PBoC Struggles to Cope with China’s ‘Bottom Up’ Rate Liberalisation…

China’s 7-day bond repo rate traded at an average of 8.2% on Friday, nearly double its level a week earlier. Interbank borrowing rates also surged, although not to the double digit levels seen in June. After markets closed, the PBoC announced that it had injected a total of Rmb300bn via special liquidity operations (SLOs), and in a sign of panic, has even used social networking service Weibo to declare its actions, rather than waiting a month as usual. In one way, both this spike in interbank rates and the one in June reflect incompetent PBoC technical management of a fast evolving financial market, as bank deposits disperse in a ‘bottom up’ form of interest rate liberalization. 

The bank will provide more liquidity this week to cap rates if needed to calm the year-end liquidity squeeze; while durations of a month and less have surged, those three months to one year have remained much flatter (albeit liquidity is overwhelmingly at the short end). However, Chinese financial markets are evolving rapidly via the shadow sector and competition for deposits is becoming intense, making it harder for the PBoC to micromanage the supply of liquidity. The PBoC hasn’t yet moved to a monetary policy framework targetting benchmark rates, as in developed economies.

On the operational level, the PBoC was complacent because it expected the central government, which has more than RMB4trn of commercial bank deposits and has traditionally allocated a large amount of that to local governments in December, to follow the usual script. That pattern appears to be much more muted under the new regime of official frugality. The key underlying structural issue is deposits have been fleeing the banking system for higher yielding wealth management products and online money market funds, reducing transparency. Additionally, the pressure on banks to secure deposits is always intense at the end of the year when they have to satisfy the regulatory requirement that their outstanding loans total no more than 75% of deposits on their balance sheets. The central bank crackdown in H1 on speculative forms of financing which used the interbank market and WMPs to fuel a property and investment bubble has been successful; monthly total social finance growth peaked back in March and had halved by July.

New total social financing in November stood at RMB1.23trn and total outstanding RMB loans were up 14.2% y/y, the same as overall M2 growth. However, total credit in the economy will grow almost 20% this year.Raising the cost of capital is the only effective way to encourage companies to borrow and invest more efficiently, as part of still very early stage efforts to restructure the economy away from its credit-intensive model that the government admits is unsustainable. The volatility in credit markets this year is a signal of just how difficult and disruptive that process will be.

Both now and in June, the bank refused to inject liquidity until signs of stress were generating panic headlines. The difference is that shadow finance has been reined in since Q2, so using interbank rates as a crude weapon to beat excess credit growth into submission makes even less sense, but also that the 1-year bond yield has been trending higher for months and has reached an almost decade high. It seems that more by default than design, China is now irreversibly shifting to positive real funding costs which will further pressure headline growth rates next year but also boost rebalancing momentum.  Overall, the diversification of China’s deposit markets and rising funding costs are healthy developments medium term but while the immediate money market squeeze will subside, I’ve always maintained that the Chinese economy would ultimately suffer a ‘margin call’ in slow motion from its own bank depositors as they conducted their own version of the global reach for yield.

Ultimately, the onset of demographic decline will see total deposits within the bank and shadow sectors peak through mid-decade as savings start to be run down. In the near-term, while interbank rates will subside and Chinese financial stocks rally into early 2014, 5-year generic credit default swaps look cheap at under 70bps and an increasingly desirable hedge for many investors in 2014, as these episodes of credit market instability are likely to recur and place the spotlight again on the challenge of stabilising overall systemic leverage growth.

China Turns on Investment Tap to Offset Liquidity Trap

The tendency of Asian rich brats from Bangkok to Singapore and Beijing to treat city streets as racetracks (frequently crashing their Ferraris spectacularly, and often mowing down pedestrians and fleeing the scene) is a disturbing insight into the sense of elite entitlement which is exacerbating political risks from historic levels of wealth and income inequality. That backdrop complicates the very predictable transition underway in China not only to a lower trend growth rate but with a very different incremental composition (despite the current Pavlovian policy response of state bank funded infrastructure stimulus). Back in the 27th  July Weekly, I concluded that: ‘Every traditional policy lever will be pulled in coming months to restore momentum, and we’ll soon find out whether they’re still attached to anything in the real economy’.

