When will China panic about growth?

BofA with the note:

Credit easing holds the key in 2H

•Despite the recent reserve requirement ratio(RRR)cut, mixed data in 2Q open adata-dependent phase of policy making.
•In our view, export uncertainty and investment weakness in 2H will lead to credit easing and help stabilize total social financing (TSF) growth at around 10.7%.

An unexpected RRR cut, then what?

After the 50bp universal RRR cutsent an unmistakable signal of policy easing, the more important question now is whether it opens an easing cycle and will lead to more RRR cuts and rate cuts in 2H21.

We do not think the current growth data would warrant any further easing immediately. Before the 2Q and June activity data release, investors were largely expecting weak readings, as they believed that might have triggered the RRR cut decision. But the still resilient numbers in June seemed to suggest growth momentum has turned around from the deceleration in Apr-May. If growth data didn’t disappoint, why would policy makers decide to use such a strong easing measure in the first place?

In our view, the motivation behind this policy move includes: (1) policymakers took notice of weak growth beyond the headline GDP figures (especially in infrastructure and property investment) and hope to shift the policy stance early to remain on the curve; (2) cutting RRR easily helped offset the expiring MLF (medium-term lending facility), which spares the PBoC from OMOs (open market operations) or MLF rollover to inject liquidity; and (3) the signaling impact of a RRR cut will help stabilize public expectations on growth and markets.

Data-dependent policy making in Jul-Aug

We do not believe top decision makers will show a clear gesture of easing at the upcoming Politburo meeting next week. Unless they have seen more signs of downward pressure on growth than 2Q/June data suggested, a wait-and-see stance is more likely to prevail.

As a result, any further easing measure with strong signaling effect will have to wait, which means rate cuts or another RRR cut may not happen immediately:

1.The current circumstance is not bad enough to justify an immediate rate cut. If history is any guide, having a RRR cut and rate cut in the same month is quite rare. That seemed to only take place in periods when growth faced tremendous downward pressures, as in 2015 or early 2020 when the economy was hit by COVID-19 (Exhibit 16). With 2Q GDP growth still holding up well at 7.9% yoy and the full-year growth figure likely to be at above 8%, we doubt the recent slowdown will trigger another policy easing move right away.

2.Policymakers may lean towards saving more policy ammunition for later. They understand activity growth data will decelerate in the coming months, as the base from a year ago rises notably in 2H21. Instead of deploying additional easing measures right away, it is sensible to wait until more data suggest downside risks to growth.

3. The central bank would prefer not to have the combination of loose credit policy and low rates. The PBoC managed to maintain a moderately tight monetary condition in 1H21 with low rates and tight credit control (esp. on the infrastructure and property sectors). To prevent a fast build-up of leverage, it will unlikely cut rates at the time when it has to relax the credit control.

But relaxing credit control doesn’t have to wait

First, the RRR cut by itself won’t be enough. After offsetting the expired MLF, the net liquidity injection of RMB600bn or so may not be sufficient to prop up the pace of credit expansion.

The key, in our view, is the tight funding control on infrastructure and property investment. In the form of slower local government special bond(LGSB) issuance as well as a sector discrimination bias in window guidance to commercial banks, these policies have restrained credit demand from the two sectors that cover almost half of China’soverall fixed asset investment (FAI).

The structural preference to rein in the property sector can be seen in the loan data. In contrast to the steady rise in medium-& long-term (MLT) corporate loan growth (17.2%yoy as of June), growth of MLT household loans (mostly of which are mortgages) eased after 1Q. In addition, total real estate related loan growth has come down to the lowest level since 2011, with the squeeze on developer loans even more significant than duringthe last deleveraging campaign in 2016-17 (Exhibit 17).

If we look at total social financing (TSF)—a broader credit indicator—the infrastructure related funding shortage is also evident in continued contraction of off-balance-sheet credit and slower growth of government bond issuance. In particular, LGSB issuance has lagged significantly this year, reaching only 27.8% of the annual total quota in 1H, much slower than in 2019 and 2020. The slow pace was caused by a delay of the frontloaded issuance quota and more stringent oversight measures. Based on the high-frequency data we track, the pace of LGSB issuance was still slow in July thus far.

