PBoC joins other major central banks with unconventional monetary policy action

Softer than expected economic growth in China (see discussion) has finally spurred the PBoC into action. However, rather than undertaking asset purchases that would inject reserves into the overall banking system, the PBoC forced liquidity directly into state-owned banks.

NY Times: - With industrial production growing at the slowest pace since the worst of the global financial crisis and foreign direct investment in a tailspin, China appears to have taken the unusual step of using monetary stimulus in an attempt to forestall further economic weakness.

China’s central bank has lent 100 billion renminbi, or $16.2 billion, to each of the country’s five main, state-controlled banks, bankers and economists said Wednesday, although the central bank and the five banks involved stayed silent. The seemingly stealthy decision to inject a total of $81 billion into the banking system this week came as the Chinese economy, like many economies in Europe, has slowed over the summer, although still expanding at a pace that would be the envy of most countries around the world.

This is probably the least effective QE-style action, as state-owned lenders are unlikely to efficiently deliver capital into the private sector. But the fact that the PBoC has taken this action tells us this could be the start of a longer monetary stimulus effort. The markets are not expecting a near-term economic improvement and instead pricing in a prolonged battle to accelerate growth. China's SHIBOR rate swap curve has become more inverted than a month ago with expectations of further rate declines.

Some form of stimulus was already being priced in, which is in part what generated the recent stock market rally.

Source: Investing.com

Now the PBoC joins other major central banks in expanding "unconventional" monetary policy efforts. The impact of such actions on economic growth however remains highly uncertain, particularly in the face of softening property markets and weaker corporate balance sheets.

Source: Reuters

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Further signs of China's slowing property markets

China's official housing index now shows home price appreciation slowing faster than some had anticipated.

Source: Investing.com

Other indicators are also pointing to weakness in China's housing markets. For example the number of cities with falling prices has spiked sharply.

Source: Scotiabank

Furthermore, the steel rebar futures in Shanghai - an important real-time indicator of construction demand - remain under pressure.

Jan steel rebar futures in Shanghai (barchart.com)

Related to the trends in residential housing, China's commercial floor space and the number of commercial buildings sold has declined materially recently (based on official reports).

Source: National Bureau of Statistics

There is no question that Beijing has the wherewithal and the will to support the housing market should things unravel faster than the government likes. Nevertheless, given how pervasive property markets are in the nation's overall economy, concerns among global investors are rising with respect to China's housing slowdown.

Scotiabank: - On the theory that where there’s smoke there's fire (and it’s not just because I’m BBQing), weak company financing and concerns surrounding potential defaults in the shadow banking sector coupled with — and likely driven by — further evidence of falling property prices will only amplify the concerns.

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Loose policies from Beijing help pump the credit bubble

If you read most media reports on People's Bank of China's latest monetary policy direction, it would seem that the central bank has only been focused on some targeted stimulus initiatives.

Want China Times: - China's central bank said on Wednesday that it will continue to implement a targeted approach in monetary policy in the second half of 2014 and shore up weak links in the economy.

More financial support will be provided to rural areas and small businesses to reduce their financing costs, according to a statement on the website of the People's Bank of China.

But are the central bank's initiatives truly as limited in scope as these stories would make us believe? Recently the PBoC has been experimenting with some unconventional policy tools that make it rather difficult to assess how loose the overall policy has been.

Xinhua: - The People's Bank of China has developed two or three monetary tools to guide short- and medium-term interest rates via an effective monetary policy transmission mechanism, said PBOC Governor Zhou Xiaochuan on the sidelines of the China-US Strategic and Economic Dialogue in Beijing on July 10.

Pledged supplementary lending [PSL], a lending instrument backed by collateral, is a new monetary tool to guide medium-term interest rates.
...
"The PBOC is becoming increasingly reliant on innovative monetary tools. It's trying not to adjust interest rates or the reserve requirement ratio, because these aren't good measures to control the direction of capital flows. So the central bank is putting greater emphasis on targeted adjustment by using tools like re-lending and PSL," Zhu said.

And there are other indicators of China's monetary policy, such as loans to the private sector (below) and the exchange rate policy.

Bloomberg has developed an index that combines some of these measures in order to assess just how loose the overall monetary policy has been. The results seem to indicate that the level of stimulus has actually been significantly higher than one would surmise from the media reports.

BW: - China loosened monetary conditions last quarter at the fastest pace in almost two years, a Bloomberg LP gauge showed, testing the waning effectiveness of credit in supporting economic growth.

Bloomberg’s new China Monetary Conditions Index -- a weighted average of loan growth, real interest rates and China’s real effective exchange rate -- rose 6.71 points to 82.81 in the second quarter from the previous three months. That’s the biggest jump since the July-September period of 2012, with May and June’s numbers the first back-to-back readings above 80 since January 2012.

