China's "Real" GDP

Chinese Premier Li Keqiang once revealed (on Wiki Leaks) that China’s GDP was “man-made” and to track growth he preferred to observe change in bank lending, rail freight volume and electricity consumption (production). It does not take a PHD in Econometrics to have a sense that China’s reported GDP has been implausibly smooth over the past decade or more, particularly during the episode in 2015/2016 when there was a clear deterioration in growth that required material policy intervention in the form of an August devaluation in the renminbi (chart 1). It is also important to note that the Li Keqiang Index has highlighted the cyclical overshoot as well as the undershoot in GDP. The big picture point is that the inputs into the index are more difficult for local authorities’ to fudge. In contrast, real GDP does not reveal the entire truth about activity in China.

For markets, GDP is not particularly useful in China or anywhere else. It is an obvious point, but markets are forward looking and it is the rate of change in activity that matters with respect to its influence on profits, prices, policy expectations and risk perceptions. As we have often noted, the credit impulse in China (the rate of change in credit growth) has been a reliable indicator of the mini business cycle in China over the past decade or more. The rate of change in bank lending is a large sub-component of the credit impulse and of the Li Keqiang index noted above.

The credit impulse is important because it has an influence on the key component of China’s GDP, property and infrastructure. In turn, that is a key reason why it leads the rate of change in commodity prices (chart 2) and commodity linked markets. As we have also noted recently, the expansion and contraction in credit also tends to have a pro-cyclical influence on risk perceptions or the P/E valuation multiple in equities. The P/E tends to expand (that is investors will pay a higher multiple) when credit accelerates and a lower multiple when the rate of credit slows. Put another way, it highlights the reflexivity in credit which is inflationary when taken on and deflationary when paid back.

The good news in the current episode is that the mini cycle slowdown in credit appears well advanced. The credit impulse slowed to -7% in August and is already consistent with trough conditions. The bad news is that the price signals in China’s high yield real estate market suggest that the contagion and weakness in property is broader and deeper. On the positive side, the ongoing strength in commodity prices (industrial metals) suggests that final demand might be holding up outside China’s property market and in other parts of the world.

Curiously, the major commodity currencies appear materially undervalued based on spot commodity prices and the underlying terms of trade (export prices relative to import prices or national income). This is true whether one looks at the Canadian, New Zealand, Australian dollars or the Norwegian Krone. Taken to its logical conclusion, the Australian dollar ought to be trading above parity to the US Dollar based on the terms of trade (chart 3). Of course, interest rate differentials suggest that the truth lies somewhere in between. Moreover, it might also be the case that the commodity markets still have to reflect the recent slowdown in China. On the positive side, if growth perceptions start to improve again in China and the credit impulse recovers, commodity currencies probably have material upside relative to underlying fundamentals.