From the AFR this morning:
When China’s Premier Li Keqiang met with a delegation of the world’s top chief executives in early June, he had firm views about the country’s medium-term growth outlook.
He told those at the meeting, including former US Treasury Secretary Henry Paulson and ANZ Banking Group boss Mike Smith, China’s economy would grow at about 7 per cent for the foreseeable future.
An increasing number of analysts are questioning whether recent global volatility is the result only of FOMC rumblings about QE taper or is, at least in part, the result of Chin’as new economic course. While the back-up in bond rates shows the Fed’s rhetoric is clearly in play, I agree that China is playing a role, which goes to the Australian dollar’s serious recent weakness against all currencies and the the exceptional rise in Australian bank CDS.
FTAlphaville has some interesting analysis from Deutsche on China’s shifting of macroeconomic goals:
A couple of points from Deutsche Bank’s GEM Equity strategy team on Friday to file under the “it’s China, not the Fed, that’s driving everything at the moment” meme:
…‘we believe that the improvement in the Chinese economic and corporate data, which has become evident since the end of August, is not sustainable’ and that ‘the Chinese growth story is starting to unravel’. As regular readers will know, our negative structural view derives from an examination of the relationship between the corporate sector and the state, especially at a local level, which we have documented in two longer research reports (China’s corporate sector; a messy transition’, 15 May 2012, and ‘China; no quick fix for the Beijing model’, 30 August 2012).
Third, ‘the dollar is likely to experience a sustained rally through most of 2013, sucking liquidity out of EM assets, especially local currency debt, though EM dollar debt is also vulnerable given the massive fund inflows since 2009’. This has also been the view of DB’s FX strategists Bilal Hafeez and James Malcolm.
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The sharp falls in emerging market equities were precipitated by the chairman of the US Federal Reserve Ben Bernanke’s statement on 22 May concerning the potential timetable for the tapering of the Fed’s QE policies through the next couple of years. The effect was then compounded by the PBoC withholding liquidity from the Chinese interbank market, which pushed SHIBOR up to unprecedented levels. We have detailed the impact on individual emerging markets and sectors (Figure 1), which has been universally negative, but with some noteworthy differences by country. There has been relatively little dispersion between sector performances with the traditionally low beta consumer staples and utilities performing closely in line with materials and energy. By country, the dispersion is much wider – the effect of the actions of the Fed and PBoC has been aggravated in the case of the stand-out worst performer Turkey, by the reaction of the Erdogan-led administration to the demonstrations in Istanbul.
Deutsche’s John-Paul Smith and Priyal Mulji go on to state they, like most other commentators, have been puzzled by the recent actions of the Chinese central bank. The strategy, to be blunt, is strange:
We accept the broad brush conclusion that the authorities in Beijing are trying to bring some discipline back into the system following the conclusion of the leadership transition. The method which appears to have been chosen, namely to engineer a squeeze in the interbank system, does however strike us as an extremely blunt instrument, which runs the risks of unintended consequences.Given that the ultimate stated objective of the new leadership is to increase the role of the private sector in the economy using a more market-determined cost of capital, it seems strange to then put pressure on precisely those medium-sized banks which conduct a disproportionate amount of lending with the only significant component of the indigenous private sector in China, namely the SMEs. This episode reinforces our conviction that the authorities in China face an almost insurmountable task to restore historic rates of productivity growth, in terms of complexity and the vested interests involved.
The major structural problem is the very blurred boundaries which exist between the state and private sector which distort capital allocation at enterprises above the SME level. The only way to resolve this situation over the longer term is for a complete overhaul of the fiscal relationship between local and central government, which would also involve wholesale changes to the fundamentals of land ownership.
But also, they wonder, what actually happened to the liquidity that was distributed into the system during last summer’s well publicised cash flow difficulties?
Statements from both the PBoC and the State Council clearly indicate a belief that much of it has gone into ‘speculative’ investments, presumably property, but there are clear indications that a great deal of the non-bank finance has been used for servicing existing loans, primarily to LGFVs and industrial companies, which are closely affiliated to regional governments. If this assumption is correct, then the authorities in Beijing have a major problem of conflicting priorities, given that on the one hand they warn against adding more industrial capacity but on the other talk of the need for the banks to serve the interests of industry and to protect ‘labour intensive’ sectors of the economy. In the meantime, overcapacity is visibly growing in most sectors covered by DB analysts, while companies were complaining about difficulties in accessing credit, well before the PBoC action. We would expect to see clearer indications of more cash flow problems across different industrial sectors in China in the near future.
And it is the increased realisation that the authorities in Beijing are not in full control — despite great efforts to appear that they are — and more importantly, that there may not be a coherent master plan behind everything they do, which may now be shaking confidence in the durability in the Chinese growth model.
