China has reached a ‘now what?’ point

Little girl jumping china bus station suitcase

The Chinese economy has reached a “now what?” point.

It’s slowing, but not fast enough for authorities to exercise the nuclear option of a full-on stimulus that would add more debt to a highly levered nation.

At the same time, it’s still slowing faster than authorities would like. Economic data is mixed, but trends to the downside more often than not.

For example, Monday’s Markit manufacturing PMI for June came in at 49.6. That’s up from 49.2 in May, but still below 50, which indicates a contraction.

“We believe that the recovery is brittle, with exports and real estate construction still contracting,” Bloomberg economist Tom Orlik wrote in a note following the PMI release. “That argues for continued policy support, and we continue to place a high probability on a fourth rate cut in the third quarter, as well as more targeted support for priority sectors.”

This was supposed to happen, just not so suddenly

HSBC-Markit China PMI June

As the government allows its economy to restructure, weak companies are getting shaken out. This is especially true for state-owned enterprises, bloated by years of implicit government guarantees. For Société Générale economist Wei Yao, this is a “long-awaited day of reckoning.”

That reckoning will come in the form of corporate defaults. According to Bloomberg, the number of Chinese corporates with falling revenue and debt of 150% of equity has hit 49, up from 38 a year before.

Of course the “policy support,” as Orlik mentioned, could help zombie companies stay afloat when they shouldn’t by keeping interest rates low.

See the problem here?

And we mustn’t forget that, while it should be considered apart from the bond market and economic indicators, the Shanghai Composite’s wondrous year-long 140% rocket up has been sputtering lately.

Last week it officially dipped into correction territory falling 13% and causing levered investors to panic.

Balancing their way to balance

All these headwinds have put a damper on the government’s plans for reform — for consolidating state-owned companies and reforming local government financing vehicles (bonds issued by local governments). Things are just too delicate.

So something has to be done. The question is what?

Again, stimulus is absolutely out.

“China should concentrate on reconstructing the economy, avoid concerns about growth rate fluctuation of one or two percentage points, and under no circumstances become so anxious as to resort to strong stimulus,” said an “authoritative insider” — aka the government — in a recent editorial on state news site The People’s Daily.

The country could make another rate cut, as Orlik wrote, but that would be the fourth since November and the other three didn’t do much, and conditions have only gotten murkier since then.

Oh, did you expect us to have an answer?

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