Europe on the mend and China decelerating

By Edward Harrison On Apr 23, 2014

The Euro area composite PMI rose to 54.0 from 53.1, making it unlikely that the ECB will move against deflation in May
The Chinese HSBC/Markit flash manufacturing PMI was up to 48.3 from 48.0. However, this still shows contracting manufacturing and means China is still rebalancing

Yesterday on Boom Bust, the finance show I produce, Marshall Auerback gave a good overview of what is going on in Europe and what the policy options are. His verdict is that eurozone breakup is off the table for now and Europe is on the mend. But these are cyclical factors that belie a still weak institutional framework for the eurozone. Video below

This cyclical rally is powerful though. The composite PMI was the best in the Euro area since May 2011 and was above expectations as the market expected a drop. Outside of Germany, there might have been a decline but the German composite PMI powered forward with the manufacturing survey rising to 54.2 from 53.8. The German service sector was even stronger, rising to 55.0 from 54.0. Given perpetually weak domestic demand in Germany, the uptick in services is a good sign.

On the other hand, France was weak. The manufacturing PMI wilted to 50.9 from 51.9, just above contraction. And the PMI for the service sector fell to 50.3 from 51.4, also just ahead of contraction. France has its work cut out as it is over the 3% hurdle with a projected 3.8% deficit for this year. That means austerity. And this will keep the numbers weak. The government’s projected 1% growth figure for 2014 looks very optimistic.

And as I have indicated before, the bank-sovereign nexus is pro-cyclical, meaning that it adds to upside momentum and adds to downside risk. Since we are in an upswing, what we see in Europe is a compression of yields as the periphery converges. And this is self-reinforcing as it buoys the balance sheets of periphery banks, removing bank capital shortfalls as a potential point of risk for the sovereign.

Portugal is the country to watch now. Two weeks ago Fitch raised its outlook for Portugal. While Italian 10-year yields are at the lowest in over 20 years, and Spain flirts with a sub-3% 10-year, Portugal’s 10-year yield has dropped 62 bps in the last month alone. That is about double the decline in Spain and Italy. So Portugal and Greece remain the best bets in terms of yield pickup in Europe.

The Portugese government is still in austerity mode. It will cut spending and reduce headcount in order to meet its deficit targets. And remember that the Troika have a 2.5% deficit target for 2015 for Portugal, which is inside of the 3% Maastricht hurdle. The Portuguese will try to cut via retirements and attrition rather than cutting wages or raising taxes.

So that’s Europe. I would say the situation is positive, with France being the sick man of Europe, while the crisis in Ukraine remains an overhang not to be dismissed. Andy Lees of The Macro Strategy Partnership notes that Europe including Turkey, Norway and Switzerland consumed 18.7trn cubic feet of natural gas in 2013. 30% of that volume was supplied by Russia, with 16% flowing through the Ukraine. To replace the Russian imports, Andy says the US would need to pump an extra 5.7tcf a year or 15bcfd. This is 56% of US shale gas production, or 74% of the entire US shale gas production given 25% of the energy lost in the freezing and transport process. Andy has a lot more. But the bottom line is Europe will remain dependent on Russian gas.

In China, the PMI showed a contraction in manufacturing. This is the fourth consecutive month of contraction. The numbers were in line with expectations and are consistent with y-o-y growth in the targeted 7.5% range. In terms of weakness, export orders dropped 2% and the employment sub-index fell 1%. New domestic continue to contract, with that sub-index at 47.7. The dollar is at a 2-year high of nearly CNY6.25, something that will create tension in Chinese-American relations.

The question at this point is when will the Chinese bring on the stimulus. I don’t think they will for a while yet. The Chinese are serious about rebalancing and have said the key variable is employment and wages. Capital Research says that wages for migrant workers are growing at 10.1%. And that’s a key variable for the Chinese in terms of trying to keep civil unrest at bay as they rebalance. That says the Chinese are fine with GDP growth dropping ever so slowly over the next few quarters and years as they deal with the bad debt problem and move away from the export and infrastructure growth model.

Also, regarding the relaxation of the reserve ratio requirement for rural banks, we should not expect this to extend to all Chinese banks as a way of easing credit conditions and adding stimulus. Michael Pettis notes that “authorities have only cut the RRR twice in the last fifteen years, once in 1999 and the second time in 2008, both times when the PBoC was worried by substantial capital outflows. If we begin to see substantial capital outflows, in other words, we might see the authorities respond by cutting RRR, but until then I think it is unlikely.”

In his weekly piece, Pettis had a lot more to say about GDP growth deceleration as an outgrowth of credit writedowns that I agree with. First of all, lets be clear that writedowns are a recognition of previous overinvestment and phantom GDP that came from that investment. And socializing these losses in various ways slows down GDP going forward by various means like repressing interest rates or withdrawing capital from sectors of the economy. So loss socialization is not a benign event that implies continued high growth. It is a recognition of phantom growth that was the result of malinvestment that is being unwound.

Here’s how Pettis puts it:

GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%. Why? Because in an economy in which losses were not simply accumulated and rolled over, the amount of the write-down (which would have occurred, either as a default, or as an equivalent transfer from a more profitable part of operations to subsidize the loss) would have shown up as lower GDP.
In that case all GDP-related data is biased in a predictable way. Productivity numbers, for example, are biased upwards, and real worker’s productivity is lower than the numbers posted officially.
Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down. Over long periods of time every economy recognizes investment losses, but depending on how these losses are treated, the recognition can take place either in the period in which the losses occur or over the loan amortization period.
There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created. If the gap is covered by financial repression, for example, (i.e. the authorities force down the borrowing cost to less than the increase in productivity generated by the project, so that the borrower shows a profit), the cost of amortizing the loss is passed onto the net lenders (usually, but not always, the household sector, who are net lenders to the banking system) in the form of a lower return on their savings. This lower return reduces their total income and, in so doing, reduces their consumption, which effectively reduces future GDP growth by reducing demand.
GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained. When the system is still accumulating and rolling over losses, in other words, GDP growth is systematically biased upwards. When it stops, GDP growth will be systematically biased downwards.

Michael has 7 other points that flow logically from the first points. But the synopsis here has to be that China’s previous GDP growth numbers overstated true GDP because much of it was goosed up by overinvestment that is now being unwound in the rebalancing.

As long as the Chinese continue to rebalance, these credit writedowns will be amortized over the life of the loans and the losses socialized in various ways that subtract from GDP going forward. This means a gradual reduction in Chinese growth rates until we hit the wall in terms of wages and jobs, which are the key element for the government before they decide to step in with stimulus.

Michael Pettis says:

Rebalancing means effectively that consumption growth (and household income growth) must exceed GDP growth, which means that even if GDP growth slows to 3-4%, as I expect, household income can continue growing at 5-6%. This explains why, contrary to the consensus, a more slowly growing, rebalancing China will not lead to social unrest.

In my view, this is going to be a drag on commodity demand and will ultimately hit commodity exporters’ economies harder than the Chinese economy given the size of the Chinese and the excess demand for commodities they added. Let’s also remember that the Chinese have stockpiled commodities for speculative purchases and in order to play fast and loose with capital control restrictions. As commodity prices drop, we will see these stockpiles come onto market as these agents face pressure from the decline in the value of collateral for debts they have incurred, further depressing commodity prices.

Two other items of interest that I don’t have time to develop thoroughly are:

US existing home sales were weak at a seasonally-adjusted annualized run rate of 4.59 million. Cash buyers and distressed sales still dominate
Russian stocks are down for the third straight day. The Russian government OFZ bond auction failed due to a lack of bids at the minimum acceptable price