2015-02 Relative Price Trends

Consumer prices increased 1.40% year-over-year in February, whereas purchasing prices fell 5.90% over the same period.  Based on this metric, China is in its 39th month of economic contraction.
Unfortunately for savers, this year’s Lunar New Year was more expensive than last year’s.  On the bright side, overseas Chinese that earned U.S. dollars abroad and then return to China for the Lunar New Year would have paid less for the same products this year. The exchange rate between the U.S. dollar and the Chinese yuan increased from ¥6.06 on January 31, 2014 to ¥6.25 per dollar on February 19, 2015, meaning a 3.14% increase in the value of the dollar.  The dollar price of Chinese consumer goods decreased 1.74% over the last 12 months, meaning China is experiencing consumer price deflation in dollar terms.

Lower than two percent consumer price inflation has led some commentators and policy makers to call for more easing by the central bank.  However, an economy with a stock market index increasing 58% in value measured in gold over a 12 month period is not an economy facing deflation.  New money creation is simply flowing into equity prices instead of consumer prices or commodities.

2015-02 Stock Market Valuation

The Shenzhen Composite ended February at 0.21 gold ounces, up 0.02 ounces from January and 58% from February of last year.  The index was trading at an average price-to-earnings ratio of 39.25.

The closing price, 0.21 ounces, was the highest price paid since December, 2007, when the stock market bubble was bursting.  This graph indicates that the price of the market is moving independently of earnings.  Higher prices seem to only be driven by higher valuations, not higher earnings.

If measured by annual percentage change in price, China has experienced four bull markets during the period covered (January, 1998 to the present).  The first was between 1999 and 2001, which lasted 25 months.  The second was between 2006 and 2008, lasting 23 months.  The third was between 2009 and 2010, lasting 11 months.  This most recent bull market started in 2013 and has continued until now, which means at 26 months in duration, it is the longest bull market in this period.  If the last twelve months are repeated over the next twelve months, the price of the market will exceed the record hit in 2007 at the height of the bubble.

2015-02 Book Review

Book Review: The Asian Storm, by Philippe Riès

Financial crises are a boon to the publishing industry. Each passing financial crisis seems to bring about another endless volley of books describing, denouncing, and distressing the various aspects of the crisis. Most of them are not worth reading. The exception to financial crises and the publishing industry is the Asian Financial Crisis. Very little has been written on an event that changed the trajectories of economies created by hundreds of millions of people. The exception to the rule that most books about financial crises are not worth reading is Mr. Riès’ book: The Asian Storm. It is a pleasure to read.

The main difference between this book and the majority of books written on the topic is that the author has a journalism background, whereas most of the people that take the time to write about a financial crisis are academics. Mr. Riès uses his mastery of story telling as well as his understanding of the economy to write this book. (Here I must mention that Peter Starr translated the book from French to English. His name did not make the front cover.)

Two downsides of a journalist writing a financial book stand out in Mr. Riès’ book. First, there are no citations. Much of the book’s content came from interviews with people involved with the ordeal, but quite a bit of the rest of the book is statement of fact taken at face value. Related to the issue of interviews is the sense the reader gets that he does not want to compromise his relationship with the powerful people that he writes about. Only two people wrote blurbs for the book: Michel Camdessus and Steve H. Hanke. The chapter about Mr. Camdessus is titled “The Most Powerful Man in Asia.” The section about Professor Hanke is titled “Dr. Hanke’s Magic Potion.” Friends and colleagues writing a blurb about a book is acceptable, but writing a blurb for a book that has its own chapter dedicated to the writer seems like intellectual conflict of interest.

Even though the book was published in 1999, quite a few of the topics discussed are relevant to China today, and most likely other countries in the future. The Chinese leadership advocates “Chinese values”, “the China Dream”, and “the China Model”, which parallel the Asian values that were exalted before the Asian Financial Crisis. Richard Holbrooke was quoted as saying: “People who are talking about sovereignty and Asian values are really setting up a smokescreen in order to prevent scrutiny of their balance sheets.” (p. 192). Korean chaebol parallel Chinese state-owned enterprises in that “The cardinal rule for the chaebol was that capital had no cost. Each group could easily borrow funds from banks that were as familiar with risk as the Sahara was with snow.” (p. 200)

While the author approaches the financial crisis from an Austrian School perspective, the rest of the book is a love letter to the International Monetary Fund. The lack of people that share both these views with the author probably explains the limited impact the book has had.

2015-02 Relative Equity Trends

Relative equity returns are indicating the Chinese economy is continuing a period of expansion that began in June, 2014.  The materials sector continued its climb higher and the decline in consumer goods accelerated slightly since January.  Not only has the materials segment outperformed the consumer goods segment, both segments are moving in opposite directions.

Interest rates are rising, making capital expenditures more expensive.  A decrease in foreign capital into projects in China are more likely than a decrease in state-sector resource allocation into raw materials production.  Consumer goods margins are also being squeezed, which will put more downward pressure on raw materials prices.  We should begin to see the materials segment decrease at a more rapid rate, returning China into a period of contraction.