And Society Generale also released a note late Friday in which they agreed with Deutsche and described the economic fallout of this shift:
In our view, there is no other ending to China’s massive credit misallocation than a painful burst. The question is when will it start unwinding and at what pace. Given the control that Beijing has over the economy and financial system, the answer lies more with the political willingness and/or policy (mis-)calculation, at least at the beginning of the process. Beijing’s tough stance on the ongoing episode of interbank liquidity tensions shows that the willingness is finally here, although the aim is still to engineer a gradual burst. Whether or not Chinese policymakers will be able to pull off a controlled burst, more negative events will follow, including corporate failures, nonperforming loans and bond defaults. This is the beginning of the end to China’s credit boom.
Beijing’s tough love: lesson one
The ongoing liquidity squeeze in China’s interbank market is unprecedented. Short-end repo rates started to spike in early June and the overnight rate once touched an alltime high of 30% intraday on 20 June. What is more unusual is the reluctance of policymakers to come to the rescue. Although the People’s Bank of China has injected some liquidity and the overnight rate has come off, overall liquidity conditions remain uncomfortably tense as suggested by the levels of 7-day and 14-day repo rates.There are several seasonal factors behind the squeeze, including corporate income tax payments, banks’ dividend payouts and reserve requirement. However, we think the persistence and the surprising degree of the tension has more to do with the slew of policy-tightening measures from Beijing on cross-border arbitrage flows, wealth management products and the bond market.
These measures are designed to limit the supply of easy liquidity from the interbank market for speculative uses and risky shadow banking activities. Market participants were clearly unprepared for such a tough stance and have been slow to adapt. By offering limited relief, the PBoC is forcing lenders to swallow the bitter pill.
Therefore, this episode of tension is largely an intended experiment by policymakers.
In the past, we would expect mostly window guidance and moral persuasion to follow regulatory measures. However, since 2010, experience has indicated the effectiveness of administrative and quantitative controls, as formal banks and shadow banking institutions work increasingly closely to innovate ways of circumventing new rules.
This time, Beijing is serious enough to go as far as inflicting real pain on the system by tolerating exorbitantly high interest rates. We would agree that this approach is not the most elegant one and the PBoC could have been more communicative about its intention, but it may just be necessary given the fast-changing dynamics in China’s financial system – especially the rising presence of shadow banking activities.
Repo rates have come off but still high
This experiment of relying more on price signals to convey policy messages is in principal consistent with the overall direction of China’s long-term goal of financial liberalisation. In light of the reform resolute that the new leaders have shown, we expect China’s liquidity conditions throughout H2 to remain tighter than in H1 and also more unpleasant than what the market hopes to see.…Smaller banks more dependent on interbank funding
We think policymakers want to see a meaningful decline in shadow bank lending, and they will probably get it. We expect total credit growth to drop from nearly 25% yoy to 16-18% yoy by the end of the year, with nonbank credit growth coming off from over 50% yoy at the moment to about 30% yoy. As the major funding source for formal bank loans is still deposits, on-balance-sheet bank lending should be relatively less affected.The growth implication of the liquidity squeeze will be undoubtedly negative. Interest rates on bank loans, corporate bonds and shadow banking credit have begun to rise across the board as we write, further discouraging credit demand. We are concerned whether this approach will really tilt credit distribution more towards the real economy in the short term. Much of the credit misallocation in China stems from the fact that lending is often not based on financial strength but on the implicit guarantee from the state.
As liquidity conditions tighten, it may still be the small and medium-sized private enterprises that are more likely to be priced out. Smaller private property developers – one of the major clients of the shadow banking system – are likely to suffer the most. On the other hand, the state sector, especially local government financing vehicles (LGFVs), is price insensitive. Higher interest rates will make them ever more vulnerable financially, which may actually increase their demand for credit even more to cover additional interest expenses. In that case, a smaller share of credit to LGFVs will actually be translated into infrastructure investment.
A meaningful tightening in liquidity conditions in H2 is already priced in our current forecast of 7.6% growth for 2013. The squeeze has come earlier and is harsher than initially expected. If the PBoC turns out to be tougher for longer than we initially expected, further downward revisions will be required.
Further downward revisions for growth forecasts are increasingly likely in my view. Can you recall any economy going through a simultaneous credit crunch, external squeeze and stock market rout without hitting growth in the following 3-6 months?
Well, yes, I can: China in 2009 (though it dropped to zero first)! But given it’s the very imbalances unleashed by the stimulus that saved growth that time around that is now the problem it’s a result unlikely to be repeated.
Don’t get me wrong, I do think that Chinese authorities are doing the right thing and that it will benefit Chinese households in the long run. The underlying dynamism of the economy is still there and the potential for productivity gains to drive income growth is still awesome.
But by year end, Chinese growth may well have a 6 in front of it.
