Nomura's China Stress Index recorded highest level in Q1
Moneylife Digital Team 25 April 2013

Nomura felt the risks in China were sufficiently non-trivial to assign a one-in-three likelihood of a “hard landing” commencing before the end of 2014

Almost 18 months ago, global brokerage firm Nomura in its China Risks report provided six reasons why it thought the risk of a hard economic landing in China had increased. They were: 1) overinvestment and excessive credit; 2) rudimentary monetary policy architecture; 3) too many privileges to state-owned enterprises; 4) potential unintended consequences of financial liberalization; 5) the Lewis turning point associated with a dwindling supply of surplus rural labour; and 6) the setting in of growing pains from worsening demographics and increasing strains on natural resources.


The brokerage defined a “hard landing” as an abrupt slowdown in real GDP (gross domestic product) growth to an average of 5% y-o-y or less over four consecutive quarters, and Nomura felt the risks were sufficiently non-trivial to assign a one-in-three likelihood of a hard landing commencing before the end of 2014.


Eighteen months on, while Nomura’s base case is that China’s economy will grow, on average, by 7.5% in 2013-14, the macro risks remain high and it has kept the one-in-three likelihood of a hard landing commencing before the end of 2014.


To help quantify the macro risks on an ongoing basis Nomura constructed its China Stress Index (CSI). It is made up of 18 indicators that are first standardized and then weighted. The CSI indicates that hard-landing risks steepened after the global financial crisis and has yet to reverse course; in fact, it rose from 101.5 in Q4 2012 to 101.6 in Q1 2013, a record high on quarterly basis


Decomposing the latest data point of the CSI—March 2013—reveals that its elevated level is because of strong credit growth, including shadow financing outside the official banking sector, and a frothy property market



The record high CSI reading is consistent with the main findings from Nomura’s recent thematic report. The brokerage highlighted three symptoms that preceded major financial crises in Japan, US, and Europe, namely the rapid build-up of leverage, the rise in property prices, and a decline in potential growth. Such symptoms also currently prevail in China.


Nomura also focussed on an interesting phenomenon that it called the “5-30” rule: financial crises in large economies are usually preceded by the domestic credit-to-GDP ratio rising sharply by 30 percentage points (pp) in the five years before the crisis is triggered. So it is not only the level, but also the speed of the debt build up, and China is in the “5-30” rule danger zone.


It appears that the rapid build-up of stress in the economy has weighed on asset prices. The renminbi forward used to price in appreciation against the US dollar now prices in a depreciation, in line with the rapid rise in the CSI in recent years. Equity prices in Shanghai have performed poorly in recent years, which probably also reflects an elevated risk premium.


Real GDP growth slowed from 9%-10% in 2008-11 to 7.8% last year, which is still strong, but there is concern among investors over its quality and hence sustainability, given the heavy reliance on debt-financed housing and infrastructure investment. Nomura believes that asset prices reflect such concerns.


Recent economic development suggests investors’ concerns are warranted. GDP growth in Q1 slowed to 7.7% from 7.9% in Q4 2012, despite very aggressive policy easing as total social financing reached an historical high. The HSBC flash manufacturing PMI dropped to 50.5 in April from 51.6 in March, despite positive seasonal factors that usually drive April readings of the PMI up. Moreover, there are many signals that the government is now tightening controls on shadow banking activities. For instance the China Banking Regulatory Commission announced several guidelines in March to tighten regulations on wealth management products and contain banks‟ exposure to local government financing vehicles. The government set the target for M2 growth for 2013 at 13% in the National People’s Congress, suggesting monetary tightening beyond Q1, as M2 growth was 15.7% in March. Nomura believes these tightening measures are necessary and will help to contain systemic risks, though in the short term they will lead to a growth slowdown.


The brokerage believes that most pivotal for the outlook to it CSI and hence China’s hard-landing risk is policy. If the government tightens policy further in 2013 (which is Nomura’s baseline case), growth will slow to 7.2% in Q4, a small price to pay, for avoiding a systemic financial crisis.


There may be isolated bankruptcy cases in the non-bank financial sector and corporate sector, but the government still has the resources to protect the banking system and avoid a sharp growth slowdown to 5% or below. By contrast, if the government focuses on the short-term business cycle and loses sight of the continued build-up of the financial cycle, by loosening policy again to boost growth (which is a policy mistake and a risk scenario), Nomura believes that it can attain growth of 8% in 2013, but the risks of a systemic financial crisis and economic hard-landing rise. In other words, easing policy this year only postpones the day of reckoning at the cost of sharper growth slowdowns down the road, according to Nomura.


Nomura maintains its out-of-consensus cautious view on China’s economy. Its 2013 GDP growth forecast has been at the low end of consensus. Moreover, the 7.5% growth reflects its baseline view, which it sees as the most likely scenario, but the brokerage also views a one-in-three likelihood of a hard landing beginning by the end of 2014.



From its analysis of China’s macro challenges and risks, Nomura identified 18 indicators to construct its China Stress Index, or CSI for short. Each was chosen not to predict GDP growth per se, but to signal the chance of an abrupt slump in growth. The indicators are forward-looking, so data such as non-performing loans are not included. The data are monthly and start in January 2000. For the indicators that are available only on a quarterly or annual basis, monthly series were interpolated from the longer frequency data. CSI is then defined as a weighted average of standardized indicators as follows:



One limitation of the CSI is that it does not give a probability of a hard economic landing. To do so would require a reference variable measuring past episodes of hard economic landings in China, the obvious one being real GDP. Yet in the past 20 years Chinas GDP growth has not fallen below 5% and before then the causes of hard landings in GDP were influenced heavily by social and political unrest. So what the CSI tells us is: 1) the direction of overall macro risk; and 2) how fast the risk has changed compared with history.


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