On Sunday I suggested that the newly-announced RMB 4 trillion fiscal package would cause markets to surge, but that the rally would not last very long as analysts began examining the numbers more closely. In fact the duration of the rally was even shorter than I expected. On Monday the markets did indeed surge, with the SSE Composite rising 7.3%, but by Tuesday markets had again turned bearish. After running up 0.7% in the first two hours of trading, the market once again lost its legs and the SSE Composite ended at 1844, down 1.7% for the day.

According to an article in Bloomberg the decline was led by financials and consumer companies “on concern a government stimulus package will fail to arrest an economic slowdown.” In fact all day analysts around the world have been weighing in on the fiscal package, with some arguing that this was a major event that would provide a serious boost to Chinese and global growth and others arguing that anywhere from RMB 1 trillion to RMB 2.5 trillion was old spending or overly optimistic projections and that the timing of the disbursements would not have a big enough impact on the immediate contraction in demand faced by Chinese businesses.

Standard Chartered’s Stephen Green, one of the bank analysts for whom I have a lot of respect, says that his reading of the package (and he warns that there are still big holes in his reading since details are so sketchy) suggests that government spending will contribute about 3.5 percentage points of real GDP growth to the Chinese economy in 2009. Since it contributed about 2.5 percentage points in 2008, this means that the total additional impact of the new package will be to boost growth next year by about 1 percentage point – not far from his original expectations.

Deutsche Bank’s Jun Ma was slightly more optimistic than Green about the additional impact of the fiscal plan (he thinks it will contribute an additional 2 percentage points to 2009 GDP growth). His optimism however was more than compensated for by his concerns that the economy is slowing faster than expected, and he actually cut his 2009 GDP growth forecast today from 8.0% to 7.6%.

Meanwhile the government seems clearly to recognize that timing is a problem. According to an article in today’s China Daily:

Premier Wen Jiabao Monday urged local governments not to “waste a single minute” in implementing the 4-trillion-yuan ($586 billion) stimulus plan unveiled on Sunday. “In expanding investment, we must be fast, effective and forceful. We must focus on priorities and adopt a down-to-earth attitude to implement the measures,” he told an executive meeting, which was presided by him and attended by provincial leaders and Cabinet ministers.

For those who are more optimistic about the effects of the stimulus package, one of the key arguments is that previous fiscal stimulus packages have worked in China. For example today’s South China Morning Post has a fairly optimistic report titled “Spending will offset falling external demand” in which the argument is explicitly made:

The mainland’s massive economic stimulus package would rouse the country’s slowing economy by offsetting flagging external demand brought on by the global financial crisis, analysts said yesterday. Shenyun Wanguo Securities macroeconomist Li Huiyong said the success of a similar programme in 1998 indicated that expanded government spending would stimulate fixed-asset investment and economic growth in the short term.

Maybe. But I think we need to be a little cautious about comparing fiscal expansion in 1998 and fiscal expansion ten years later. In the 1990s economic conditions were much tighter and fiscal activity likely to have a larger impact. It was relatively easy for a smallish country to benefit from stimulating fixed asset investment since the world could easily absorb higher production. At that time the US was receiving massive capital inflows – especially from Asian countries looking to shore up reserves after the great scare of 1997 – and its financial system was finding ever new ways to intermediate liquidity to consumers eager to take advantage of rising real estate and stock market prices to increase spending. The US, in other words, seemed able to absorb almost unlimited expansion in Chinese capacity.

But, as I argue in Sunday’s entry, conditions have changed dramatically. First, China’s GDP is about 2.5 times bigger today than it was back then, and exports have grown much faster than GDP, so China is far from being a “smallish” country. More importantly, the world is looking for more demand right now, not more supply. In a global system with so much excess capacity, and with a marked tendency to excess savings (Americans have to save more, Asians don’t want to consume more), I am a lot more pessimistic about the domestic impact of China’s fiscal expansion, especially if the goal is to increase investment. The world will not simply absorb a lot more Chinese capacity. This package is only useful to the extent that it boosts real demand, especially if it boosts household demand, but that doesn’t seem to be in the cards.

At any rate we need to wait a while longer before we can really judge the potential impact of the fiscal package. And we also need more time to see exactly how fast other parts of the economy contract. In that sense my guess is that the government rushed to announce the package partly as a shock to confidence, perhaps because the numbers they are seeing are much worse than what we have been able to see so far.

