quarter of 2019 was a remarkable run recovery. We saw it in our flash data in February, it became consensus when public data showed that the first week of April, maybe week before. What was so amazing about this was not just the fact that there was more credit, or there was more borrowing. It was the type of firms that were borrowing at the time. We saw typically disadvantaged firms like private firms and small medium sized enterprises outborrowing other firms in the economy. We saw rejection rates at the lowest level in China Beige Book history. Clearly, the message from Beijing was get these guys credit, keep them afloat at all costs. That was Q1 that caused the recovery, Q2 was something very interesting, because then we saw the return of shadow banking. In addition to a still very active credit provision regime in the second quarter, we saw a return of shadow banking, and the last two quarters, second quarter and now, third quarter. We've seen the highest share of shadow banking as a percentage of overall borrowing that we've seen in the entire history of China Beige Book. Shadow banking is back. Now, what's so interesting about the third quarter-- second quarter, just to look back to the second quarter, the second quarter was interesting, because you actually saw a more resilient economy than what was being talked about. The headlines were all about 27-year lows in GDP. We weren't seeing anything good, but we were also weren't seeing the bottom for the economy, like a lot of people were talking about. We saw Q2 performance that was very stable from Q1. Now, the interesting thing about the third quarter is that despite the continued provision of this much credit, 6-year highs in firm and corporate borrowing, the highest bond sales we've ever seen going up five straight quarters. Despite the resurgence of shadow banking, that's at the highest levels we've seen in the history of the survey, the economy still turned downwards, and every sector still turned downwards. It's quite amazing. This could be an inflection point for the Chinese economy right now. Because what they have been doing up to this point, which has not been the big infrastructure investment of 2016, all our construction subsectors are looking very bad right now. They are not using the economy the way they did 2016, but what they are doing is providing an enormous amount of credit to firms, including firms that don't merit that type of credit access, and they're keeping the economy going. In the third quarter, it wasn't enough and things slowed anyways. I think one of the problems with the official story on China is that because they don't acknowledge the downturns, they can't acknowledge the upticks. You've had a story, a popular story that's been a slowing China over the last few quarters and now, you're seeing more credit provision. Most of the story is about looking at sort of the aggregate credit numbers, and you're seeing a turn up at some of the aggregate credit numbers. You're seeing a belief then that this is going to lead to a stronger economy. The reality is that they had been pumping quite large amounts of credit in the economy for firms for a long time now. This is nothing new but it's also not leading to an uptick. It's finally wearing down more and more credit as needed. At some point soon, if they don't have a solution to the trade war, and there isn't a reversal in some of the global trading dynamics that we see have been slowing to, you're going to have to see stronger stimulus. That's when they might start considering some of the old methods back in 2016. I think a lot of it depends on whether the third quarter really is an inflection point, not just in the strength of the economy, which I think it might be, but also in Beijing's mindset on how to treat slower growth. One of the things the Chinese Communist Party has had a very hard time doing over the past several years, is acknowledging slower growth, acknowledging a path forward of dramatically slowing growth because the promise that the party has made to its people for decades now has been, "We will bring you out of poverty, and we will make you richer." That's not going to happen in terms of aggregate GDP growth being kept at a very high level anymore. Now, because of the dynamics of the global economy right now and specifically, because of Trump's trade war, the Chinese now have an external excuse for why things are slowing. In a very bizarre way, the fact that they're undergoing all these problems right now gives them a beautiful excuse for why it's not Beijing's fault that they have to acknowledge lower growth. What you're seeing for the first time, and this is not a coincidence that a bunch of sell side institutions, a lot of banks have been out there with growth numbers for the next year in 5s. This is because Beijing has told them it's okay to release that type of information. The reason Beijing is okay with this is they're starting apparently, apparently starting to acknowledge the story that we're on a long term slow down. This is not 6 forever, 7 forever, or heaven forbid, 8 forever, which is what we used to hear about five years ago about this GDP. This is a long term slowdown and that that will lead to a healthier, a slower, healthier Chinese economy, but not one that can grow anywhere near the levels that it has been for a long time. If the