The August lending data suggests that they are, and we should consequently get a ‘dead cat’ bounce in some cyclical sectors this autumn. However, beyond the current slowdown, recent well publicised events suggest that the party probably faces a legitimacy crisis to rival 1989, when Beijing students were more worried about being crushed by tanks than Italian sports cars. Cancelled Macau junket trips, Burberry coats left on the racks and slumping steel and other commodity prices all reflect the aftermath of the deflating 2009-11 credit bubble which much as many commentators seem to wish, can’t be resurrected.

The downside risks in the Chinese steel sector were obvious early last summer as the policy squeeze began, and covered in a note at the time; prices for hot-rolled steel fell to an almost two decade low in recent weeks, the latest sign of deflationary forces engulfing the heavy industrial parts of the Chinese economy, reflected in a still slumping official PPI. The China Iron & Steel Association has said the situation is “disastrous”, with even the strongest groups such as Baosteel losing money. Even before the impact of inflation and GDP growth since, the latest RMB1trn investment package compares poorly to the RMB4trn stimulus after the Lehman crisis, although is combined with a provincial spending spree of dubious funding; Chongqing and Tianjin have each unveiled $240bn programs.

Having been bearish since last summer on the whole construction related heavy industrial area of the market, if I had to bet on one cyclical Chinese sector as a Q4 trade it would be cement, simply because the product is inherently perishable and hence not subject to the vast inventory overhang in say steel and non-ferrous metals. It’s also distinctive in that output trends are already stabilising. Overall, the headwinds on the cyclical part of the market should abate in coming months, although that doesn’t help the longer-term rebalancing narrative. The biggest question for global investors right now is whether China is fully invested in terms of its physical capital, and the answer depends on how you view the data. On a per-capita basis, the country’s capital stock remains a fraction of that in more developed Asian economies such as Malaysia or Thailand, let alone the US and Germany. However, relative to the country’s GDP (or indeed GDP per capita), things look more ominous for industrial commodity bulls.

The bottom line is that while you can make a cost-benefit analysis argument for urban mass transit etc., the number of truly economic infrastructure projects in China at its current level of per-capita GDP/household income is probably tiny after the fast-forward rollout of projects previously planned to 2020 and beyond funded by the post-crisis stimulus. A 200km race track around Beijing for those Ferraris would be a nice multi-billion project appreciated by the party princelings and which would technically add to GDP as it absorbed steel and cement, but it would also add to an economy wide debt burden heading for 200% of GDP. There is a widespread misconception that China has overturned the dismal laws of economics and doesn’t face financial constraints because of the 50% of GDP in foreign reserves etc., but that is simply deluded as the FX inflows those reserves represent have already passed through the economy when sterilised by the PBoC.

Investors are as addicted as Beijing policymakers to the investment ‘fix’, and when last week the NDRC approved 60 new projects, led by railways, roads, harbours and airports; the Shanghai Index jumped 3.7% (although the ECB news was at least as important on the day) and even steel shares bounced, despite chronic overcapacity and unprofitability. Between January and July, China churned out 419mt of crude steel, still up 2.1% y/y despite crumbling demand. The fragmented industry’s gross margin was as low was only marginally positive  and sector wide profits sank 49% y/y to 66bn RMB in H1 according to data from the NDRC.

Sentiment if not financial reality should benefit from project approvals and new investment picking up with bank lending and total credit growth, consistent with a more proactive policy stance in recent months (and signs of life in real estate, a very mixed blessing).  Of the new loans in August, medium- to long-term loans accounted for RMB286bn, versus RMB210bn in July, with their share of total new loans rising to 40.6% from 38.9%, suggesting that banks are funding the pickup in infrastructure investment from announced new projects in Q2. While this will help draw a line under the recent free-fall, it’s constructive only in the literal sense. Banks are supporting the government’s move to fast-track infrastructure projects (not that they had much choice when those red phones rang).

