Economy

Special Report

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Chart 1Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West​​​​​ Chart 3Turkish Energy Ties With Russia Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary The Chinese Economy Is Facing Deflationary Pressures China’s economy is facing a deflationary threat. Core consumer price inflation is below 1%, and producer (ex-factory) price inflation has decelerated rapidly and will soon deflate. Bank loan growth remains subdued due to the deepening property market slump and lackluster credit demand in the private sector. In view of the reluctance of households and enterprises to spend, invest and hire, the multiplier of stimulus in this cycle will be lower than in previous ones. China’s property market woes continued in August and a turnaround is not likely in the near term. China’s overseas shipments are set to contract in the months ahead. China needs to reduce interest rates and weaken its exchange rate to battle deflationary pressures and reflate the system. Thus, Chinese authorities will not prevent a further depreciation in the yuan versus the US dollar - as long as the decline is orderly and gradual. Bottom Line: The risk-reward profile remains unattractive for Chinese stocks in absolute terms. For global equity portfolios, we recommend a neutral allocation to Chinese onshore stocks and an underweight stance in investable stocks. Escalating deflationary pressures mean that onshore asset allocators should continue to favor government bonds over stocks.     Recovery prospects for China’s economy remain dim. Despite August’s better-than-expected growth in industrial output and retail sales, economic activity in the months ahead will be weighed down by a lingering real estate slump, recurring disruptions linked to Covid and a budding contraction in exports. Related Report  China Investment StrategyThe Party Congress And Beyond As discussed in our previous report, China’s transition from zero Covid tolerance to a managed approach to living with the virus will be a measured but protracted process. The conditions are not yet in place for a pivotal change in the country’s dynamic zero-Covid strategy. Thus, the risk of outbreaks and ensuing lockdowns still constitute a major hurdle for private domestic demand in the near term. China’s exports are set to shrink in the coming months due to a relapse in global demand for consumer goods (ex-autos). Domestic and external headwinds confronted by China underscore that the primary economic risk is deflation. Chinese policymakers need to lower interest rates and allow the currency to depreciate to battle deflationary pressures. Odds are high that the PBoC will cut rates further. However, the efficacy of reflationary efforts is doubtful due to three factors: uncertainty over the dynamic zero-Covid policy and the outlook for Omicron; persistent real estate woes; and the downbeat sentiment among corporates and households. Chart 1Upsides In Chinese Equity Prices Are Capped Without Aggressive Stimulus Therefore, our outlook for China’s business cycle remains a U-shaped recovery with risks skewed to the downside in the next few months.  Consistently, the risk-reward of Chinese stocks remains poor. Their absolute performance is also at risk from a further selloff in US/global equities as discussed in the latest Emerging Markets Strategy report. We continue to recommend a neutral stance on Chinese onshore stocks and underweight allocation for Chinese offshore stocks within a global equity portfolio (Chart 1). Depressed Credit Demand And Low Stimulus Multiplier Demand for credit from China’s private sector remains depressed, reflected by a very muted credit impulse when local government bond issuance is excluded (Chart 2). Critically, banks have been unable to accelerate the pace of lending even after the PBoC cut rates and urged them to boost lending (Chart 3). Chart 2The Credit Impulse Remains Muted Chart 3Subdued Loan Growth Despite Lower Interest Rates The growth rate of medium-to-long-term consumer loans, which are primarily composed of residential mortgages, continues to plunge (Chart 4, top panel). New household loan origination is contracting (Chart 4, bottom panel). Our proprietary measure of marginal propensity to spend for households dropped to an all-time low, mirroring consumers’ downbeat sentiment (Chart 5).  Chart 4Household Loan Demand Is Depressed... Chart 5...And Sentiment Remains in The Doldrums Corporate credit flow improved slightly with medium-to-long-term corporate loan growth ticked up in August (Chart 6). While it is difficult to quantify, it is likely that the recent modest improvement in corporate loan growth was mainly due to state-owned banks’ lending to local government financing vehicles (LGFV) to purchase land. The latter is de-facto bailing out local governments that heavily depend on land sales. Land transfer revenues made up 23% of local government aggregate expenditure in the past 12 months (Chart 7). Chart 6Corporate Loan Growth Slightly Improved In August Chart 7Land Sales Are Critical For Local Government Financing Chart 8Corporates' Investment Sentiment Is Worsening Consistent with poor business sentiment, enterprises’ investment expectation deteriorated in August (Chart 8). Given private-sector’s reluctance to borrow, the multiplier of stimulus will be lower than that in previous cycles. Consequently, China’s policymakers have no choice but to bump up fiscal stimulus and cut interest rates even more. Property Market: No Turnaround In Sight Yet China’s property market woes continued in August with a further weakening in housing market indicators (Chart 9). Home sales tumbled by 25% in August from a year ago. Real estate investment shrinkage deepened and home price deflation accelerated. Property market indicators probably will begin to show a rate-of-change improvement in the coming months due to a more favorable base effect. However, their annual growth rates will remain deeply negative, probably posting a double-digit retrenchment from a year ago. In brief, the level of housing sales will continue withering (Chart 10, top panel). Chart 9Housing Market Activity And Prices Chart 10Shrinking Sales = Less Funding Shrinking home sales mean a scarcity of funding for real estate developers who heavily rely on advance payments from homebuyers to finance their projects (Chart 10, middle and bottom panels). Hence, a contraction in property investment will remain intact for the next three to six months and housing construction activities will stay depressed (Chart 11). Chart 11Less Funding = Reduced