In the news:

• [WSJ] “Even as China’s car sales grow at a 10% annual clip, many of its domestic auto makers are expected to report 2014 results that will be their worst in years. Great Wall Motor Co. , considered a rising star, projects a 2% decline in net profit for 2014, its first year-over-year drop since 2008. Geely Automobile Holdings Ltd. , whose parent company owns the Swedish Volvo brand, warned of a roughly 50% slump in last year’s net profit, its first year-over-year decline since 2002.”
• [SCMP] “Snack food producer Want Want China said its revenue and profit for 2014 may not “follow the increasing trend as demonstrated in the past year” due to the slowdown of the Chinese economy.”
• [Bloomberg] “Chinese insurers and banks rallied in New York on Feb. 13 after government data showed the broadest measure of new credit rose for a third straight month in January. Aluminum Corp. of China Ltd., the nation’s biggest producer of the metal, posted the steepest weekly gain since the five days ended Jan. 9.”
• [Bloomberg] “Baoshan Iron & Steel Co., China’s biggest publicly traded steelmaker, surged to the 10 percent daily limit in Shanghai after announcing it would set up a 2 billion yuan ($320 million) e-commerce unit to trade steel.”
• [Bloomberg] “China Petroleum & Chemical Corp., PetroChina Co. and [CNOOC] Ltd. are cutting spending and controlling costs to cope with crude’s plunge in the past seven months that’s already crimped 2014 earnings. [Chengyu Fu], chairman of Sinopec, as China Petroleum is known, said on Jan. 15 that profit from exploration and refining “fell off the cliff” in the three months ended Dec. 31.”

2015-01 Interest Rate Trends

In January 2015, state-sector and private sector interest rates continued their convergent trend. The overnight Shanghai Interbank Offer Rate (Shibor) ended January at 2.81%. That was a significant decrease from December’s close of 3.53%. However, it was still higher than the trailing average for January and February closes, which were 2.61% and 2.34% respectively. Both January and February are considered to negate the effects of the Lunar New Year.

The Wenzhou Comprehensive Index ended January 2015 at 19.75%. That was slightly higher than December’s close of 19.68%, although it was in between the trailing average for January and February closes, which were 19.91% and 19.62% respectively.

Although these two rates should be significantly different because of time horizons and risk profiles, there are more factors than just these two influencing the spread. As Ludwig von Mises reminded us, “[O]ne must never lose sight of the fundamental difference between the market phenomena of prices, wages, and interest rates on the one hand, and the legal phenomena of maximum or minimum prices, wages, and interest rates, designed to nullify these market phenomena, on the other hand.” (Human Action, 1998, p. 394, fn 25) The Shanghai Interbank Offer Rate is primarily determined by the liquidity of the Big Four state-owned banks, institutions that receive artificially created credit first. The Wenzhou Comprehensive Index is determined by the liquidity of private lenders and borrowers, who in most cases are cut off from state-owned bank funding, so are the last to receive artificially created credit.

Interestingly, the growth in M1 is now lower than the yield on a 12 month certificate of deposit. That usually means trouble for banks in a fractional reserve fiat currency system.

If interest rate liberalization continues, these two rates will converge further. That most likely means higher interest rates for the state-sector, which is highly leveraged and experiencing deteriorating cashflows on rapidly devaluing assets. Fortunately for the private sector, not being direct beneficiaries of the largest artificial credit expansion in history means that if it can survive the last few years of high interest rates and still maintain positive earnings, the future contraction phase of the business cycle will be much more bearable.

2015-01 Relative Price Trends

 

Consumer prices increased 0.80% year-over-year in January.  Purchasing prices decreased -5.20% over the last twelve months.  This adds another month to China’s contraction in the structure of production, which has now lasted 38 months.

This year’s January data is impacted by the fact that last year’s Lunar New Year was in January, but this year falls in February.  The Lunar New Year in China is a time of pent-up consumption as much of the migrant population returns home and spends time off with family.  We can hope that consumer price increases continue to decelerate into negative territory so that this year’s Lunar New Year is less expensive that last year’s for all of the people that saved money throughout the year.  Ideally, the price of everything would fall to five mao.

Most of the analysis done after the release of this data by very well-paid people has been advocating more of the same.  Ms. Xiaoping Ma of HSBC said “We still don’t see any positive effects of the stimulus measures put through at the end of last year. Obviously, policy makers need to do more.”  Dariusz Kowalczyk said “There are very strong arguments from all directions of a need for monetary easing.”

These price trends are not happening for unexpected reasons that only central banks can fix with knee-jerk reactions.  The real root cause of this downward cycle was only partially mentioned in the Wall Street Journal article that quoted the above economists.