Chinese can use external circumstances as an excuse for why the economy is slowing, instead of the real reason, which is an enormous amount of debt, good money chasing after bad for decades now that has slowed the return on investment, and met made sure that growth will continue to slow down precipitously over the coming years, it's a beautiful story for Beijing. It's one that they might start adopting. There is definitely an impact on the Chinese economy in terms of the trade war but this is essentially a story of China's slowing. One of the big mistakes that people made when China's growth looked very strong in the end of 2016 and 2017, and even into 2018, was buying into the government line that this was rebalancing and a movement to the new economy and that this was a services story or a retail consumption story. None of that was actually evident in the data. Now, we did see some rebalancing back in 2013, 2014. That's not what we've seen since 2015. The strength that we saw in the economy for the last several years, before the current dip, was manufacturing driven. This was an overheating manufacturing economy. This was the old economy. This was property, this was commodities, exactly the opposite of what China promised that they would be transitioning their economy to. The problem here is that manufacturing is now overheated. It has enormous headwinds on the international scene because of trade and because of a global manufacturing recession, and other reasons. You need other parts of the economy to pick up the slack, but you're not seeing services pick up the slack. You're not seeing retail pick up the slack. Consumption isn't falling off a cliff, but the Chinese consumer is not going to save us all. What is needed right now is a rethinking of the idea that we have this inevitable transition of the Chinese economy into a services new economy. The Chinese haven't been doing enough on that front. In fact, they've been going backwards for three years. Now, they're facing enormous downward pressure, because manufacturing has run its course, and other sectors of the economy weren't prepped to be able to pick up the slack. Well, they're going to blame Trump on the one hand, and the second, they're going to disavow the numbers for growth. Now, the Chinese have historically promised a lot of things. [Indiscernible] is protect the 8, which was 8% GDP growth that if you talk to Chinese economists, they would claim you're going to see 8% Chinese economic growth for the next 30 years. Now, this was never realistic, but it was always the talking point. When growth dip below 7, it became 7, and then it became 6. I think what's happening now is a rewriting of the story. Now, the fact that Beijing has an external actor or actors to blame on this makes this a lot easier. What they're going to start saying and they should have been saying for a long time, is that the Chinese economy doesn't have to grow at some enormous level. What it needs to do is get stronger and more robust and it needs to deal with the problems like bad debt in the system, it needs to restructure towards new economy sectors, not old economy sectors, it needs to have less emphasis on manufacturing more on services, all the old maxims here, they all apply. China's going to have to redefine its narrative as part of a slower, healthier course to more sustainable, lower growth. Now, China can come out the other side, fine, one piece. The problem here is the countries around the world, particularly the commodities producers, who have relied on China's sky high GDP growth to fuel their economies, and they haven't taken this opportunity to diversify their economies away from the reliance, overwhelming reliance on Chinese demand. China could come out of this okay on the other side if they play their cards right. These other countries who have been relying on sky high Chinese demand, they're in real trouble. Well, any of the big commodity producers, South Africa comes to mind, Brazil. I think that anyone who is- - to some degree, Australia, a lot of countries that have long relied on Chinese demand for their commodities are going to be in big trouble. You're just not going to see that demand going forward. These economies have had years to transition out of being one trick ponies, and most of them have not done that. These are the dislocations we'll start to see beyond China, outside of China. Those countries that have been relying on Chinese growth blindly for years and years and years, are going to finally realize that these official GDP numbers that they've been relying on, crumble like sand. The problem with this question is that on any particular day, the Trump administration swings from one side to the other so depending on what day you play it, this will either be extremely forward looking or it'll look wrong. I think generally speaking, you were very, very close to a deal back in May. The claims were that the deal was 90% done, the deal was 90% done. The Chinese backed out and ever since you've had a much thornier path forward. Now, the thing to keep in mind here is that this was never about structural reform of the Chinese economy. The original deal even before the Chinese blew it up May of last year, was never about true structural reform, which of course would be reform of SOEs, identification and transparency ever, say local