Completions And Investments Chart 12Households Are Reluctant To Buy When House Prices Are Falling Interestingly, to revive housing sales, Guangzhou (a southern Chinese metropolis) plans to loosen price controls to allow new house prices to drop up to 20%. Other provinces might follow suit. This would eventually make housing more affordable, but homebuyers might be reluctant to buy until house prices bottom (Chart 12). Therefore, an imminent rebound in home sales is unlikely. Overseas  Shipments Are Set To Shrink China’s export growth, in both value and volume terms, slowed noticeably in August. The global demand for goods continues to dwindle, which does not bode well for Chinese overseas shipments. Imports for processing trade,1 which historically led China’s exports growth by three months, sank in August (Chart 13). In addition, Shanghai’s export container freight index has plummeted sharply (Chart 14). Both signal an impending shrinkage in the country’s exports volume. Chart 13Plummeted Processing Imports Herald A Downtrend In Exports Chart 14A Sign Of Exports Relapse Notably, the country’s exports to the US began to wither in August and this trend will only accelerate in the months ahead. We elaborated on the reasons for the global trade contraction in a previous report. Consistently, the continued underperformance of global cyclical stocks versus defensives, which historically has been a good leading indicator of global manufacturing cycles, points to a worldwide manufacturing downturn (Chart 15). This will be bad news for China, which is the largest manufacturing hub in the world. Deflationary Pressures Will Intensify The Chinese economy is facing a deflationary threat with core consumer inflation below 1% and producer (ex-factory) price inflation falling sharply (Chart 16). Chart 15Global Manufacturing Is Heading Into A Contraction Chart 16The Chinese Economy Is Facing A Risk of Deflation As weaknesses in domestic demand, real estate price and exports deepen, deflationary pressures in the mainland economy will likely intensify. Producer prices will begin deflating in the coming months. Manufactured goods prices have already deflated modestly, which will dampen investment in the industrial sector (Chart 17). Deflationary pressures are set to proliferate given that manufacturing output accounts for one-third of China’s GDP and manufacturing investment accounts for 32% of the nation’s overall fixed-asset investment. Investment in the real estate sector deteriorated severely in August. The downtrend in manufacturing and property investments will cap China’s overall capital spending growth through the end of this year, despite the ongoing rebound in infrastructure investment (Chart 18). Chart 17Manufacturing Prices Are Deflating Chart 18Weakness In Property And Manufacturing Investments Will Cap Overall Capital Spending Chart 19Sluggish Household Consumption Weak income growth and an unwillingness by consumers to spend have taken a heavy toll on retail sales and the service sector since early this year. The growth in goods sales volume edged up in August but remains lackluster and well below pre-pandemic levels (Chart 19). In addition, online retail sales of services continued to shrink (Chart 19, bottom panel). More Downside In The RMB  China needs to reduce its interest rates and weaken its exchange rate to battle deflationary pressures. Therefore, Chinese authorities will not mind more deterioration in the yuan versus the US dollar as long as it is gradual. The PBoC lowered the banks’ foreign exchange (FX) deposit reserve requirement ratio (RRR) from 8% to 6%, effective September 15. However, this will have little impact on altering the current weakening trend of the RMB. The balance of FX deposits at commercial banks was US$910 billion at the end of August. A 2% decrease in the FX deposit reserve ratio will only free about US$18 billion in FX liquidity, which is not large compared with US$80 billion in China’s net portfolio outflows through bond and stock connects so far this year. Capital outflows from China will likely persist for the next few months due to the disappointing economic recovery and widening interest rate differential relative to the US (Chart 20). Moreover, slumping exports will heighten selling pressures on the yuan and increase the government’s tolerance for a weaker currency. The FX settlement rate by banks on behalf of clients has continued to drop, which reflects the reluctance of exporters to sell their foreign currency receipts to banks on the expectation that the RMB will weaken even more (Chart 21).   Chart 20China-US Rate Differentials Indicate RMB Depreciation Chart 21Contracting Exports Will Weigh On The RMB Furthermore, despite a 12% depreciation against the US dollar since this March, the RMB remains strong in trade-weighted terms (Chart 22). Finally, the RMB is modestly cheap, which does not constitute sufficient conditions for the exchange rate reversal, especially when macro fundamentals warrant a weaker currency (Chart 23). In short, we expect that the RMB has another 5% to fall versus the US dollar. Chart 22RMB Is Strong In Trade-Weighted Terms Chart 23The RMB Is Modestly Cheap But Might Undershoot Stay Cautious On Chinese Equities Deflationary pressures confronted by the Chinese economy suggest that onshore asset allocators should continue to favor government bonds over stocks (Chart 24). Chart 24China's Onshore Stock-To-Bond Ratio Will Continue Relapsing Chart 25A-Shares Have Broken Below Their 6-Year Moving Average The onshore CSI 300 stock index had broken through its 6-year moving average technical support, which will become new resistance for the index (Chart 25). The Hang Seng Tech index, which tracks Chinese offshore tech stocks/platform companies, has failed to break above its 200-day moving average (Chart 26). The above tell-tale signs raise the odds of cyclical new lows in these indexes. Within Chinese equities, we continue to recommend overweighting interest rate sensitive sectors, such as consumer staples, utilities and autos (Chart 27). Chart 26Chinese Tech Stocks Still Appear Brittle Chart 27Interest Rate Sensitive Sectors Benefit From Loosening Monetary Conditions Finally, we reiterate our long A-share index / short MSCI Investable stock index recommendation, a position we initiated in March 2021. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes 1     Processing trade refers to the business activities of importing raw materials, components and accessories, and then re exporting the finished products after processing or assembly. Strategic Themes Cyclical Recommendations