Morgan Stanley isn't impressed by what's driving China's economic resurgence

Photo: Buddhika Weerasinghe/ Getty Images.

After initial concerns that China would fall in a heap led to dramatic financial market volatility to start 2016, the nation’s economy has surprised many of late, rebounding strongly in recent months on the back monetary and fiscal stimulus and a steep recovery in property-related sectors.

Risk assets have ripped higher in response, particularly emerging markets and commodities, mirroring the improvement in sentiment from investors towards the Chinese economic outlook.

In just the first three months, sentiment seemingly went from armageddon to adulation in the blink of an eye.

With most Chinese economic data continuing to improve in March, the question many are now asking is whether the improvement will be fleeting or the start of a longer-lasting trend that has the potential to lift both Chinese and global economic growth in the quarters ahead.

Although researchers at Morgan Stanley believe the acceleration will likely continue over the next three to four months, helping to avoid what they describe as a “growth shock” for the economy, it expects momentum will ease in the second half of the year as policymakers refrain from adding to monetary and fiscal stimulus.

The financial firm also suggests the factors that led to a sharp economic rebound in March — increased credit growth, infrastructure spending and property investment — not only raises questions over the sustainability of the recovery but also the government’s desire to deliver meaningful near-term economic reforms.

“We are concerned about the deteriorating quality of the cyclical improvement, as it has been mainly a government-led recovery in investment growth – especially infrastructure and property. The cyclical improvement doesn’t solve the structural problems of high debt, excess capacity and persistent disinflationary pressures,” says Morgan Stanley.

“Private investment growth has been decelerating to a historical low of sub-5% reading, in contrast to the pick-up in SOEs [state-owned enterprises] investment growth to over 20%. The nature of government-led investment recovery also means a further increase in leverage ratio.”

The chart below, supplied by the bank, tells the story. The blue line — fixed asset investment from Chinese SOEs — surged in the first quarter of the year, completely overriding a further deceleration in investment from private firms, shown in yellow.

According to the Morgan’s, the acceleration in government infrastructure and property investment potentially risks exacerbating concerns which the Chinese economy is already grappling with at present — overcapacity and bloated inventory levels in its industrial and property sectors.

The investment-led growth recovery means further build-up of inventory and excess capacity, which is already at a high level. In the property market, inventories have remained high despite the strong recovery in property sales (Exhibit 17). However, the renewed positive growth in property new starts means the inventory is likely to increase from the current elevated levels, especially if property sales start to slow. Meanwhile, the progress in inventory reduction in lower-tier cities remains slow, as they saw relatively flattish property price trends and relatively weak purchasing power compared to top-tier cities.

In addition, the improvement in investment growth has resulted in temporary price reflation and, in turn, delays in the excess capacity shutdown and even encouraging some capex spending because of the increase in profit margin and improvement in confidence. This means the excess capacity problem is likely to become acute once growth starts to slow.

Along with policies that are potentially exacerbating existing problems, Morgan’s suggest that Chinese policymakers are getting less bang for their buck when it comes to stimulus boosting short term economic growth. Our emphasis in bold.

Compared with the previous rounds of mini-cycle recoveries since 2012, this round of recovery arrived after more intensive policy easing: accumulated six rate cuts and 350bp RRR [reserve requirement ratio] cuts, the lowest level of real mortgage rates (since 2010) and the historical high ratio of fiscal deficit/GDP ratio. However, it took 6.4 units of new debt to generate one unit of nominal GDP in 2015 (vs. 4.2 in 2014).

Here’s the evolution in China’s debt-to-GDP ratio, along with the its incremental capital output ratio (ICOR), over recent years. Morgan’s note that both figures have continued to increase, implying the lower return
of capital deployed.

As a result of recent policy actions — something that many deem to be a return to China’s old growth model of ramping up credit growth and government investment — Morgan’s believe that pickup in economic activity will likely remain in place until the second half of the year.

“While we maintain our base case of recovery to taper off toward end-3Q, we see risks slightly tilted to the upside in the near term,” says Morgan’s.

“However, we must highlight that while a bad growth mix could drive a cyclical recovery for a while longer than expected, it will only mean more downside risks in the medium term.”

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