With the inflation rate subdued (chart below) the PBoC has been free to let the flow of credit going full speed.

In fact the overall credit expansion across China - including the so-called "shadow banking" - has been tremendous.

Source: Scotiabank

And while some have been expecting a slew of defaults this summer by a number of overextended companies, the availability of easy credit allowed firms to simply roll their debt - for now.

Scotiabank: - One reason why the feared wave of summertime defaults out of China’s shadow banking system has yet to emerge is that China’s credit cycle is not slowing down and so credits are generally being successfully rolled over. That’s a short-term plus but hardly counters concerns that China’s credit cycle remains far too loose.

China's policies, including the PBoC's activities, continue to facilitate flows of enormous amounts of stimulus into the economy via credit expansion. It's no longer the direct injection of capital that Beijing used to undertake, nor is it the reserve ratio targeting by the PBoC. Instead, the nation has developed an incredible appetite for debt and the authorities in Beijing are happy to oblige in order to maintain economic growth targets.

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5 indicators pointing to persistent economic weakness in China

China continues to pose a significant risk to global economic expansion. The country is close to becoming the world's largest economy and a further slowdown will be felt worldwide. From the Eurozone to South Korea, major economies are carefully tracking developments in China and the extent to which their own economies may be impacted. So far key economic and market signals from the nation point to an economy that remains in the doldrums. Here are the latest indicators:

1. The unofficial manufacturing PMI shows that the manufacturing sector is still contracting.

Source: Markit/HSBC

HSBC: - The final reading of the HSBC China Manufacturing PMI stabilised at 48.1 in April, up slightly from 48.0 in March, and revised down from an earlier flash reading of 48.3. The latest data implied that domestic demand contracted at a slower pace, but remained sluggish. Meanwhile, both the new export orders and employment sub-indices contracted, and were revised down from the earlier flash readings. These indicate that the manufacturing sector, and the broader economy as a whole, continues to lose momentum. Over the past few days, Beijing has introduced more reform measures which could support growth by inducing more private sector investment. We think bolder actions will be required to ensure the economy regains its momentum.

2. Property price correction is looming and investors are becoming jittery - both domestically and abroad. The recent yuan depreciation (see Twitter post) has exacerbated the situation. Concerns over property developers running into financial problems are rising, particularly as credit tightens.

Want China Times: - The one-way movement of the renminbi in recent years has boosted yuan-denominated assets and lowered the cost of overseas lending among Chinese real estate investors, with the former attracting the inflow of foreign capital into the country's housing market and the latter making it more convenient for the companies to raise funds overseas.

But the sudden depreciation of the yuan has prevented international money inflows into China's housing market and has reduced yuan-denominated house prices. It is hard for real estate developers to raise funds with the rising cost of overseas lending. Therefore, a change in the current financial condition will naturally trigger a cyclical adjustment in housing prices.

3. Related to the issue above, industrial commodity prices in China are still depressed - unable to sustain a recovery after the sharp declines back in March. This does not bode well for industrial demand.

Steel rebar June futures (barchart)

Iron ore June futures (barchart)

4. The rate swap curve remains inverted, which is never a good sign.

Source: Chinamoney

5. The Shanghai Composite Index is once again toying with the psychologically important 2,000 level. If we move below that level and stay there, concerns over China's economic trajectory will rise further.

The Shanghai Composite Index (source: Bigcharts)

China's government is pushing through some fiscal stimulus to give the economy a boost. The focus these days is on rail infrastructure investment.

China News Service: - China's national railway operator has raised its fixed-assets investment target to more than 800 billion yuan ($127.2 billion) for 2014, which is part of the country's efforts to stabilize growth through infrastructure construction, experts said Saturday.

But will it be enough?

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4 signs of economic slowdown in China

The thesis of China facing weaker nearterm economic growth is widely accepted at this point.  Moreover, the slowdown in the nation's manufacturing sector this month (see chart) has provided some support for this view. But as we have seen in recent years, it could be a temporary correction related to some seasonal patterns. Given the difficulty in obtaining reliable data out of China, what other evidence do we have that the nation's economy is actually slowing? Here are four signs that seem to support the "slowdown"  thesis.

1. For the first time China's "insiders" are calling for weaker growth:

WSJ: - China’s state media have long accused foreign analysts of being too bearish on the Chinese economy. Those analysts looking in from the outside are often said to be too eager to be “chanting decline”—chang shuai—when it comes to the economy’s prospects.

This time around, China’s own economists seem to be chanting a pessimistic tune about growth prospects. Perhaps they are not quite as negative as those pesky foreign counterparts—who according to at least one report China’s state media are being told to avoid—but they are increasingly outspoken about slowing growth and rising financial risk.

