The Chinese economy is strange in many ways. Not only is it a hybrid between private capital and state control, but very few people directly invest in the mainland. And yet everybody is interested in how the second largest economy in the world will develop.
That’s because Chinese demand determines the prices of world commodities, and the operations of multinational companies in China impact earnings. When the yuan falls, markets across the world get jittery.
China observers accept the fact that official data out of China is severely flawed, and often simply fabricated, yet they still use it to analyze the Chinese economy and markets, because there are few alternatives.
One alternative, however, is the China Beige Book International (CBB), a research service that interviews thousands of companies and hundreds of bankers on the ground in China each quarter. They collect data and perform in-depth interviews with Chinese executives.
Leland Miller, the founder of CBB, spoke to The Epoch Times about why China’s economy is so strong right now, why firms aren’t flinching at higher interest rates, and what the greatest risk to recovery is.
The Epoch Times: Where is the Chinese economy at right now?
Leland Miller: This quarter was a best-case scenario for China’s economy. We’ll call China out when things are much worse than they admit, but this time it’s good or even slightly better in some ways. It was exactly what the Chinese government was hoping to hit at this time of the year.
The government has been saying we’re going to do whatever it takes to get stability, to get this strength, to get this momentum. And what we saw was the old economy generally out-performing the new economy. Manufacturing has had this major recovery in the last year, plus the commodities were sizzling and property was still doing well in the first quarter.
The Epoch Times: What are some of the risks you see in this positive scenario?
Mr. Miller: We track profits and of course revenues and cash flow. We track receivables and payables as reported by firms. What we’ve seen over the past year or so has been profits improving.
There has been a recovery in the economy from a very dismal late 2015, early 2016. There has been a rally across sectors, but the real problem here is that cash flow continues to deteriorate. In a market economy, you would see profits battle cash flow and then one would win out in a relatively short amount of time. In China, this battle has gone on for over a year now. Even during these very strong quarters, cash flow continues to deteriorate, even in sectors that are undergoing a boom, like commodities.
Even as firms are reporting better profits, they’re having a harder and harder time getting paid and paying out to their vendors. At some point, cash flow or profit will win out over the other.
The Epoch Times: So either the positive trend for profits spills over to cash flows or the negative cash flow trend will hurt profits at some point. How will rising rates affect this dynamic?
Mr. Miller: So in the first quarter, we read a lot about the so-called deleveraging campaign, but we weren’t seeing higher rates for corporates. We looked at the interbank markets and we saw that some small- to medium-sized banks were having some problems with higher rates, but they were not passing those rates on to the corporates in the first quarter.
We saw relatively good performance in the first quarter that was supported by the fact that rates continued to be low. Now, in the second quarter, we did see these higher rates. We saw bank rates jump, we saw shadow bank rates hit the highest level we’ve ever seen. So we did see corporates have higher cost of capital.
But we were told something very interesting. We talked to these thousands of firms, and they were extremely optimistic about the future. They saw the 19th Party Congress ahead in the fall and so they had robust six-month revenue expectations. We call that the “Party Congress put.”
But these firms said, “We have higher cost of capital, but the Chinese government is not going to allow any real pain.” So they operated as if this was a headache and not a long-term disease of what they’d have to deal with, and they remain relatively buoyant considering the fact that rates made a big jump this quarter.
If you see this “deleveraging” happen in 2018 and it doesn’t have the Party Congress as the backdrop, I think people will be surprised how much differently it works. There is a specific set of circumstances that allowed people to essentially ignore higher cost of capital.
That was the wind-at-their-back, beautifully clear international situation, with nothing blowing up and no trade war (yet) and no currency problems (yet) and no central banks hiking rates aggressively. In the future, you might see a different set of factors, and with the Party Congress out of the way, I think firms will be a lot more indecisive.
The Epoch Times: Supposedly the higher rates were going to lead to more defaults, but that hasn’t happened.
Mr. Miller: You see in the headlines that they’re allowing defaults now, here and there in small bits and pieces. But the reality is that when people buy more wealth management products, when they buy trust products, when they invest in a risky venture, they don’t think it will be allowed to fail.
As long as that mindset continues, you’ve got a great investing environment—until you don’t, and then it’s a real problem. And so the major thing that China will have to do is inject the risk assessment mindset into Chinese firms.
They have to understand that if they make bad investments, they will fail. They have to be allowed to fail. That will make the economy a lot safer, but there will be repercussions as these failures are allowed to settle into the economy and to cascade through it.
It’s a very painful process, it can look very scary to investors when it starts because people don’t know if this is the start of something huge or not. You’re going to have a crisis when they start really doing it in any material way. But it has to happen, and Xi Jinping has said they understand that. I think they do understand it, and they’re going to have to start dealing with these problems sometime soon after the Party Congress.
Interview edited for brevity and clarity