Can China stimulate again?

Via the excellent Damien Boey at Credit Suisse:

On Friday evening, the PBoC announced another 50bps cut to the reserve requirement ratio (RRR) for major banks. The announcement came just before the release of weaker-than-expected Chinese trade data, which revealed that year-ended growth in USD-denominated exports fell to -1% in August from 3.3%. Interestingly, the CNY and CNH appreciated in response to the PBoC announcement.

Firstly, on the weakness in Chinese trade data, trade wars are clearly having an effect here. Over the past year, we note that China has lost share in the market for US imports. Europe has gained. Also, it is worth highlighting that activity growth continues to undershoot financial conditions, as proxied by our proprietary financial conditions index (FCI). Our FCI does not capture all of the incremental shifts from trade policy changes, because it focuses on price and quantity measures of the easiness of domestic liquidity conditions, as well as the strength of US demand all other things being equal. And for what it is worth, the FCI has been pointing to better growth outcomes for some time because of easier liquidity conditions and robust expansion in US retail sales.

Secondly, on the RRR cut, China’s monetary policy response function to trade developments is clearly evolving. RRR cuts are designed to release reserves to the banking system, so that banks can lend more. Unlike developed markets, where the availability of reserves is not a binding constraint on bank lending, because central banks must supply any and all liquidity needed by the banks to maintain a target cash rate, in China, the PBoC has opted to pursue domestic quantity rather than price targets instead. Bank loans still create deposits – but banks are not assured that they can get ample interbank reserves from the PBoC to satisfy regulatory and liquidity requirements. Therefore, reserve rationing has been an effective way for the PBoC to control bank lending. Historically, the PBoC has allowed interbank rates to fluctuate in response to liquidity drains and adds, highlighting how different the monetary regime is to Western counterparts, where cash rates do not move apart from central bank decisions.

With this in mind, it is interesting to note that RRR cuts are often a sign of bad news, or the PBoC falling behind the curve. Therefore, investors tend not to give the PBoC credit for effective easing. Typically when the PBoC cuts its RRR, it does so in response to capital flight. When foreign investors choose to repatriate capital out of China, say because of concerns about CNY overvaluation, the PBoC is confronted with a difficult choice. It could choose to let the CNY, the international price of money, depreciate, at the risk of encouraging further capital flight. Alternatively it could allow quantities to adjust instead. If foreigners no longer want CNY-denominated deposits, the PBoC could simply delete them from the system, and their accompanying reserves. The trouble with the latter option is that by removing reserves from the system, banks get squeezed in terms of their ability to lend. Domestic liquidity management becomes much more complicated. Therefore, the PBoC cuts the RRR, in the hope of encouraging banks to lend more to create more CNY deposits, providing an offset to the liquidity drain from capital flight. Also, the government typically launches fiscal stimulus to create new CNY deposits. However, if the CNY is perceived as overvalued, these actions too could trigger a run on the currency, because they fundamentally dilute the CNY even further. Ensuing capital flight creates a binding constraint on policy makers’ ability to stimulate, until the CNY corrects its full measure, or the capital flight simply peters out. Easing proves ineffective in the short term.

Against this backdrop, it is interesting to note that the CNY and CNH have appreciated as the PBoC has cut its RRR. Currency appreciation tells us that investors do not think that the PBoC’s hands are tied by large scale capital flight. Indeed, appreciation tells us that there may actually be net scope for stimulus (whether through credit or fiscal channels).

We also note that the Chinese yield curve is one of only a handful of yield curves around the world that is not currently inverted. 10-year bond yields in China are more than 40bps above the 3-month SHIBOR. Bond market investors are anticipating reflation – not a deflationary dynamics like we saw from 2012 to mid-2018.

Interestingly, there is some debate about what the PBoC might be doing now to make the Chinese yield curve great again. Some commentators believe that the PBoC has recently changed its policy response function to deliberately prevent the SHIBOR rate from spiking in response to capital flight and liquidity drain. If this is the case, the PBoC must be acting more like developed market central banks in choosing to target interest rates rather than quantities of money strictly. It must be willing to do whatever it takes in terms of reserve injections to keep the interbank rate stable. Perhaps then Friday’s RRR cut is merely the latest attempt by the PBoC to manage interest rates. Bears will argue that the PBoC is running out of options. But bulls will highlight that if the PBoC is indeed running out of ammunition, the CNY and CNH should be depreciating as the central bank dilutes the currency – yet the evidence is that the CNY and CNH are appreciating!

Our long-held view is that the PBoC is broadly ahead of the curve. It has been ahead since mid-2018. To be sure, the central bank is incrementally reacting to adverse trade developments. But the good news is that the more the US constrains China via the trade channel, the more the Chinese are prepared to give up “growth rebalancing” objectives (ie more consumption-led, rather than investment- and property-led growth), in order to reflate the “old economy”. The good news is also that the CNY is no longer as overvalued as it once was, across a variety of metrics. Therefore, Chinese authorities are actually freer than they have been in the past to pump prime the economy. The longer-term backdrop is actually very supportive of the financial demand for commodities.

I disagree. China is stimulating but it’s doing so as it chases falling industrial output growth and, soon enough, property as well. CNY and CNH are clearly falling and RRR cuts will make that worse at the margin.

This is not a bullish environment for commodities. Not until the PBOC panics and goes all-in with rate cuts for one last spin of the property roulette wheel.

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