“We are now in a painful stage,” economist Wang Luolin told a seminar this week. “Let’s not try to dress things up,” said the consultant to the Chinese Academy of Social Sciences, a government think tank.

Yu Bin, a senior researcher at the influential Development Research Center under the State Council, took a similarly pessimistic view.

“The fact is, China’s economic growth is facing substantial downward pressure,” he said. “I don’t think we should get our hopes up for this year’s growth.”

2. The nation's central bank has once again halted the currency appreciation. The authorities tend to do this during periods of economic uncertainty in order to provide some support for China's exporters.

Chart shows USD appreciating against CNY (Source: Reuters)

3. Australian coal prices have been under some pressure - mostly due to mediocre demand from China.

Australian thermal coal price (source: Ycharts)

Similarly iron ore price has been weaker recently, with China having stockpiled massive amounts of the commodity (inventories at highest level since 2010). This could be an indication of slack in industrial demand.

4. Perhaps the most significant indicator of slowing growth in China is the decline in longer term interest rates combined with an inverted yield curve.

Why is the yield curve inversion (short term rates higher than long term rates) so important to watch? In many countries an inverted yield curve is often a harbinger of an economic slowdown. Just to put this in perspective, here is what the US yield curve looked like in the middle of 2007 (about six months before the start of the Great Recession).

Of course nobody is calling for a major recession in China, but a slowdown looks increasingly likely.

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From our sponsor:

An explanation for persistent weakness in China's stock market

There have been numerous theories attempting to explain China's stock market's lackluster performance in recent years.

 China Stock Market (SSE Composite) - source: Tradingeconomics.com

One of those explanations focused on the need for reform. Once the economy and the markets undergo some key reforms, the market will take off. At least that was one of the theories. So now that some major reforms have been announced (see story), why hasn't the market responded? Donald Straszheim of the ISI Group wrote a comment this weekend that provides a hint...

ISI: - This week, PM Li said that China has entered a transition period - from 'high growth' to 'medium-high growth'. He's got the direction right. Li also indicated that China is losing its competitive edge in low- and medium-level (tech) products. He's right, sharp wage gains are eroding the Middle Kingdom's competitiveness. His solution - China must rely more on technological innovations to drive future growth. Unfortunately, innovation is and will remain, we believe, China's weak point. In other words, if innovation is China's future - that future is grim. China is a technology adaptor; it is not an innovator. Li made the above remarks at an annual government-sponsored meeting which highlights major accomplishments (and makes monetary awards) in the science and technology arena.

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Reduction in fiscal stimulus creates tight monetary conditions in China

China's short-term rates have spiked again. In a replay of this summer's liquidity squeeze (see post), term money market rates (SHIBOR and repo rates) have risen across the board. The PBoC had to inject liquidity to stabilize the situation.

WSJ: - The People’s Bank of China said Friday it had been forced to inject more than 300 billion yuan (US$49.2 billion) into China’s money markets over a three-day period after the interest rates banks charge each other for short-term loans surged to 8.2%. The injection helped bring down rates to 5.6% by Monday morning.

Last week’s levels were the highest since June’s cash squeeze sent short-term rates soaring above 28%. Then, China’s lenders were caught in a credit squeeze caused by a combination of factors, ranging from lower capital inflows and seasonal tax payments to a mismatch between banks’ short-term funding and longer-term lending. The PBOC let the problem fester before stepping in, to teach banks a lesson.

Source: China Foreign Exchange Trade System & Nation Interbank Funding Center

The explanation this time around seems to be reduced government spending. The banks and the economy as a whole rely on seasonal fiscal stimulus, which is not nearly as potent this time around. Reforms focused on reducing "unnecessary" government spending are being put in place.

WSJ: - Those seasonal factors have come into play now as well. But “the recent rate spike is, to a large extent, a reflection of the government’s tighter stance on spending,” Citigroup economist Ding Shuang said.

The Chinese government usually draws down fiscal deposits — the amount of funds the government keeps in the financial system—more quickly in December, as it speeds up spending and fiscal disbursements before the end of the year, UBS economist Wang Tao said in a recent note.

That boost in government spending adds liquidity to the banking system, and the PBOC normally withdraws liquidity at the end of the year to offset the inflows. This time, though, the government’s tighter fiscal policy means year-end spending has been restrained, Ms. Wang said.

China’s Communist Party has launched a campaign this year to crack down on unnecessary government spending, from official banquets to investment projects. Even budgeted investment projects that are deemed unnecessary won’t get funding, Citigroup’s Mr. Ding said.