Of course part of the rushed timing is probably to head off potential trouble at the upcoming G20 meeting. By announcing such a large headline package, China can argue that it is contributing both to the global monetary easing as well as to global fiscal expansion. This will take the pressure off other demands – for example one way China can contribute to global expansion is by a more radical reforming of the currency regime, and it clearly does not want to do that. October’s trade surplus – announced today – was 20% higher than September’s all-time record. This won’t make it easier to argue that they desperately need to keep the RMB from rising too much.

In all the hoopla about the fiscal package, two economic numbers slipped out almost unremarked. Yesterday the National Bureau of Statistics announced that PPI inflation had declined from 9.1% year on year in September to 6.6% in October. Today they announced that CPI inflation declined from 4.6% year on year in September to 4.0% in October.

I am going to be accused of unrelenting pessimism, but I will explain nonetheless why even this “good news” worries me. As regular readers of my blog know, I tend to have a very monetary view of inflation, and I was convinced until two or three months ago that China’s furious money expansion of the past few years was going to lead inevitably to rising inflation. As I see it, when money growth outpaces the needs of the economy for a sustained period of time there are only three ways to adjust. The most benign way is that over a period of time the central bank engineers slower-than-warranted growth in money so that, in exchange for a temporary slowdown in economic growth, money supply and the real economy can get back into line.

The less benign ways consist either of a surge in inflation that causes the nominal value of the economy to rise sufficiently to meet the money supply (which is what I was expecting), or of a rapid and unexpected contraction in the money supply, which usually takes place in the form of a collapse in credit and in asset prices. If the former isn’t happening, then my model says that the latter must be happening, especially since the decline in inflation isn’t just because of food prices. Non-food inflation dropped from 2.0% in September to 1.6% in October.

We know that some of this contraction is indeed happening. Real estate and stock market prices are definitely falling. Loans in the banking system aren’t growing as fast as the government would like to see. But these aren’t new enough, or dramatic enough, to explain the rapid fall in inflation. Could it be that real credit growth is much lower than we think – that perhaps there has been a sharp contraction in off-balance sheet loans and in the informal banking sector? We don’t know, but we need seriously to consider that this indeed may be happening.

The just-released trade numbers have little to bring cheer. Export growth continues to slow (19.2%, compared to September’s 21.5%), but as a warning of how bad domestic demand conditions might be import growth slowed much more sharply (15.6%, compared to September’s 21.3%, and less than half of July’s 33.7%). The consequence was a surge in the trade surplus, which rose by one-fifth over last month’s record number. This is the third month we have broken world records, and this certainly isn’t going to please China’s trading partners who are struggling with their own domestic slowdown.

Money continues to pour into China via the current account – I wonder what is happening in the rest of the country’s balance of payments. Is hot money outflow accelerating? I guess we won’t really know until January’s fourth quarter data release.

Tags: Fiscal package

China’s stock markets keep bouncing around, sometimes in synch with the rest of the world and sometimes out of synch. Yesterday it was out of synch as it lost 2.9%, largely because a number of corporations announced lower-than-expected earnings growth. A useful chart I filched from yesterday’s Wall Street Journal Asia shows the slow-down:

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Today Chinese stock markets seemed to rejoin the global pack with the SSE Composite rising 2.6% to close at 1765. Last night’s interest rate cuts by both the Fed and the PBoC spurred some limited optimism and especially drove up financial stocks. The 3-year deposit rate was cut by 36 bps (greater than the traditional 27 bps), the 5-year deposit rate was cut by 45 bps (ditto) and the 1-year to 5-year lending rates were cut by 27 bps.

I say optimism is limited because trading today was sluggish and volume very low. We have now closed four days in a row below the supposedly solid support level of 1800, below which (once again) the market could not go. In belated recognition that 1800 was not as rock-solid as they had once thought, the government seems to be backing away from the introduction of short selling and margin trading – a policy it announced a few weeks ago to my great surprise. According to an article in yesterday’s South China Morning Post:

The central government is set to delay the launch of margin lending and short selling amid mounting worries the potentially risky trading methods will exacerbate market turbulence. Sources said the State Council had put on hold plans for the much-anticipated launch next month because of fears the introduction of the practices could send the market into another tailspin.

It is another remarkable about-face for mainland financial regulators, who delayed the introduction of index futures last year after getting cold feet about the impact on the market.

