We left off yesterday asking whether China’s economy was in worse shape than many people think…and whether that portends trouble for Australia.
In preview, the answer is yes, and yes.
I’ll get to the details in a moment.
First, let’s have a quick look at yesterday’s half-yearly profit release from National Australia Bank [ASX:NAB]. Apparently it was good. The market liked it. NAB’s share price rose 2%.
But there are a few question marks…or one in particular. Why, or how, are NAB’s bad debts falling compared to the other banks? As the Financial Review reports:
‘NAB’s bad and doubtful debt charges in Australia fell 7 per cent over the half to $375 million, which at 14 basis points is half the level of ANZ Banking Group and lower than Commonwealth Bank of Australia and Westpac Banking Corp.’
The market will sort that out. If NAB’s being dodgy, you’ll see it reflected in the share price over the next few days and weeks. More importantly, the bank’s profitability is declining. Return on equity (ROE) fell from 15.8% in the same period last year, to 14.1%.
As I mentioned earlier this week, ROE is a very important measure for the banks…and for all companies for that matter. But the trend in ROE is clearly down for the banks now as mortgage growth tapers off, and they need to hold more equity against their assets. This week’s interest rate cut might help a little bit but, as far as I can tell, the tide has turned.
Speaking of the banks, they have a new central boss. Phillip Lowe, the current deputy governor of the RBA, will take over when Glenn Stevens retires in September. My guess is that not much will change. Central bankers tend to be victims of circumstance, and they don’t many chances to assert themselves. The tide of macroeconomic reality tends to swamp them.
I remember reading one of Lowe’s research papers when he was working at the Bank of International Settlements. It was a criticism of the Greenspan-led Federal Reserve. He argued against the Fed’s insistence that central banks should only ‘mop up’ after asset bubbles burst, rather than fighting against them with monetary policy in the first place. It was a very good report.
So at least we know Lowe has a good deal of common sense. But employing it when you’re in the driver’s seat is a different proposition to being a backseat driver. At the very least, it will be interesting to hear Lowe’s comments on managing Australia’s property bubble versus propping up the economy with more interest rate cuts.
Lowe certainly takes the helm at a difficult time. The Aussie economy is beginning to suffer under the weight of excessive debt, a situation made more acute by the RBA’s post-2011 interest rate cutting program.
Which brings me back to the start: Australia’s economic destiny (over the next decade or so at least) will be driven by China. And China’s economic position is extremely fragile.
This week, I read a China research report by investment bank CLSA, which was sobering to say the least. You can see why China hit the stimulus accelerator at the end of last year. The benefits of this are now showing…but for how long?
For example, net new job creation FELL 28% in 2015. Rising wages and falling productivity means China is losing jobs to lower wage countries like Vietnam. The government’s attempt to slow the property boom began to bite a little too hard during 2015.
The problem is that China’s economy IS the property sector. Fixed asset investment (largely property construction) still accounts for a massive 43% of economic growth. While consumption represents a growing percentage, at 53%, the performance of property prices impacts on consumption.
At the end of 2015, year-on-year property investment growth turned negative for the first time in 20 years. This threatened to slow the economy to unacceptable levels, so the government turned on the stimulus tap again.
Because China’s economy is structured around property investment, firing it back up is the only way they can revive growth quickly. But the problem is that this growth is unproductive.
According to CLSA, China now has five years of housing inventory, and that’s assuming there will be no more land sales. 2015 was the only year since 2000 where property sales exceeded housing starts; but with the recent stimulus measures, inventory levels will build again.
The excess housing inventory means there is overcapacity in all the industries that contribute to it, like steel and cement. But overcapacity is not just related to property.
CLSA points out that power demand in China grew at just 0.5% in 2015. Yet power generators added 10% to capacity last year, pushing power utilisation rates to a 38-year low.
It gets worse. Based on government targets and approvals, another 15%-plus power capacity will be added to the grid in 2016.
All this unproductive growth means bad debt levels are on the rise, making the economy (and banking sector) extremely vulnerable to an economic slowdown.
Slower nominal economic growth is akin to a cash flow crunch at the national level, and highly indebted companies will not be able to service their debt. But the government’s only option is to fire up unproductive growth to hold off the day of reckoning.
Can you see why, years ago, Jim Chanos famously said China was on a ‘treadmill to hell’? It’s still running, sweating profusely…
According to the International Monetary Fund’s (IMF) latest assessment, 14% of the debt issued by Chinese listed companies is ‘bad’. They arrived at this number by seeing how many companies had an EBITDA (basically cash flow) to interest expense ratio of one or less. In other words, those companies that don’t generate enough cash to pay the interest bill (let alone run their business).
CLSA points out that this is a very generous interpretation. If you can’t pay your interest bills, you’re basically insolvent. But many of these companies are state owned enterprises, kept alive by the central government.
Back in 2014, IMF did the same exercise but used a metric of EBITDA/interest expense of two or less to determine debt at risk. Perhaps not to publish too disturbing a number, they halved their requirement for China’s debt-soaked economy, vintage 2016.
If they run the numbers at the 2014 level, 28% of China’s listed company debt would be ‘at risk’!
That is extraordinary.
I think you get the picture. Next time you read about China’s economy ‘recovering’, or whatever the upbeat version is, take it with a grain of salt. It’s in all sorts of trouble. That will become apparent again in a few months’ time when this latest stimulus effort begins to wear off…
For The Daily Reckoning