Withdrawal from years of stimulus is bound to have its side effects. And tight monetary conditions are likely to be just a part of the overall impact.

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From our sponsor:

China's retail investors have given up on the stock market; could we be approaching the bottom?

China's retail investors have lost all confidence in the nation's stock market. In spite of improving economic fundamentals (see discussion), the market continues to plunge. Unlike many other emerging markets, China's domestic stock market trading is dominated by retail investors. And many feel they have been duped, as the market hits new lows.

JPMorgan: - Of the households with stock market investments, 77% had not made a profit. The stock market has been the worst performing asset class over the last 5 years from various investment instruments available to the retail investor. If a retail investor put Rmb100 into the CSI300 5 years ago and left it, it would only be worth roughly Rmb 47 today...

Shanghai Stock Exchange Composite Index (source: Yahoo Finance)

China's brokers have spent the last few years hyping the market, with a positive projections each new year. And each year retail investors have been disappointed. Now some are waiting for the government to effectively "bail out" the equity market before they would feel comfortable getting in.

WSJ: - “Local retail investors have lost faith on the stock market over the past three years. How can we expect investors to rush into a market where all expectations for a bottom, say the 3000 and the 2000 level, have proven to be wrong?” said Amy Lin, analyst at Capital Securities.

“The market is likely to stay weak until the government launches significant market-friendly measures, such as more stock buybacks of listed companies and another cut in banks’ reserve requirement ratio,” she said.

Many of China's retail investors simply left the stock market altogether, preferring property and gold instead.

FT: - The domestic Chinese investors who dominate trading in Shanghai have had plenty of bad news to weigh up over the past couple of years. China’s economy has slowed for seven straight quarters and is on track to record its lowest annual rate of growth for a decade this year. There are concerns, too, that the political paralysis surrounding the country’s once-a-decade leadership transition has delayed needed reforms.

Indeed, many Chinese investors have simply given up on equities and moved to other investments such as property, gold or high-yield wealth management products.

The percentage of dormant brokerage accounts has been rising.

Source: JPMorgan

In a market with a more diversified investor pool, one would see this retail capitulation as a bullish sign. But there are very few active institutional players in China's domestic market (although the government has been trying to change that by increasing foreign investment quotas.) For now it will take either retail investors coming back or a government action to turn it around. And given the change of the guard in China's leadership, it may take them some time to organize a decisive action. For institutions who do have access to China's domestic market however, this may be a good time to start testing the waters.

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Stresses in China's manufacturing sector point to further economic slowdown

The latest Foxconn incident (see video below) is raising more questions about China's manufacturing sector's ability to grow. It is becoming difficult to see how China's overall economy can expand at projected rates with such uncertainties around manufacturing.

WSJ: - The riot raises questions about the sustainability of China's vaunted manufacturing machine. And it poses a challenge to the government that is struggling to satisfy the soaring expectations of a new generation of Chinese workers who came of age in an era of double-digit economic growth and are less willing than their parents to make personal sacrifices for their country...

We are now seeing clear signs of strain faced by China's high tech factories as they attempt to squeeze more production out of their thin margins (discussed here) - and hitting bottlenecks in the process

FT: - [Foxconn] is the sole assembler for the iPhone 5 this year, with 80-85 per cent of shipments next year as well, according to analysts at Barclays. At an estimated $8 a phone, that workload brings in revenue, but has also put the company under strain. To handle Apple’s demands, Citi analysts estimate, Hon Hai must increase headcount at its Zhengzhou iPhone factory from 150,000 workers in June to 250,000 in October.

The relentless selloff in China's domestic stock market is reflecting this uncertainty in manufacturing growth (as well as the renewed volatility in Europe). The Shanghai Composite Index hit a new multi-year low this morning.

The Shanghai Stock Exchange Composite Index (Bloomberg)

China's official news has little on the incident in Taiyuan, but the authorities are clearly preparing the population for weaker growth ahead. As discussed about a year ago (see post), the impending slowdown will increase risks of social unrest and possibly additional production disruptions. That in turn will hurt confidence and investment, as the economy will become increasingly dependent on government stimulus.

China Daily: - China's economic growth is likely to slow for its ninth consecutive quarter in the period from July to September, top policy advisers said on Tuesday.

If their predictions prove true, the government may find itself taking "remarkable measures" to combat the slump, they said.

Zheng Xinli, deputy head of the China Center for International Economic Exchanges, a government think tank, said China’s economic data for August has turned out worse than expected and the economy’s prospects remain gloomy. Amid those circumstances,the country’s GDP is unlikely to grow at a faster pace in the fourth quarter.

"The urgent need right now is to clarify what are the most effective ways to boost domestic demand," Zheng said.

