Giving Credit Where It’s Due

Chinese manufacturing appears headed for a six-month low. HSBC’s Purchasing Managers Index (PMI)—the unofficial measure of the country’s smaller, private manufacturing firms—shrank to 49.6 in January (readings under 50 signal contraction). Headlines were surprisingly even handed—nary a chest beating over Chinese hard-landing fears. Most attributed the drop as a one-off due to a workers’ holiday surrounding the Lunar New Year. But manufacturing has fallen for the last several months, and though they seem unrelated at first wash, we think the government’s simultaneously clamping down on shadow lending is more than coincidence. Without shadow financing, small, private manufacturing firms struggle—a real world unintended consequence of the Chinese government’s interfering with credit. But since China’s communist economy is largely skewed toward larger, state-run firms, this doesn’t fully capture the trend of overall output. In addition, even these larger firms are subject to political headwinds that don’t apply economy-wide.

Earlier this year, China started cracking down on off-balance sheet lending primarily to stop what officials consider a runaway practice with a lot of potentially toxic debt, particularly at the local government level. But even after imposing strict regulations, the People’s Bank of China (PBOC) is becoming incrementally stingier with banks practicing shadow lending. More and more, they’re incentivized to deleverage and extend far fewer non-traditional loans.

For China’s banking system, this is probably a good thing—more transparency! Though, it likely doesn’t do much to keep local government debt from rising too outrageously. Municipalities have plenty more funding options. Instead, this crackdown crimps credit for other non-traditional loan recipients—small, private businesses. Historically, state-run banks lent primarily to state-run firms. Shadow financing was smaller firms’ lifeline, and as it has tightened, they’ve struggled. Comparing the HSBC manufacturing PMI to China’s official PMI (which largely tracks easily funded big, state-run conglomerates) illustrates that well. (Exhibit 1) Private firms that can’t finance business endeavors easily can’t produce or profit as much. Hence, the relatively steep drop in HSBC PMI last June—when the PBOC started its anti-shadow-financing campaign in earnest.

Exhibit 1: HSBC vs. Official PMI

Source: FactSet, Bloomberg, as of 1/24/2014.

HSBC’s gauge has consistently underperformed the official gauge since the shadow-lending crackdown began, but growth in the official PMI has slowed some recently, too. So some may wonder if this is a harbinger of coming economic weakness. But here, too, politics largely explain the slowing. While small manufacturers are unintentionally being pinched by difficulty getting credit, some larger, state-run manufacturers are caught in an intentional industry slowdown: The government has made no secret of its efforts to tackle overproduction in steel, aluminum, cement, shipbuilding and more for the last several months. And it’s seeking to cut back more. That’s not fundamental weakness—just communism. We probably wouldn’t have seen a rebound in new orders during the second half of 2013 if the economy was hurting.

So the government’s intentionally slowing industrial activity is apparently working. Why crimp it more with less shadow banking? If there is one theme to China’s economic policy, it’s to attempt to retain control of growth and inflation to placate the subjugated populace. Shadow lending is largely outside their control, funded via issuance of wealth management products (WMPs) and loans extended with little oversight, so their attempts to curtail this lending are unsurprising. In addition, investor fears over Chinese shadow lending further incent the leadership to crack down. Part of that crackdown seems evident in Thursday’s news a WMP may default, and investors are already looking to the government for reimbursement.

Friday, China unveiled what may be the next step in their plan: They announced an unprecedented injection of liquidity into the small- and medium-sized banks. Typically, such funding is directed to the six largest banks. This shift to a larger group of smaller banks could mean more traditional credit for small manufacturers and non-financial firms nationwide.

In the meantime, some speculate new fiscal stimulus will likely offset the slowdown in shadow lending, but that’s probably just hot air. None of this is new. It’s the government’s monkeying around with the economy and banks’ financing in the first place that created this situation! More of the same would lead to more oversupply—and they’d be right back at square one before too long.

The long-term solution is allowing private banks to exist and fill the funding gap for small, private businesses on the books. But as of yet, state-run banks dominate, and allowing more private banks to open still seems a ways off (though it’s often discussed). But either way, we’d suggest the likelihood an engineered slowdown in manufacturing turns into an engineered Chinese recession threatening the stability of the government is exceedingly low.