"Falling prices can also make debt more difficult to repay, a big issue in China where local companies are saddled with huge liabilities assumed after the 2008 global economic crisis. Fitch, a global ratings agency, estimates that the stock of debt—mostly corporate—in China’s economy had risen to 242% of gross domestic product by the end of 2014, up from 217% a year earlier."

The cost of debt in the future is not important if there had not have been so much debt built up in the past.

An Introduction

The most common understanding of a recession is a contraction in overall economic activity. A different way to view economic expansions and contractions is to determine the relationship between consumer goods and the higher orders of production. Relative increases in higher orders of production indicate the business cycle is in the expansion phase. Relative increases of consumption indicate the business cycle is in the contraction phase. The mainstream and alternative view of business cycles often align, but the alternative understanding of business cycles allows for a better understanding of changes happening within the economy.

Since the Chinese economic reforms that began in 1978, China has never experienced a contraction in overall economic activity. Gross domestic product, as it is officially reported, has never decreased from one year to the next over this period. However, research into the structure of production reveals that China has experienced multiple periods of expansion and contraction.

The purpose of this blog is to be a source for an alternative view of Chinese economic indicators to both reflect on business cycles in the past and the business cycle as it unfolds in the present. Posts on this blog will consist of reporting on main economic indicators as they become available, links to news stories on current events, and special articles on economic or financial events in the past. Two main economic indicators will be referenced to determine the status of the business cycle. The first indicator will be the relationship between purchasing prices and consumer prices. The National Bureau of Statistics publishes these monthly. The second indicator will be the relationship between equity returns in the consumer goods industry and the materials industry. These can be tracked by the Global X China Consumer ETF (CHIQ) and the Global X China Materials ETF (CHIM).

A consumer price index is available back to January 1987. A purchasing price index is available back to October 1996. With these two data sets we can compare the relationship between purchasing prices and consumer prices back to October 1996.

From the start of our dataset until September 1997, China was in a state of contraction. This would correspond to the Asian Financial Crisis, which according to official statistics, China avoided. The production structure began expanding again only during the three months of quarter four in 1997. However, it soon began contracting again as the decline in purchasing prices outpaced the decline in consumer prices. This trend began in January 1998 and continued for almost two years until November 1999. Although gross domestic product did not decrease during the Asian Financial Crisis, it seems China’s structure of production was not immune from it.

Between December 1999 and March 2001, the production structure began expanding again for almost five quarters. The length of this expansion was shorter than the following period of contraction starting in April 2001 and lasting six quarters until September 2002. This corresponded to the establishment of asset management companies to deal with non-performing loans in the state-owned banking system.

The following period of expansion lasted for almost five years until May 2007. This corresponds to the economic boom fueled by artificially low interest rates throughout the world. China’s production structure contracted for six months, starting in June 2007, similar to when the rest of the world began experiencing the effects of economic recession. Unlike the experiences of the rest of the world, China experienced a period of expansion between December 2007 and November 2008. This was followed by another twelve months of contraction.

Most countries officially exited the recession in 2009, which is the same time China’s production structure re-entered a period of expansion. This lasted until November 2011. Interestingly, between December 2011 and the end of this data set, China’s production structure has been in a period of contraction. This is the opposite of the signals that gross domestic product statistics are sending. Unfortunately for savers, in addition to this being the longest period of contraction, it is also the only extended contraction during our period that the rate of change in consumer prices has not entered negative territory.

An exchange traded fund tracking the consumer goods industry (CHIQ) was launched in December 2009, followed by one tracking the materials industry (CHIM) in January 2010. We can use these to compute 12 month growth rates beginning in 2011.

This dataset begins with China in a period of expansion, similar to our previous indicator. The growth in earnings from CHIQ began to exceed that of CHIM in May 2011. CHIQ increased by 19.12% while CHIM only grew by 17.81% that month. In June 2011, CHIM outpaced CHIQ by growing 20.78% against CHIM’s 14.00% over the previous 12 months. Soon, both began to experience double-digit negative growth, although the decline in the materials industry outpaced that in the consumer goods industry. This period of contraction continued until May 2014. Although the consumer goods industry recovered during the later part of this period, the materials industry was in negative territory almost every month.

Unlike the relative price index trend indicator examined above, the relative equity earnings trend indicator showed China’s production structure in a state of expansion starting in June 2014. We are most likely seeing a drop in consumption in order to finance higher orders of production.
Why am I starting this project now? Because 2014 was the first year in 20 years that the Chinese yuan depreciated against the U.S. dollar. It is a sign of bigger things to come.

The expansions and contractions in China’s structure of production that are revealed by these indicators correspond to regional or global recessions, such as the Asian Financial Crisis or the Great Recession. However, gross domestic product, as officially reported, has expanded every year since economic reforms began. Eventually, we can expect fluctuations in China’s gross domestic product to correspond to changes in the structure of production. This means that China’s gross domestic product will also experience a decline. Considering that both of these indicators have experienced the longest period of contraction seen so far during this period, China will most likely experience negative gross domestic product growth in the very near future.