Goldman wakes in fright. Given the enormous pile of inventories in DMs now, I do wonder if the trade shock will not be sharper than these other recessions.
China’s May activity data showed clear improvements from the April trough and surprised market expectations to the upside. Auto sales, online goods sales, property sales and housing starts registered the biggest sequential gains, benefiting from easing Covid restrictions and increasing policy support. That said, the level of output is still low, especially in consumer and services sectors, and our current Q2 GDP forecast assumes accelerated recovery momentum in June.
Domestic growth uncertainties including Covid, housing and policy linger, and the recent Covid cluster in Beijing is a case in point. Even with frequent mass testing, local outbreaks and district-level restrictions may still take place from time to time. But the associated economic damage is likely to be much smaller than the Shanghai lockdown given the much faster responses to Covid cases. Overall, the latest batch of data and news suggest domestic risks have not increased.
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However, external risks have risen notably. Although our 4% full-year GDP growth forecast has already embedded a notable slowdown in Chinese exports, the higher-than-expected inflation and faster-than-expected pace of central bank tightening overseas impose downside risk to external demand for Chinese exports. Using the US 2001 and Europe 2012 recessions as a benchmark for the downside scenario, we estimate 0.5-1pp potential drag to GDP growth.
In an effort to ease financial conditions and support growth, Chinese policymakers have been more receptive of allowing the Renminbi to weaken against the dollar recently. The correlation between daily changes in USDCNY and DXY (a proxy for the broad dollar) has increased from 0.32 in March/April to 0.67 in May/June (Exhibit 8). This helps to prevent Fed hiking and USD strengthening from leading to a much stronger trade-weighted CNY and therefore overly tightening financial conditions in China. However, sharply rising front-end interest rates overseas may make the PBOC even more cautious in conducting high-profile monetary easing such as RRR cuts and policy rate cuts due to
concerns over interest rate differentials, capital outflows, and FX market volatility. In fact, at the June 15 State Council meeting, Premier Li said to increase the policy support to the economy but “not to over-issue currency”. Taken together, we believe the risk for China’s growth outlook from front-loaded central bank tightening and growth slowdown overseas mainly comes from the trade channel, while the impact from the financial channel looks modest thus far.
Looking ahead, we think the trajectory of CNY depends mostly on China’s growth outlook and the direction of the broad dollar. While other factors such as potential tariff reductions matter, they are less important and less persistent in our view. For example, Exhibit 9 shows the largest single-day CNY depreciations over the past five years. The largest move took place on February 3, 2020 when the Covid outbreak led to a national lockdown in China, followed by August 5, 2019 amid the US-China trade war. The next three largest moves mostly coincided with significant dollar strengthening. This is evidence that domestic growth and dollar strength are key drivers of USDCNY. As dollar strength is unlikely to dissipate in the near term on recession fears, we expect USDCNY to stay elevated (3-month target of 6.75). But if domestic growth continues to improve in China and ex-China recessions can be avoided, we expect CNY to strengthen against the USD over the medium-term.
Pantheon still sees more easing and a lower CNY to come:
The PBoC is in a holding pattern at the moment, leaving policy settings unchanged, despite a faltering economy. A reopening-led rebound in growth should reduce the pressure for further easing, for now. But we expect momentum to peter out in Q3, and even with the rebound, the year’s growth target still looks out of reach. If policymakers still care about the growth target, the central bank will likely need to provide further liquidity to accommodate fiscal policy later in the year. The private sector remains reluctant to borrow, so the state must do the heavy lifting.
The 1- and 5-year loan prime rates were left unchanged on Monday, echoing the decision to keep the MLF on hold earlier in the month. This suggests the PBoC sees policy as sufficiently accommodative, for the time being. But monetary policy in China must be interpreted differently than in developed markets. Policy rates have seen few changes since the pandemic, despite the pressure on the economy, as shown in our first chart. Chinese monetary policy is still in a transition from quantity to price targeting, and liquidity remains the preferred tool.
The PBoC has been more active when it comes to liquidity injections, at least until recently, as shown in our chart above. But after a turn in the policy cycle towards the end of 2021, monetary policymakers have been treading water, dashing market hopes of a more robust turn in the credit impulse, which would be supportive for risk assets and growth.
The problem—to which we have alluded before—is that monetary policy at this point is pushing on a string. Rate cuts and liquidity injections only work
if there is demand for credit which is going unmet because it is currently too expensive or too scarce. But the credit data, and complaints from the PBoC about a breakdown of monetary transmission, suggest this is not the case.
Credit growth is increasingly reliant on the state sector. Overall TSF growth has been driven by government bond issuance this year, while an acceleration of lending growth in May was not attributable to either household or corporate borrowers, as seen in our chart above. It is unclear where new loans are going, but we suspect local government financing vehicles are benefitting.
It is always difficult to know exactly why lending is weak, as banks will typically deny any shortcomings on their part. The Q1 banking survey reporting weak demand amongst borrowers cannot be taken entirely at face value. But risk aversion in the private sector seems at least partly to blame.
Growth in household time deposits has been accelerating, even as demand deposit growth has slowed, suggesting precautionary saving amidst an economic slowdown. The relative performance of the two series has reflected depressed animal spirits in the past, as in the last property cycle downturn, illustrated in our chart below. Corporates are also under severe pressure at the moment, as evidenced by the flood of supply side measures aimed at reducing costs. Absent stronger domestic demand, they have little reason to borrow to invest, and most borrowing demand will be to meet short-term financing needs.
Property developers, who would love to borrow, are largely prevented from doing so by the Three Red Lines, which impose limits on developer leverage.
We also think, however, that lenders are less chirpy than they claim. It is true that non-performing and special mention loans have been falling as a share of the total since Q1 2020, but that strikes us as suspicious, given the performance of the property market and the preponderance of property-related lending. The economic slowdown currently underway should also pressure loan quality.
Increased caution on the part of lenders would be entirely justified, with the creditworthiness of prospective borrowers called into question. In particular, if most of the private sector is choosing not to borrow, those still wishing to borrow will be viewed with more suspicion than normal.
Monetary easing by the PBoC would have little beneficial effect, in such circumstances. It will not alter risk aversion on the part of households and corporates, and it seems unlikely to ease any credit constraint, in part because conditions are already quite easy, and in part because banks are likely engaged in credit rationing anyway. If this constraint is overcome, the risk is that monetary easing prompts a reduction in credit standards, storing up financial risk for the future.
We think further easing will wait until there is another concerted push by the fiscal authorities, who need to act if they are to come close to the growth target. In part, liquidity injections at this point will be needed to facilitate low-cost financing for investment projects. But a successful fiscal stimulus would also boost aggregate demand and increase private sector credit demand, making monetary easing less futile than it currently would be.
I agree. China is going nowhere in a hurry and CNY is going to fall further which markets hate!
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