Source: Reuters

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Six indicators pointing to China's deteriorating conditions

China's slowing economy continues to pose a major risk to global growth. Here are a number of updates to the developments discussed earlier (see this post).

1. Imported iron ore prices continue to decline. Stories abound of desperate sellers dumping at below official market levels and buyers defaulting on purchase agreements. Steel prices are at new recent lows as well and the steel industry is in deep trouble. Part of the problem has been overproduction by steel mills owned by local governments who are in desperate need of revenue.

FT: Steel traders are also finding themselves in a desperate position. “We have to try every possible means to sell [our steel] even if we lose money. We will lose more if we don’t sell,” says a trader with a large steel trading company in Henan province.

Another reason for the slump in China’s steel markets is the unique structure of China’s state-dominated steel sector. This year Chinese mills have maintained high levels of steel production – even when running at a loss – rather than shutting down their furnaces, because many state-owned mills are incentivised to maximise revenues instead of profit. Revenues from steel mills means more tax revenues for the local government, their ultimate owners.

China import Iron Ore Fines 62% Fe spot (CFR Tianjin port) USD/metric tonne (Bloomberg)

2. Exports are slowing. The ISI Group combined the official and the Markit PMI numbers into a single set of indices. Here is the chart for the exports portion of the PMI.

Source: ISI Group

3. ... While finished goods inventories are rising (also discussed here).

Source: ISI Group

4. Housing prices have actually been rising (also see this discussion). At first glance this may be an indication of good news, but it actually points to an escalating battle between Beijing and the local governments. Beijing wants to keep housing prices under control to prevent a housing bubble driven by speculation. China's municipalities don't want the music to stop because land and housing has made politicians and their friends rich and continues to provide government funding. The central government will push even harder to tighten controls on housing sales practices in an attempt to arrest these increases. This will make implementation of stimulus programs more difficult (see this discussion).

Source: ISI Group

5. China's banking sector is now under pressure as "bad loans" begin to rise. On one hand local businesses are complaining to their politicians that banks are refusing to roll some existing loans - while politicians pressure banks to do so. On the other hand bank regulators don't want to see non-performing loans increase. Much has been swept under the rug for now because the definition of "nonperforming" is still in the eyes of the lender.

China Daily: - China's commercial banks are facing a high risk of increased bad loans, partly due to a lending spree to support massive economic stimulus three years ago.

That risk might worsen as local governments have attempted to unleash a new round of stimulus packages amid the current economic downturn, market analysts have warned.

Seven out of the 16 Chinese listed banks reported a rise in their Non-Performing Loan ratios in the first half of 2012, according to their interim reports.

6. Finally, China's stock market hit another post-09 low this morning, continuing this relentless bear market in domestically listed shares.

Shanghai Stock Exchange Composite Index (Bloomberg)

Of course as data shows worsening economic conditions across the board, the propaganda machine from China's official media gets turned up.

People's Daily: - Rational economists are confident about the future of the Chinese economy. They believe that the internal factors driving China’s economic growth are expanding steadily. Rapid urbanization, huge consumption potential, and the rebalancing of China’s growth toward western regions will further unleash the country’s growth potential, and provide lasting impetus to its economic growth.

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Latest on China: all is well and "economic growth is stabilizing"

Here are some of this morning's key economic news coming out of China. Given that China has been the largest component of the global GDP growth, the situation is worth monitoring closely.

1. China's stock market hit a new post-2009 low. It seems that the PBoC is not in a hurry to implement a massive stimulus program, sending stocks lower. The global stimulus addiction continues (see discussion)

Reuters: - Mainland Chinese markets underperformed after the People's Bank of China surveyed demand for a new long-term money market instrument, suggesting it remained reluctant to resort to blunter policy measures such as reducing bank reserve requirements.

This apparent lack of aggressive policy disappointed market players, who see any "formal" easing measures as crucial to shoring up onshore Chinese markets.

The Shanghai Composite Index slid 1 percent to 2,053.2, its lowest close since February 2009. The CSI300 of the top Shanghai and Shenzhen listings shed 1.1 percent.

The "long-term money market instrument" would presumably be used to sweep out liquidity, which is already relatively tight (see discussion).

2. Imported iron ore prices are collapsing, pointing to extreme weakness in industrial demand. Steel and coal prices remain weak as well. There have been speculations that this is a coordinated attempt by China to control commodity inflation and stick it to the Australians. It's not clear if there is merit to these rumors.

China import Iron Ore Fines 62% Fe spot (CFR Tianjin port) 
USD/metric tonne

3. China's Index of Leading Indicators declined further, suggesting that the slowdown is not over.

Source: ISI Group

4. At the same time food prices continue to rise. It's interesting that the news on food prices is coming directly from the official sources.

