Why China could be in for a sharp slowdown

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What a week. When I wrote last time that Asian stocks were set to go lower, I didn't expect it to be as abrupt as this (the email was put together before the news about Lehman broke).

Big news though it is, we won't go into what happened on Wall Street here. The latest issue of MoneyWeek covers it in detail and there'll be more to come on Friday. As for what it means for Asia, we can sum it up in one word: turbulence.

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Instead, let's look at a couple of bits of news about China that got lost in the confusion. Growth there may be set to slow quite sharply over the next few months. This isn't a problem in the long term, but suggests that investors should be cautious with their stock-picking for now

Keeping an eye on electricity

The key number out of China last week was something that most people don't ever look at. After all, why would you care about electricity consumption if you didn't run a power plant?

But electricity matters because demand for it is closely linked to how quickly the economy is growing. In fact, electricity demand is probably a better measure of Chinese growth than the official GDP numbers. Many economists believe that these are fudged by the Chinese government to create the impression of steady, smooth growth. Electricity shows a choppier and more believable picture, as you can see in the chart below.

So what happened to electricity consumption in August? It rose by 5.14% year-on-year what Citigroup's Lan Xue called "a shockingly low level". That follows growth of just over 8% in June and July, a sharp slowdown from a 14% average in the first five months of the year. Given that electricity consumption is reckoned to rise about 1.2-1.3 times faster than GDP, that suggests there's been a very sharp slowdown in GDP over the last couple of months.

Things are not that bad but they're still slowing

Now, the picture is probably not as bad as the raw data suggests. A couple of factors are making Chinese statistics particularly unreliable at the moment.

First, there's the Olympic effect. The government ordered factories around Beijing to shut down in August and September to lift the blanket of smog over the city. For this reason, it's hard to read much into statistics that showed slower industrial production during the last couple of months, and it's quite likely that the factory shutdown also curbed electricity demand. If that's true we should see a rebound in both electricity demand and industrial production in the October statistics.

Secondly, there's a bottleneck in electricity production. Government caps on power prices hammered profitability for generating firms because coal prices and other costs were still rising strongly. Unable to pass these extra costs on, some generators seem to have cut production as a way to reduce their losses.

Meanwhile, transport bottlenecks and the closure of many small mines for safety reasons have meant even when generators are willing to pay the price, they may not be able to secure reliable deliveries. So it may be that electricity supply growth has slowed because producers aren't meeting demand, not because the demand doesn't exist.

So we mustn't jump to the conclusion that China has slowed to the levels that the 5% would suggest. But this data, plus slowing exports, weaker consumer confidence and the property market problems, strongly suggest China is slowing and that the next few months could be bumpy.

Goodbye inflation, growth is the new fear

It's also clear that the pro-growth camp in Beijing has gained the upper hand in recent weeks. Although Chinese policymaking is secretive, it seems there is a struggle between two factions at the top, one concerned about inflation and the other growth. And with headline inflation dropping, the pro-growth side is back in control.

Now, they may be declaring victory against inflation prematurely there are still plenty of pressures that could let it come back in the future. But for now, the government is easing policy by relaxing lending quotas, reducing interest rates and reducing the amount that banks have to keep in reserve at the central bank. They've also brought the rise in the renminbi against the dollar to a standstill. All this is aimed at keeping the economy strong and helping struggling firms especially exporters, which have been hard hit by the global slowdown.

This will probably be a bit of a boost to the economy. And as conditions get worse, we'll see more rate cuts, plus other measures such as increased government investment and perhaps tax cuts. But regardless, the economy is almost certain to slow further.

This is not a problem for the long-term bull case on China. Indeed, in many ways it's a positive: it shakes out weak firms, punishes bad investment decisions and hopefully rebalances the economy for the better. But this will get tough for a bit especially for marginal manufacturers and exporters, and anyone who depends on confident, free-spending consumers.

No good news for property or banks

Meanwhile, the problems in the property sector that we talked about two weeks ago are clearly getting worse, with buyers going on strike as they wait for prices to fall. And in this panicky market, investors are getting worried. Credit default swaps (CDS) on a number of Chinese real estate developers have soared over the last few days, as you can see on the chart below. (CDS are essentially insurance against a company defaulting on its debt. A high value means that markets think there's more chance of a default.)

Meanwhile, the latest move on interest rates will not help banks at all. While the lending rate was cut, the rate on deposits was unchanged. This reduces banks' net interest margins (the difference between the rate they pay to get funds and the rate they get on lending them out) and so cuts their earnings. Add in the writedowns that are probably coming on bad loans to property developers, property speculators and troubled exporters, and there could be some nasty surprises coming up.

In short, this is not the time to add cyclical Chinese stocks to your portfolio. Regardless of how cheaper they look, most will get cheaper and we'll hang on until they are before hunting for bargains.

That's it for this week. Before I go, just a reminder that we've put together a guide to buying international shares and list of brokers who deal in them, which can be downloaded free from the MoneyWeek website here: Foreign dealing guide / Broker list

Some of you may have had trouble downloading the broker list last week. The problem has now been fixed and you should be able to download it without any trouble. If you have any difficulties, you can email moneyweekasia@moneyweek.com for technical support.

Turning to the markets

Like the rest of the world, Asian stocks rebounded on Friday as it became clear that the US was considering an enormous bailout of the financial system. China closed largely unchanged on the week after dipping below 2,000 for the first time since December 2006. A cut in the trading tax and news that the state would buy back shares in three large banks led to hopes that the government would succeed in putting a floor under the market.

Thailand's political problems showed no signs of easing. The ruling party selected Somchai Wongsawat as the new prime minister, but as the brother-in-law of exiled former prime minister Thaksin Shinawatra, it's unlikely that he'll be able to reconcile the government and the opposition. The People's Alliance for Democracy protest group is expected to continue with their attempts to overturn the elected government and replace it with appointed representatives.

Chinese milk firms Bright Dairy and Inner Mongolia Yili were the two worst performers in Shanghai and Mengniu Dairy was suspended on the Hong Kong exchange after a baby-milk contamination scandal. Four children died and thousands fell ill after the industrial chemical melamine was added to watered-down milk to make its protein content seem higher.

And on the foreign exchange markets, the renminbi continued weakening against the dollar. Traders have largely given up on the idea that the currency will strengthen at all over the next twelve months, reasoning that the Chinese government will try to help struggling manufacturers by weakening the currency to make their exports more competitive. At one point, the forwards market was pricing in a fall to 7RMB/USD by this time next year, down from around 6.8 at present.