The cash flow squeeze throughout the corporate sector remains intense, but there are signs of credit life; China’s total social financing aggregate, a broad measure of liquidity in the economy, rose to 1.24trn RMB in August from 1.04trn in July. Soft M2 growth was probably due to a transfer of RMB savings to deposits in USD on expectations of further local currency weakness, a trend I covered in the 24th  August Weekly. Outstanding deposits in foreign currencies rose 62.1% y/y at the end of August to $415.1 billion while RMB outstanding deposits rose only 12.2% y/y to 88.31trn at the end of last month.

One positive from the slowdown in FX inflows is that the PBoC is becoming a more ‘normal’ central bank, freed from the straitjacket of relentless FX sterilisation and increasingly reliant on the policy tools of its global peers such as reverse repos in its open market operations to support interbank liquidity growth; that also implies that the period of explosive M2 growth in China is now over. Looking ahead, in H2 only RMB275bn of bills and RMB40bn of repos are set to mature, counterbalanced by the RMB300bn of reverse repos outstanding, limiting the ability for open market operations to boost liquidity further. That makes a belated further reduction in the RRR more likely. Added to some form of export support scheme in the works, it all should goose animal spirits at the margin but 7.5% growth is the ‘new normal’ for China and would actually be a good result.

Value-added industrial output in China rose 8.9% in August from a year earlier, down from 9.2% in July, and the slowest growth since May 2009. The slower industrial production growth was likely due to continued destocking of inventories in cyclical sectors as well as weak domestic demand. This destocking process is likely to continue until late Q4 or early Q1 next year. The country’s CPI rose 2% y/y in August, up from July’s 1.8% rise; the main driver was the price of food, which rose by 3.4% from a year earlier, compared with a 2.4% rise in July. China’s inflation always looked likely to pick up in the coming months due to the upswing in global food prices caused by drought conditions in the US, which alongside a stubbornly resilient real estate market is restricting the opportunity for aggressive stimulus measures. Meanwhile, China’s PPI fell 3.5% y/y, compared with a 2.9% decline in July, and a sustained debt deflation across heavy industrial sectors plagued by chronic overcapacity is another threat to bank NPLs. Fixed Asset Investment growth stabilised at just over 20% growth y/y. Even before the latest spending plans were announced, the fiscal deficit was widening; fiscal expenditure growth accelerated from 17.7% y/y in June to 37.1% in July but revenue growth slowed from 9.8% y/y in June to 8.1% y/y in July.

The level of economic activity in August looks consistent with economic growth of about 7.5% for this year, against the 9% plus consensus forecasts coming into 2012, and no significant rebound should be expected next year. Headwinds from excess capacity and inventory build-up, corporate deleveraging, subdued investment, and banks facing rising NPLs mean that the best hope is that with appropriate policy easing growth will stabilise in a 7-8% trend range. In the February 2011 monthly on China’s sobering historical parallels, I concluded that: ‘The key is a rational capital allocation system which finances projects based on marginal economic returns…that economic ‘reboot’ will inevitably mean a major dip in growth to maybe 6% for 2-3 years before it reaccelerates toward a trend 7-8% on a more sustainable services and consumption led basis. If the current distorted and increasingly wasteful model is pursued much beyond 2012/13, a hard landing is likely soon after which will depress growth for the rest of the decade and have destabilising political implications.’

As foreign investment banks scramble to downgrade 2013 growth estimates toward 7.5%, it’s still plausible that a multi-year growth dip to as little as 6% is in prospect as the economy deleverages amid huge asset write-offs (whether than number is ever reported as such is a different matter). If that leads to productivity rather than input driven growth amid wider reforms/deepening of capital markets, it should ultimately be very positive for long-term China investors. After all, crude GDP growth has never correlated well with EM risk asset returns, and nowhere less so than in China…