China Ministry of Finance: - The price of eggs in Beijing, Shanghai and Guangzhou saw an increase of 6.8%, 5.9% and 2.9% as compared with that of the previous week. The wholesale prices of 18 vegetables rose by 1.2% compared with that of the previous week, 1 percentage points lower than that of the same period, of which eggplant, Chinese cabbage and celery were up by 7.5%, 7.1% and 5.1% as compared with that of the previous week. The wholesale price of meat was widely on the increase, of which the price of pork rose by 0.8% as compared with that of the previous week, still decreased by 22.7% [YoY]. Pork price in Chongqing, Beijing and Xiamen rose by 3.7%, 2.3% and 0.6% respectively compared with that of the previous week; beef, chicken and lamb rose by 0.6, 0.3 and 0.2% respectively. The wholesale price of 8 aquatic products were up by 0.3% as compared with that of the previous week, of which crucian carp, grass carp and carp up the most, saw an increase of 1.4%, 1.2% and 0.4%. Retail price of grains and oil maintained a steady rise, of which peanut oil, rapeseed oil and soybean oil were up by 0.5%, 0.3% and 0.2% respectively compared with that of the previous week; the price of rise was up by 0.3%; while the price of rice and wheat flour remained unchanged.

Note that the year-over-year decline in pork prices has to do with the Chinese government dumping a big slug of its 220,000-ton strategic pork reserves into the market last year. Now meat prices are on the rise again. Vegetable prices have now increased for a 6th consecutive week. The spike in global soy prices is yet to propagate through China's wholesale food markets. Further increases are coming (see discussion) and this is likely the reason that the PBoC remains cautious on additional monetary easing.

5. It seems China's government is more interested in providing stimulus on the fiscal side via tax reform and tax rebates.

Reuters: - Finance Minister Xie Xuren also told parliament that the government would continue to revamp its tax system by carrying out various reforms, including expanding property ownership tax and deepening reforms of resource tax and consumption tax.

He also pledged to quicken the disbursement of export tax rebate and further expand the use of export credit insurance to support the battered export sector, repeating Premier Wen Jiabao's position set out over the weekend.

"In the next stage, we will continue to implement proactive fiscal policy to promote stable economic growth and will push ahead with fiscal and tax system reform," Xie told the top legislature.

6. But of course according to government officials, all is well and China's economy is stabilizing.

Xinhua: - "The current situation shows that the government's policies and measures have been effective. Economic growth is stabilizing at a slow pace," Zhang said, commenting on the performance of China's economy in the first half of the year.

SoberLook.com

China's slowdown can no longer be masked by cooked economic data

As today's flash PMI numbers show, the declines in iron ore prices (discussed here) were indeed signaling an ongoing broad based slowdown in China's economy.

Bloomberg: - China’s manufacturing may be contracting at a faster pace this month, signaling more monetary and fiscal stimulus is needed to secure a second-half rebound in economic growth.

China's rates and currency markets indicate more stimulus; the equity market says that's not enough

China's Premier Wen Jiabao announced that the stimulus efforts to keep the economy growing at the target rate are working.

Reuters: - Wen, who made the comments during a weekend tour of Sichuan province in southwestern China, said the economy was running at a slower, more stable pace of growth.

"The economic growth rate is still within the government target range set early this year, and stabilization policies are working," Wen was quoted as saying.

Some of this stimulus is visible in two major financial markets.

1. The interest rate swap market is pricing in significant rate cuts going forward:

1 year interest rate swap

2. The currency (CNY) has been allowed to weaken further to help the exporters:

CNY per 1 dollar

But thus far equity market participants don't believe that this stimulus will translate into improved corporate earnings (which would result from improved economic activity). China's equity markets are hitting new recent lows in anticipation of slower growth.

The Shanghai Stock Exchange Composite Index 

The three daily indicators above will be important to watch going forward to determine how much stimulus Beijing is willing to provide and whether this stimulus is expected to have a material impact on growth.

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China's central bank will have to cut rates further to avoid hard landing

As China's inflation rate moderates, the real lending rate is rising. In fact the ISI Group is predicting inflation of 1.8% (annualized) within the next couple of months. That would translate into a 4.5% real lending rate - the highest since 2009.

China real 1-year lending rate (red = forecast)

But in 2009 China's economic growth was considerably stronger than it is now, justifying higher real rates. In the current environment however, real rates need to come down in order to avoid a "hard landing" scenario. That means PBoC should aggressively lower policy rate from the current 6% level.

And that's exactly what the rate swap curve is forecasting. Within a week, not only did the SHIBOR swap curve move down considerably, but it also became more inverted, pointing to further PBoC easing.