government subsidies, doing something about made in China 2025, none of these were ever part of the negotiation. What we saw originally was a desire by the White House, when they realized that, to come to some quasi-substantive deal that also had a political upside. What you saw was a targeting of intellectual property, which has been a major problem, and the original May text had some very strong protections on intellectual property. On the intellectual property side, you actually had a fairly robust regime that was being talked about. This was a problem that the Chinese acknowledge privately is a major, major problem. With an advanced economy, they're no longer a copycat economy, they have been moving more and more towards understanding the need for stronger intellectual property. You had intellectual property protection, you had greater market access. You did have some substance to the original deal. You also had things that were purely political. There was an enormous frontloaded purchase component to this, which was intended for no other reason than to get President Trump reelected in 2020. You had this deal that was a mixed bag, wasn't structural reform, did have some substance, and this broke down last May. Ever since then, you've had the White House go back and forth between whether they think it's advantageous to really stick it to the Chinese with maybe the full 550 billion of tariffs on the Chinese economy to really weigh Chinese growth down and create leverage, or whether it makes more sense to make a deal to get agricultural purchases back before the election to help farmers out and there's been this back and forth. I think we're things are now is it more and more hawks are trying-- even the hawks in the White House are looking at the December tariffs, which are set to kick in on the last tranche of tariffs and would like to not have that head. You're working-- the White House is much more conciliatory right now. They're working to try to peel this back. They're looking to peel back even the September tariffs, if possible, and get a 250 billion tariff line, which I think is sustainable, to carry straight through the election. No big deal. A stalemate with some small deals, you get agricultural buys ramped up, it helps the President and maybe you get some substance on intellectual property. It sounds good. The problem is that the Chinese aren't really interested right now in giving President Trump victories. I think they would like nothing more than to get him out of office by 2021. The balance here will always be how much pressure is on the Chinese economy right now, which is quite considerable as we talked about, versus how easy would it be for them to simply concede some ag purchases, which they'd like to do, and maybe some easy, substantive provisions coming from the IP chapter in May to get to some baby deal. Right now, they're working on a little bit more than the baby deal, but I think that they would like that middle course but right now, it's a lot of gamesmanship on whether we're going to be able to get there. What was very clear back in May is that the deal agreed on between Liu He, who was the emissary of Xi Jinping, and Bob Lighthizer at USTR, the deal agreed was just not going to pass muster in Beijing and we could speculate all day whether this was Xi himself or was hardliners in Beijing. When he brought the deal back, it was returned with writing all over it. Now, here's some reason to believe that the Chinese thought they could get away with it. What you saw in the weeks up to that May revision was a lot of things just being pulled out on the US side to get to a deal. You saw all kinds of cyber security and other provisions that were taken out of the deal, because they realized that President Trump was interested in getting this deal in May. They thought that once they'd agreed on the frontloaded purchases amount, that they would be enough to get the President there, he wouldn't be concerned about some of the other aspects. They were right, except on one count. Structural reform, as we said, was never going to be in this agreement. However, the President and Lighthizer have claimed the structural reform will absolutely be part of this. The way that they're going to defend structural reform there is a deal is by saying structural reform doesn't mean what you think it means, doesn't mean what a China watcher would typically say structural reform is, it means codification of the deal in the Chinese law. Because we've looked at what happens when a former US president, previous US presidents have gotten agreements from Chinese leaders, they've gotten promises and they've never panned out. What structural reform would be in this context would be not just a promised by Xi Jinping but a codification of the agreement in the Chinese law so the Chinese had to implement what they promised. Now, that's a little bit naive to start with. You have Chinese Communist Party is not beholden to rule of law, they can do what they want. The idea that a rubber stamp National People's Congress would call this law really had no substantive basis. It's very important to be defensible by the president, that this had structural reform in it. The agreement broke down in May over the idea that the Chinese wouldn't just promised to implement this on their own timeline, that they needed to put into