Slipping traction for Chinese stimulus

Recently, we saw the People’s Bank of China begin easing by cutting reserve requirement ratio ahead of a rather disappointing PMI figure. That 50 basis points cut made CNY400 billion available for banks to lend.

It is always worth saying that central banks ease policy when things are getting bad, so for starters, I am not sure why investors hope that China’s (or indeed, everyone else) monetary easing will save them from their money-losing investments. With respect to China’s monetary easing, there are a few points I would like to stress.

To start off, China’s trade surplus has been declining. Year-to-date, trade surplus as a percentage of GDP is roughly 2%, way off the high back in 2007. As the external environment remains challenging, we could see trade surplus vanishing in 2012:

Take a step back: one of the reasons why China has a large foreign exchange reserve is that China is consistently running a trade surplus. To maintain the large trade surplus and not allow the Chinese yuan to appreciate greatly, China has to create large amount of Chinese yuan to purchase foreign assets. If the trade surplus disappears going forward, there should be less demand for Chinese yuan, and the central bank will not need to create as much Chinese yuan as it had to in order to prevent the yuan from appreciating too greatly. This is the first point.

The second point is related to capital flow. We can use the change is FX position as reported by People’s Bank of China, and exclude the trade surplus, to estimate the amount of money flow into or out of China. The latest numbers for October suggest that there has been a capital outflow off roughly CNY130 billion. At that rate, the 50 basis points cut in RRR will be offset by capital outflow in 2 more months:

Again, China experiences capital inflow for most of the time, and the last time China saw large capital outflow was at the time of the 2008 financial crisis. Because of consistent capital inflow, together with the desire to keep Chinese yuan from appreciating too greatly, the central bank is obliged to create more Chinese yuan, and hence the same story: accumulating foreign exchange reserves.

Because of consistent trade surplus and capital inflow, the central bank has to create more Chinese yuan, thus China has, most of the time, found it difficult to rein in the excess liquidity. But the above two sets of data suggest that it might change. And we have more evidence for that (albeit somewhat patchy at this stage).

As previously pointed out, foreign exchange reserve fell in September. This might just be a blip caused by foreign exchange volatility or something else or, this was indeed some money flowing out such that there is no need to accumulate foreign assets (or even they have to sell in order to prop up the yuan):

We now also see the offshore yuan market in Hong Kong now traded at a discount to the onshore market, which is a new phenomenon since the existence of offshore yuan trading. We have also seen the onshore yuan market dropping towards the low end of the trading band for 8 consecutive trading days. As one FX trader told the media: “every client is scrambling to buy US dollar… with $500 million bid on US dollar, can Yuan not fall?”. That means that people probably no longer hold the view that the Chinese yuan will always go up (something that I have been arguing against).

I have to stress that the evidence for capital outflow for the time being is rather patchy, so I hesitate to draw firm conclusions that capital is flowing away on a large scale, though I think we could make the case of why that might happen. Together with the shrinking trade surplus, a few points can be made.

With less demand for Chinese yuan because of a shrinking trade surplus (or even trade deficit) and slowing capital inflow (or downright massive outflow), there will be less need for the central bank to create Chinese yuan if their goal is to maintain the exchange rate at where it is. With this in mind, we can make the case that the foreign exchange reserve accumulation will slow going forward (or even shrink), and with less yuan created, that will naturally tighten monetary conditions (or in a more extreme case, where the central bank has to sell foreign assets to prop up yuan, that will further tighten monetary condition).

Against this backdrop, I would view the latest cut in RRR and future cuts in RRR (which are looking increasingly likely into 2012) more as measures to offset the tightening bias of monetary condition due to a shrinking trade surplus and capital outflow. As such, I don’t necessarily see the latest and future cuts in RRR as particularly helpful in supporting the slowing economy and/or to avoid a hard landing, particularly as the latest developments in the real estate sector is looking increasingly worrying.

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