China's interest rate swap curve

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The longer term trend in commodities will be driven by China, not central banks

Commodities seem to have found a support level after a massive selloff recently. The CRB index recently broke through the previous support, correcting back to the levels of the early days of QE2. Have we now stabilized?

CRB Commodity Index

This stabilization in the past few days seems to be driven by stories of a potential coordinated central bank action that will supposedly provide liquidity after the Greek election this weekend. Given the global slowdown, central banks seem to be the only source of support for risk assets, as global addiction to stimulus continues.

Reuters: - European Central Bank President Mario Draghi said on Friday the bank was ready to support euro zone banks, should it be required, while Bank of Japan Governor Masaaki Shirakawa said central banks can offer liquidity to calm markets in case the weekend Greek elections heighten tension.

But we've seen this movie before. A new action from central banks, even a coordinated one, is not expected to last long. As soon as stimulus stops, risk assets (such as commodities) begin to correct (unless another stimulus action is anticipated). Ultimately any lasting strength in the commodities markets will have to come from emerging markets growth - particularly from China. The chart below from the ISI Group shows how strong the relationship between China's corporate sales and global commodity valuations has been.

Source: ISI Group

If China experiences a "hard landing", it would be hard to imagine that the ECB, the Fed, and the BoJ can really do anything to prop up risk assets. And although analysts are not yet predicting such a sharp slowdown, even the expectations from within China have not been great:

Reuters: - China's annual economic growth could drop below 7 percent in the second quarter, an influential government adviser said in published remarks on Wednesday, the most pessimistic forecast of any government or private-sector economist.

Sub-7 percent growth would reflect the pace of the economy during the global financial crisis. China reported economic growth of just 6.6 percent in the first quarter of 2009.

Ultimately to understand the longer term trend in the commodity markets, one needs to pay far more attention to China than to central banks.

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More China stimulus coming

The ISI Group believes that more China stimulus is on the way, as the nation is facing a real slowdown. The measures taken so far have been relatively insignificant, particularly as a percentage of total GDP (chart below). The difference this time vs. 2009-10 is that the central government wants to control the stimulus process as opposed to allowing regional governments to run with it. And the central government’s approach has been far more measured.

Another reason further stimulus may be on the way is simply because the bank reserve ratio requirement (RRR) cuts – the most visible monetary action this year - have been ineffective due to low demand for loans.

Source: ISI Group

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China responds to economic weakness by letting RMB depreciate

Further signs of economic slowdown in China have shown up in the HSBC China PMI index.

WSJ: - The preliminary May reading marks the seventh straight month the index has been in contractionary territory. A reading below 50 indicates contraction from the previous month, while anything above that indicates growth.

"China's real economy is getting weaker," Citi Investment economist Ding Shuang said following the release of the PMI.

"The likelihood that May industrial production and fixed-assets investment, two major gauges of economic activity, will improve is slight. The data are likely to stay weak," he added.

Ding expects growth in China's gross domestic product to slow to 7.5% in the second quarter from a year earlier, slowing from the first quarter's 8.1% expansion, which was the weakest in more than three years.

Source: HSBC

To address this slowdown, we've already seen China accelerating infrastructure projects approvals.

Reuters: - ... the government had asked for project proposals by the end of June, even for those initially earmarked for the end of the year, said the China Securities Journal, one of the country's top financial papers.

Citing government sources, the article said Beijing did not rule out bringing forward next year's projects, if it thought more investments would be needed to stimulate the economy.

But now the Chinese authorities have also allowed the Renminbi to weaken. Feeling confident about their ability to control inflation, PBoC is viewing currency weakness as a form of stimulus. It certainly makes sense for a nation addicted to exports (weaker currency will make China's exports more competitive).

CNY per one dollar (higher numbers mean weaker currency)

It's unclear how US politicians will react to this move. While the Obama administration remains tempered on this issue, this move will likely add fuel to Mitt Romney's goal to brand China a "currency manipulator". This is sure to become a point of debate in the US later this year.

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China's domestic rate liberalization may create unintended consequences

A World Bank report entitled "China 2030" (attached below) has pointed to China's liberalization of domestic interest rates as one of the critical reforms needed to transform China into a market-based economy. But the World Bank report also warns that this policy change would need to be gradually phased in.

World Bank: - ... after the above institutional and governance structures are in place, the Chinese authorities can also prepare and implement a plan that phases out the ceiling on deposit rates and the floor supporting lending rates; this step will facilitate the commercialization of banks and ensure stability in the financial sector. And as is actually well recognized and understood in China, this final stage of interest rate liberalization will have to be properly sequenced—long-term market instruments first, and short-term deposit rates last. Careful monitoring of the progress of liberalization will be crucial to ensure that banks do not indulge in destabilizing competition that erodes margins or in reckless lending that harms the quality of the loan portfolio, and that any emerging risk of distress is dealt with swiftly.