Chinese law. The Chinese didn't want to do this. They didn't think this would be a big enough issue to break off talks. President Trump thought otherwise and ever since, we spiraled off in another direction. Well, you've got more factors to play now than you did say six months ago, or 12 months ago. You have President Trump looking at a slowing US economy, you have the Chinese under a lot more pressure for their economy, you have the Fed potentially jumping in on Trump's side. On the other hand, Trump needs purchases to help support his farm base. You have a bunch of different factors here and everybody's trying to play a game of chicken. Now, the chances for a deal by the end of the year are still relatively good, not a great deal. Not a big deal, not a substantive deal, but a deal. The Chinese, if they think they can get something worthwhile, and the optics are okay, they don't look like they're conceding, would be more than happy to do a bunch of agricultural buys. They need pork, they need soy, they're happy to buy up US commodities, but they don't want to give a victory to President Trump for nothing. If you have a baby deal, that's one possibility. You have ag purchases in return for a punting of tariffs going forward, it's a baby deal, things don't get worse, but things don't get much better. What the White House would like to do right now, they just haven't figured out the way to gloss the pig, to get the Chinese to buy on to this, would be to get a deal, a bigger deal so what they could get is some substantive aspects of the May deal. For instance, taking some important parts of the IP chapter from the original May deal and in exchange for that, peeling off the September tariffs you've already seen and in exchange for ag purchases, you're punting on the December tariffs, probably October tariffs too, you return the tariff level to 250 billion. Now, you hear these types of middling plans all the time. You have a lot of skepticism when you hear them but what makes this one different is it's backed by some very important hawks in the administration, including USTR. They would like to see the level pulled back to 250 billion if there's something to be given an exchange, because this is a level in which a lot of people in the administration think is sustainable to carry through from now through the election, not destroy the Chinese economy, but put a lot of pressure on them, have it very defensible politically for Trump if he faces Elizabeth Warren, or if he faces Joe Biden or someone else. It's the perfect middle ground. That's what they're moving towards now but it's a very difficult problem to try to figure out how to get something substantive from the Chinese as more than a promise. You don't have an infinite amount of time at the end of the year. They could promise to change the IP regime but when does that get implemented? Does the implementation, is that required in order for the tariffs actually to get kicked, or the tariffs punted until then? None of this has been worked out but they're working on being more conciliatory. They'd like to pull things back by the end of the year. Well, the fascinating thing is that the best case scenario, in some ways, is going to look a lot like the worst case scenario, at least from 30,000 feet. What you're going to see over the next 10 years, say give or take a few years on either side, is an economy that descends into 1% or 2% growth, that'll be the cruising altitude of the Chinese economy going forward. How they get there is going to be very, very different, or it's very key how they get there. On a best case scenario, they start doing all the things they should have been doing for the past couple of years but have not, they restructure, they reform, they do leverage, they stop relying on massive amounts of infrastructure, which they've been good at for the last year at least. They start focusing on slower, healthier growth. They push a rebalancing into the services economy, they stop the transition from happening out of commodities and property. You've got to allow layoffs, you've got to allow defaults, you've got to allow trust products to go belly up and companies to go belly up. You've got to eliminate the zombie economy aspects that you're seeing too much of now, this desire for the government not to let anyone fail ever. If you get rid of that, you're going to have some choppy periods. China could soar into this next period with a much more robust albeit slower economy. If they don't do the things I just talked about, they're also going to be seeing 1% or 2%, maybe worse growth, 10 years from now, but you're going to be seeing it fall outside their control. They'll continue to boost the economy through debt, through infrastructure, through supporting everything and everyone and every product all at the same time. Eventually, you're going to have an intrinsic slowdown, because the stagnation that comes from pouring good money into bad over and over and over again instead of productive investments will eventually slow the economy down. They'll have much more headwinds to being this global power that they wish to be. Either way, I think the Chinese economy is going in one direction but Beijing right now has the ability to guide it towards a healthy, slower outcome or a disastrously slow outcome and we haven't seen which they've chosen yet.