It may be embarrassing for them to have retreated so dramatically, but it is better to be embarrassed than wrong. Hopefully their retreat won’t have added to market fears.

What is more likely to inspire fear is information recorded in an interesting article by Geoff Dyer in today’s Financial Times. One of the things that had surprised me recently was the continued strong domestic demand in September. I had expected that as the buying spree associated with the Olympics wore off, we would see a sharp drop in the growth rate of domestic consumption. So far that hasn’t seemed to happen except in certain big-ticket items, like cars and apartments.

In fact in September retail sales – the best available but not always satisfactory proxy for household consumption – grew at a record pace in nominal terms, around 23% year on year, and with the decline in CPI inflation this translates into even higher relative real terms. But the things that we can measure didn’t hold up as well as that might imply.

Car sales, for example, in September were down around 4% (I am quoting from memory, so the number may be wrong), which is the first time this has happened in many years, and I am hearing that October isn’t going to be much better. Fewer people flew on domestic airlines last month than they did in September of last year. And not only are real estate prices dropping quite quickly, but volume seems to have collapsed.

Yet the September numbers show healthy retail sales growth. Perhaps weakening demand will show up in October numbers. According to Dyer’s article:

Signs are growing that China’s economy could be cooling quicker than expected, with a string of big industrial companies announcing production cuts over the past week. The cuts have come as anecdotal evidence from other companies suggests a surprising weakening of demand in October amid the global financial crisis and a local housing market slowdown.

…”Orders for cars and home appliances have already begun to shrink,” Xu Lejiang, chairman of Baosteel, China’s biggest steelmaker, said last week. Zhou Xizeng, analyst with Citic Securities, said steelmakers were trying to adjust rapidly to uncertainty about demand and an inventory build-up. “The recent drop in production is a sort of psychological panic,” he said.

Executives in a number of other industries also said demand had been unusually weak in recent weeks. But some executives said the slowdown could also reflect shorter-term factors such as customers reducing their inventories because of global uncertainties. “We had been expecting this to pick up a bit after the end of Olympics restrictions on factories, but things have been very quiet,” said the chief executive of the China operations of a large paints company. “We are trying to work out how much is due to weak demand and how much to destocking.”

As I have said many times on this blog, rising inventory is going to be a key indicator of trouble ahead. So far we can find trouble in specific areas, but inventory levels on the whole seem fairly stable. Obviously this will change if we see a real slowdown in demand, but so far the numbers are not disquieting.

On that note a group of about a dozen crack Peking University finance students, mostly graduate students, have recently formed the Guanghua Students Monetary Committee to act as a sort of shadow PBoC, and Logan Wright and I are their advisors. They will meet every Saturday to analyze economic and financial market conditions and the PBoC balance sheet, and to discuss PBoC policy, and one of the things they plan to compile and report on is inventory levels among Chinese corporations. They’ll have their own website up and running soon enough, and I’ll publish the address when that happens, but I expect to be able to use some of their findings in this site.

Finally, before closing I want to flag, for those who are interested, another excellent report from Standard Chartered’s Stephen Green. This one, called “China – How much bang for the fiscal buck” was published on October 27 and starts out:

How much growth can we expect the Ministry of Finance (MoF) to provide over the next few years? With China’s economy slowing, many folk are already breathlessly awaiting a fiscal rescue. In recent notes we have looked at how other governments stimulate their economies, how China organised its stimulus package 10 years ago, and how this coming package might be funded. Today, we think through what such stimulus might mean for GDP growth and the overall economy.

Green attempts to estimate the parameters of fiscal expansion and the amount by which it might boost next year’s GDP growth, and his calculations will surprise many. He figures that an expanded fiscal package might only add 0.5-1.0% more growth in 2009 than it did in 2008. Fiscal expenditures, in other words, are unlikely to make up for any significant slowdown in the economy due to slowing exports, weakening domestic demand, or declining investment unless the expansion is much greater than most think it is likely to be.

I have no ability to forecast or estimate growth based on anything more sophisticated than my previous experiences working in countries that have gone through economic slowdowns with weak balance sheets, and the two tend to be self-reinforcing, so the smartest projections tend systematically to under-estimate growth in rising markets and over-estimate growth in declining. As I have said often enough, I expect to see analysts continuously revise their estimates downwards for the next few quarters, as they have already been doing. Already I am hearing a number of pessimists posit 7% as an upper limit. Yikes!

Tags: Fiscal package, Green, GSMC