Without immediate further policy easing, we expect TSF growth to edge down and stabilize at around 10.7% yoy by end-2021, even assuming that the pace of government bond issuance will catch up meaningfully in 3Q and 4Q to fulfill the total annual quota.

The trickiest question might be whether such sectoral credit control has been gradually relaxed. With June money and credit data surprising on the upside, it is hard to imagine it was done without any help from the central bank. What we heard from commercial bank channel checks was that loan quotas were relaxed starting from May due to weak credit demand since March. We will need to watch TSF data in July and August to gauge where we are in the credit cycle.

Export and investment weakness should lead to further policy easing in late-3Q

In our view, the temporary relief on growth from 2Q will likely fade in 3Q. With more uncertainty from exports and an increasingly notable investment slowdown, we believe an outright shift towards policy easing in September will be triggered.

China’s exports remained strong in 1H21 on the back of global re-opening and stillconstrained production capacity in other EM countries due to the COVID waves, and that has contributed a notable 19.1% to GDP growth in the first two quarters. However, asglobal demand may shift from goods to services more notably and the comparison base rises further in 2H, tailwinds for the export sector could dissipate quickly. In addition, infrastructure and property FAI growth have slowed notably in 2Q, to a level that was even lower than pre-COVID time. Given that these FAI series are in nominal terms, if we deflate the FAI growth with PPI (PPI inflation avg. 8.2% yoy in 2Q), it implies investment may look even weaker in real terms and infrastructure investment may have contracted for an even longer period of time.

As we have argued in our previous report, infrastructure investment growth may recover gradually in 2H, as the LGSB issuance ramps up, but it will probably take some time. Meanwhile, though property FAI growth was still at 9.6% yoy in 2Q, it will most likely slow further given tight credit control. Monthly new starts have been in contraction since April, pointing to potentially weaker investment in the upcoming months.

Last but not the least, we cannot rule out another RRR cut in 4Q. From a liquidity management perspective, given a large amount of MLF expiration in 2H, especially in November and December, the PBoC could potentially use RRR cut again to maintain sufficient liquidity in the system. But in view of the already quite low RRR applied on small-sized banks (at 5.5% currently), there is limited room for RRR cuts to be used on multiple occasions.

If China is having another crack at deleveraging property and infrastructure, why would it ease up on property and infrastructure? The sectors are fading but not yet critical. The same goes for overall growth.

Authorities are also clearly trying to pop the commodities bubble. It will important to them to do so before any further easing to ease pressure on productive sectors. The RRR cut is further evidence of this. It does nothing to boost the segments China is trying to deflate while offering a little respite to the sectors it wants to promote.

The danger in this is that the infrastructure and property sectors are joined at the hip in ways that authorities cannot combat. Local government borrowing has been remarkably weak. It continues to be so despite efforts to revive it. This is probably the result of several factors including Beijing signaling deleveraging, NDRC infrastructure proposals approvals being constrained by green benchmarks and, perhaps most importantly, the Three Red Lines policy to deleverage developers, which has hit land sales, a key source of local government revenue which may be constraining balance sheets for borrowing.

If so, then local government borrowing will fail to rebound, a significant growth air pocket will develop with accompanying deflation in commodities, and then a wholesale easing panic.

In this sense, deliberately so or otherwise, the RRR cut is the first step to broader easing. But not before China’s old economy gets materially worse.

Let me put it this way:

  • China is trying to manage a flight path to lower growth to avoid a debt and middle-income trap.
  • However, the descent is getting harder to manage because each previous round of credit has made the plane even heavier.
  • Nowadays, the debt-soaked cargo is so heavy that authorities only have to ease back on the throttle a little for the plane to start falling.
  • They then try to give it a bit more juice but the plane keeps falling.
  • A little more juice but the plane keeps falling.
  • A touch more juice but the plane keeps falling.
  • At a certain point, the “pull up terrain” alarm goes off and they open the throttles again.
  • But the plane has already fallen so low that everybody has a near-death experience before it regains altitude.
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