Investors need to get real about China's slowdown
A steep fall in nominal growth will erode profits at companies at a time when sales growth is declining and tighten liquidity for corporate sector
Over the past few weeks, as the trickle of data from the mainland has turned slightly more positive, investor sentiment towards the world's second-biggest economy has perked up.
With industrial production picking up, liquidity easing and activity in the property market recovering, optimism is growing among analysts that the mainland's economy has bottomed out and is poised for a rebound.
With mainland stocks now looking cheap relative to other markets, a few brave fund managers are even talking about a handsome buying opportunity.
They may be just a little too courageous. It is true that at first glance the mainland's economic slowdown appears relatively modest. After all, growth only dipped to 7.5 per cent in the second quarter, down from a 10-year average of 9.6 per cent.
A drop of just over two percentage points hardly looks like the end of the world. But the apparent shallowness of the slowdown is misleading.
That's because the deceleration to 7.5 per cent refers to the slowdown in real growth - that is growth in gross domestic product, adjusted for inflation to give a consistent measure over time.
But the slump in nominal growth - that is in the unadjusted growth rate - has been far more severe. In the second quarter, nominal growth fell to 8 per cent, down from a 10-year average of almost 16 per cent.
The drop has been so pronounced because of a steep fall in economy-wide inflation.
Unlike the consumer price index used to calculate everyday consumer inflation, this "GDP deflator" takes into account prices right across the economy, from raw materials, through components entering factory gates, to accounting services, as well as the prices of goods in consumers' shopping baskets.
And while consumer inflation has only fallen from 6.4 per cent in the middle of 2011 to 2.7 per cent at the end of June, over the same period the overall economy-wide inflation rate has dropped from 7.9 per cent to just 0.5 per cent.
As a result, as the first chart shows, the mainland's nominal growth has plunged more than half in the past 18 months.
And as Vincent Chan, China strategist at Credit Suisse, and his colleagues point out in a recent research report, nominal growth is important, especially to equity investors.
That's because it is nominal - rather than real - economic growth that drives companies' sales growth.
Because of the build-up of excess capacity in the economy, in recent years mainland companies have enjoyed little pricing power. As Chan explains, instead they have relied on operating leverage and high sales growth to boost profitability.
With sales growth now declining in line with nominal GDP growth, in the absence of major structural reforms, it is likely that many companies will see their profits evaporate.
Even worse, the steep fall in nominal GDP growth means that monetary conditions are likely to get far too tight for the corporate sector's comfort.
That's because the mainland's policymakers set benchmark interest rates with an eye on consumer prices, generally keeping the "real" lending rate deflated by consumer price inflation low but positive.
As the second chart shows, for most of the past 10 years, that has meant the "real" lending rate deflated by the more relevant economy-wide inflation figure has been far too low, fuelling the excess investment boom.
Now, however, because of the plunge in economy-wide inflation, the position has reversed, with the "real" lending rate deflated by economy-wide inflation rising sharply, and climbing above the real rate deflated by consumer inflation.
That amounts to a nasty pro-cyclical tightening of monetary conditions just when the economy - and the mainland stock market - needs it least.