Until recently such reforms have been difficult to achieve. While rates have officially been liberalized, lenders made little differentiation in the spread they were charging various borrowers or other banks. But according to a recent report from Deutsche Bank (DB), this is starting to change. As inflation increased, the PBOC controlled rate on deposits became negative in real terms (sounds familiar?). To service some of the wealthier depositors who demanded better returns, banks started offering "wealth management" products that pay more of a "market" rate (materially above the PBOC benchmark rate). To fund these more expensive deposits China's banks were forced to raise rates on loans.

Percentage of loans at, below, or above the PBOC benchmark rate (source: DB)

DB: - But by the end of 2011, two-thirds of borrowers were paying above-benchmark interest rates and only 10% were benefitting from below-benchmark rates. The average interest rate on bank loans was 145bps above the benchmark rate. That is, whereas the PBOC had raised its benchmark interest rate 125bps since the beginning of 2010, the average interest rate on bank loans had actually risen 250bps. Effectively, the higher funding costs faced by the banks at the margin – by having to borrow via “wealth management products” at significantly higher interest rates than the official deposit rates – are being passed on to borrowers.

It seems that interest rate liberalization in China is taking shape, all within the last couple of years. It is a positive development indeed, but as with any such rapid transformation, the nation will face challenges. There simply hasn't been the time to carefully orchestrate the steps described in the World Bank report. Here are two key unintended consequences of this rate liberalization that need to be considered.

1. The stronger borrowers in China have recently been tapping the fledgling bond market that according to DB is now RMB4.2tn. They don't want to pay the higher bank rates. This is leaving banks with increasingly risky portfolios of loans as the most credit worthy borrowers use the capital markets for their funding needs - particularly for longer term financing. With bad loans forming a larger portion of credit portfolios, bank capitalization may become an issue.

DB: - We contend that it is too late for policymakers to turn back the clock on these developments. Instead, they should act urgently to recapitalize banks so that they can meet the challenges of a more competitive financial system.

2. The other "side effect" of rate liberalization is a further increase in domestic lending rates, as discussed above. The removal of artificially low rates may mean significantly slower growth in the coming years.

DB: - At the same time, policymakers and investors should accept that as interest rates onshore rise – possibly doubling in the coming years – domestic rebalancing may mean significantly slower growth as the subsidy on investment is removed.

China-2030 report from World Bank

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China's Consumer Satisfaction Index is back to November lows

China's Consumer Confidence Index declined in March by some 5%. The Consumer Confidence Index is composed of the Consumer Expectations Index and the Consumer Satisfaction Index. The key driver for this overall index decline has been the Consumer Satisfaction Index, which dropped back to the November lows. China's citizens are quite unhappy with the current state of things.

Source: ISI

Having said this, the Consumer Expectations Index has not declined nearly as much, with the Chinese consumer somewhat more sanguine about the future.

This is another indication that China will be pushing through more stimulus in the near term.

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China widens the range for currency fluctuations, but is it really making the exchange rate more flexible?

Today China announced its willingness to allow RMB (Chinese yuan) to fluctuate over a wider range against the dollar.

PBOC: Effective from April 16, 2012 onwards, the floating band of RMB’s trading prices against the US dollar in the inter-bank spot foreign exchange market is enlarged from 0.5 percent to 1 percent, i.e., on each business day, the trading prices of the RMB against the US dollar in the inter-bank spot foreign exchange market will fluctuate within a band of ±1 percent around the central parity released on the same day by the China Foreign Exchange Trade System.

And of course officials around the world are applauding the move. China is moving toward exchange rate flexibility and away from artificially keeping its currency weak.

IMF (Christine Lagarde): "This underlines China's commitment to rebalance its economy toward domestic consumption and allow market forces to play a greater role in determining the level of the exchange rate."

But is that what's really going on? With its GDP slowing and trade surplus at the lows, China is not interested in allowing the currency to strengthen. PBOC is pushing through stimulus to avoid a hard landing and a stronger currency will make that more difficult. In fact one needs to look at what Beijing is doing rather than what it is saying. From the beginning of 2012, the RMB on average has not moved against against the dollar.

RMB (CNY) per 1 US dollar (Bloomberg)

So this wonderful policy change to widen the trading range will create larger fluctuations around the 6.3 level - making RMB look more like a free floating currency. But these fluctuations may simply mask the fact that PBOC is likely to keep the average level unchanged. It appears they've ended the policy of gradual currency appreciation that has been in place since 2010 - at least for now.

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