So Is Everything Fine Now in China?

China prepares for a handover of power...

THE OFFICIAL China PMI index for last month inched above the 50-mark – which is convenient, coming just in time for the crucial Communist Party conference, writes Sean Corrigan for the Cobden Centre.

The news was enough to gladden the heart of loyal cadres and sell-side analysts everywhere. Truly now the bottom is in place and we can return to unbroken months of expanding economic activity under the wise guidance of the new leaders, all the while looking forward to inexorably higher asset prices across the globe!

Well, perhaps. But, is it really sensible to suppose that the weight of evidence offered by this one, single datum is enough to tip the scale of judgment, or would it be better to seek for confirmation elsewhere – not least in the next installment of said series, given that it is not seasonally adjusted and so is subject to the vagaries of the Chinese lunar holiday calendar?

Certainly, we might be allowed to nurse our skepticism a little longer, if only because one of the main economic sectors contributing to this uptick was the otherwise badly bruised steel industry. Having increased production by a bare 1.7% in the first nine months over the like period in 2011, October's more favorable constellation of input prices has combined with a long-overdue reduction of inventories to spur the country's mills to encompass a PMI-boosting, 8% jump in the daily rate of output when compared to late September.

All well and good, but recall this is an industry in which profits of the so-called 'above-scale' firms fell 68% YOY, while the listed steel companies actually made an aggregate net loss. Even the mighty Baosteel has been suffering; printing a 'profit' partly by dint of asset dispositions – and, even then, returning less on capital than would one of China's notoriously unremunerative bank deposits. Incidentally, we put the quotation marks around the 'profit' to highlight the fact that the explosion in the firm's accounts receivable has amounted to almost four-fifths of reported operating income over the last six months.

Rationalization, in a business with fast approaching 900mt of capacity servicing no more than 680mt of domestic demand, has proved elusive, largely because of the usual curse of local government politics. Not only are steel companies major local employers, but they pay taxes based on output, not profit, greatly increasing the perverse incentives to which their management is subject.

Adding a certain frisson to the situation is a Bernstein Research report into steel trader fraud. Here, with echoes of the Great Salad Oil Swindle perpetrated by Tino de Angelis exactly fifty years ago, it appears that a number of firms have not only been pledging the same steel as collateral several times over, but that some of the alloy so committed consisted of nothing more than a surface layer of steel laid on top of a pile of near-valueless sand. As a result of this discovery, it is said that Guangzhou traders are now only making good on half their orders, rather than on the already recession-shrunken 70% characteristic of the previous three months, raising the question of just who will buy the new product pouring out of the mills.

Though there are the inevitable murmurings of better things to come as the government launches yet more, white elephant, infrastructure projects, those pinning their hopes on a sustainable upswing manifesting itself in the near future would do well to listen to what Ma Guoqiang, Baosteel's general manager recently said in an online briefing.

Judging from current global and domestic economic growth, it is realistic to expect the 'cold winter season' to last for three to five years, and the steel sector will not be an exception.

Some heed of this ill wind seems to have been taken by the big miners, notably BHP Billiton, which has radically restyled its corporate message in recent months to the point that the most prominent slogan in its latest presentational material was that its "focus has shifted from the marginal tonne to the capital efficient tonne."

A far cry, indeed, from last year's defiant emphasis on the super-cycle; on ever mounting, Chinese per capita usage; and on the heady plans for the $80 billion in new capex need to surf this envisaged wave.

Highlighting the contrast, Chief Executive Marius Kloppers – fresh from cancelling no less than $68 billion of those projected expenditures – struck a much more sombre note last month, telling his audience that:-

Miners have responded to unsustainably high prices for some commodities such as iron ore and metallurgical coal over the past decade by building new production capacity. Over that period, robust demand growth from China and other developing nations outstripped production growth as the industry grappled with escalating mining costs and strengthening currencies in commodity producing countries...

But the industry has improved its ability to meet incremental demand with low cost supply and commodities demand growth from emerging economies, particularly in China, is forecast to moderate as developing economies transition to consumption-led growth from infrastructure-led growth...

