We have all seen China’s PMI numbers and they look okay. Yes, they slowed a bit, but this was expected. More importantly, it looks like May’s rapid and violent de-stocking exercise has come to an end (China’s July PMI new orders versus inventories ratio saw its first increase since April). Some of the excitable financial market types who worried that China was both overheating and having a housing bubble while at the same time rapidly moving towards a crash landing now agree that China is in the process of a “soft landing” – i.e. a modest, orderly slowdown. There is some good evidence for this. Services and consumption are faring much better than manufacturing and heavy industry. Retail sales remain strong, and retail sentiment is showing a very significant improvement at the same time as pollution-creating and energy intensive industries face fairly meaningful headwinds.

This slowdown appears to be uneven and shallow. Of course, much of it is self-imposed. So, for instance the restrictions on credit extension, the property market, and energy & resource intensive heavy industry are all, in theory, easy to reverse and could all even go in the complete opposite direction if necessary – possibly on a moment’s notice, as we saw back at the end of 2008.

Although managing China’s economy is never an easy task, Chinese policymakers should be feeling pretty confident right now. They have just had two consecutive experiences of getting China’s economy to respond extremely well to government-led signals and policies. Just as the old adage “don’t fight the Fed” made its way into the lexicon I suspect that China’s version – “don’t fight the State Council” is probably even more important for many emerging markets equity investors these days.

But China’s past policy “successes” may have sometimes been too successful – with violent reactions in the economy and markets frequently leading to misallocation of capital and other unintended consequences. For instance, the infrastructure spending and bank lending binge that drove last year’s stupendous recovery has led to the morass of local government funding vehicles and their debts. While we are not too worried about systemic risks from local government funding vehicles the fact is that while they have been getting a grip on the problem and making sure it does not balloon into something systemic, things could be bumpy for a while.

Of the many different piecemeal tightening measures put in this year, a large part have already “done their worst” with most of the effects and after effects already visible and “in the price”. The ones whose potency has largely been spent include the three consecutive RRR hikes in 1H, more restrictive quotas for new bank loans and the resumption of the 75% loan-to-deposit ratio requirement for mid- and small-size banks. The effects of these measures are well understood and largely “in the price”.

But a number of other measures will continue to have a meaningful impact over the next 6-18 months. During the first half of the year banks were able sell securitized loans as “wealth management” products through trust companies. This is now extremely difficult and has effectively been shut down as a loophole for getting around bank lending quotas. This has a particular impact on property developers, as the yields were high enough to keep these products attractive and this was an area banks were particularly keen to shift off balance sheet.

The noise about the Local Government Financing Vehicles which were the principal conduits for the infrastructure project surge has also had an impact. The recognition that the current system is far too messy to be allowed to continue in its previous form led to a temporary suspension of new loans to these vehicles while a new system was hammered out. While we do not see any systemic risk here, the new system is likely to be far less free-wheeling.

There are a plethora of other controls and directives, such as limits on leverage for large centrally managed SOEs, restrictions on the use of loans earmarked to pay suppliers of infrastructure construction companies, and a number of measures targeting the property market. These include loan-to-value restrictions on mortgages and tightened checks on first home buyers have been implemented. For property developers they are now required to pay land premiums more quickly, develop existing landbank faster and also face restrictions on the use of loaned funds.

The aggregate impact of all of these measures together is still somewhat unpredictable. Based on how the economy has been coping so far, it looks like it will be easily managed, but whenever measures that directly target multiplier effects in the system are in place, bumps and jolts become a reasonable possibility.

All of these measures will likely continue to dampen liquidity creation over the next 6-18 months and will, at the very least, put a drag on the ability of the system to rapidly utilize liquidity and create leverage. There are positive offsets, of course, such as what is rapidly becoming known as “TARP for China” – otherwise known as the successful listing of the fourth, and worst managed of China’s big state banks, the Agricultural Bank of China. All of the other big state banks have either raised or are going to raise capital as well. This, along with what will likely be continued government support in the form of regulated margins, will mean a continued relatively problem-free banking system for the foreseeable future.

But nonetheless, with most economists now pencilling in continued economic deceleration over the next few quarters, investors are asking “how soon” policy is going to “change” or in other words return to the good old days of massive stimulus and free money for everyone. At the same time, however, most agree that without a substantial fall in property prices, or at the very least a long period of stagnation, property-specific measures are unlikely to be reversed (it is now understood that this is a political movement rather than purely an economic adjustment). In the meantime, the government is serious about the construction of social housing and projects finally seem to be going ahead at a reasonable pace, which will likely accelerate next year, which puts a floor under investment activities, but also increases supply. While this can be viewed as a form of fiscal loosening, it is also a longer-term political priority, and should not be viewed as intending to signal looser policy.

In the meantime, we are wondering whether it is worth having another look at inflation. Clearly, July inflation numbers are looking likely to have popped back above the official 3% target. Agricultural product prices have been increasing. Pork supply also seems to face some constraints. Wages are rising somewhat faster than they used to and this is having a particular impact on service sector pricing. Inflationary expectations are contained, still, insofar as most consumers continue to expect prices to
increase at something like a 5% pace. Yes, there are base effects and nothing seems to be out of hand yet, but the number of piecemeal measures (releasing grain reserves, increasing corn imports, directives to local governments to stop hoarding and speculation in agricultural markets, etc.) make us wonder whether to expect some further action to stabilize inflationary expectations.

So the picture in China remains relatively sanguine. The economy is slowing “comfortably” but we expect some unavoidable bumps and jolts on the liquidity front, the beginnings of which can already be seen in a wave of high yield bond issuances and placements by property developers. If we had to guess on the near term market outlook, we would say “range trading”.

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