“While the contagion once again spreads through Europe, there is enormous denial over the Chinese economy.” So begins Jefferies’ latest note to clients from their global equity strategy team led by Sean Darby.
The Jefferies strategists think economists are focusing on the wrong numbers. “On many ‘on-the ground’ measures of economic growth, GDP is trending well below 7%. China is still slowing.”
They note that metrics such as inventory growth, working capital loans and letters of credit issued in Taiwan (a major trading partner) are on a similar trajectory experienced through the 1H08. Indeed, forward and trailing earnings have dropped far more than in 2008. This is true for both financial and non-financial profits.
China has registered a sharp downturn in inventory growth in recent months, the steepest decline since the second half of 2008 when the economy took a severe hit in the wake of the Lehman Brothers fallout:
Jefferies says this decline in inventory growth is “inhibiting overall GDP.” However, Jefferies looks at the decline in working capital growth “more worryingly,” furnishing this chart, which shows a steady and sustained decline in working capital since early 2010:
Finally, they show letters of credit issued in Taiwan, writing, “On this measure, China, Taiwan’s major trading partner went into a sharp growth contraction in mid- 2010.” Take a look:
So where is all of China’s working capital disappearing to? Jefferies provides the following explanation:
The unintended consequences of higher inflation (low real deposit rates) and financial liberalization has meant a significant shift of deposits away from the formal banking system into the ‘informal’ private financial sector. The latter has offered higher deposit and lending rates in return for underwriting much riskier projects such as property or local government infrastructure projects. Working capital appears to have become ‘stuck’ between the two systems and also because so much money has been used to finance non-productive assets such as property.
Bottom line: Chinese leaders are definitely not hitting their targets and need to address the working capital problem in order to turn things around.
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