...what we are now witnessing is the rebalancing of supply and demand and a progressive recalibration of prices back to long term sustainable pricing levels. In effect, what this means is that the record prices we experienced over the past decade, driven by the 'demand shock', will not be there to support returns over the next 10 years. What we can instead expect is demand growth at more predictable and sustainable levels and more moderated pricing. This 'mean reversion' in prices and returns is something we at BHP Billiton have anticipated for some time...

...The physical iron ore demand of China will go down. That high end of the cost curve will disappear. Still a very good business but not the massive EBIT margins we have today... a very significantly less amount of revenue...

It may well be, of course, that Mr. Kloppers will prove no more prescient regarding the genesis of this tough, new reality than he was in foretelling the demise of the old, Klondike era but it would seem foolhardy not to assume that the head of one of the largest and most successful integrated mining companies might be able to give us some pointers as to conditions on (or may be, under) the ground.

Elsewhere in Asia, PMI's were mixed in terms of month-on-month changes, but were almost universally mired on the contractionary side of the ledger – though you would never have guessed this to be the case, given the positive glow elicited by the one or two less gloomy releases seen in the region of late. We would only reiterate that the place still suffers from a widespread reliance on exports to a faltering Europe as well as to a still-tepid America. Together with the complex entanglement which much of the Orient has woven with a China still wrestling with the superposition of a Gosplan-like growth directive and layers of rampant nest-feathering on top of a very Austrian credit bust, this strongly implies that it will take more than a brief – and possibly random – interruption of the downwave to instill any confidence that the worst truly is behind us. Just ask Panasonic, HTC, Dongyang, or Sharp.

Adding to the suspicion that things are not exactly steaming full ahead, the first intimations of October's banking figures from China suggest that an almost complete reversal of the prior month's large deposit increase was suffered by the Big 4, while, on the other side of the balance sheet, lending was very weak right up to the last three days of the month when an extraordinary CNY100 billion late burst saved the day. Word is that much of this took the form of corporate credit – but how much of that represents distressed borrowing, only time will tell.

Amid press comments to the effect that SME loan demand was weak (not surprising perhaps, given the lackluster showing at the autumn installment of the Canton Fair), that lending was 'about complete' for the year, and that even local infrastructure finance was largely being limited to roll-overs and to ensuring completion of existing projects, matters seem a deal less settled than the permabulls would have us believe.

And let us be in no doubt just how pivotal Chinese banks are to the whole, top-heavy, output-driven, malinvested superstructure. In the year through end-September, just sixteen of them were responsible for no less than 54% of the entire sum of aggregate profits posted by the country's 2,493 listed companies – even if they could only manage this unhealthy predominance by the determined misrepresentation of their bad loan levels. After they had extracted their bounteous harvest of rents, the nation's commercial and industrial rump of 2,477 firms saw their revenues inch up by less than 5%, their pre-receivable 'profits' fall 18%, and their already exiguous operating margins slump 22% to a mere 4.3 cents on the Dollar.

Nor was there much cheer to be had from Li Zibin, president of the China Association of Small and Medium Enterprises, who announced that his members were facing more difficulties this year than they did in 2008. Citing the slowdown both home and abroad, Li said that rising labor costs, pricier raw materials, fund-raising difficulties, and the appreciation of the RMB were among the private sector's litany of woes.

Then again, a certain degree of caution is only to be expected when we take into account the ongoing rumors that the imminent leadership handover is still the subject of internecine strife between the factions. Not only has former leader, éminence grise – and 'conservative' hard-liner – Jiang Zemin been unusually prominent of late but reformists Zhu Rongji and Li Ruihuan have also resurfaced from self-imposed obscurity to root for the opposing team, if to little obvious effect if we believe the spin the SCMP has put on events.

Tellingly, the PLA Daily issued a forthright declaration of its loyalty to the Party and Chairman Hu, warning of the need to guard against the existence of "hostile forces in and outside China... ready to make trouble." Note the ominous use of the first of those two positional prepositions.

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