Beijing may question the yuan peg as the Fed prepares for liftoff

Today's ISM non-manufacturing report showed US services sector expansion considerably stronger than economists had anticipated. The strength of services sector expansion however has diverged materially from what we see in US manufacturing.

Source: St. Louis Fed, ISM

The reason for the divergence is the strength of the US dollar, which on a trade-weighted basis is at the highest level in over a decade.

Source: St. Louis Fed

Strengthening US currency has generated a significant drag on growth in the manufacturing sector. We've all read the headlines.

But haven't we seen this divergence between the services and the manufacturing sectors elsewhere? Indeed just yesterday Markit published a similar chart for China.

Source: Markit

This of course is more than a coincidence. China's currency tie to the US dollar resulted in a similar dynamic of manufacturing sector significantly underperforming. Unlike the US however, China's manufacturing is more sensitive to exports, making the slowdown far more pronounced - resulting in an outright contraction (PMI below 50 in the chart above).

In recent months the yuan has been firmly pegged to the dollar. There are a number of reasons for this linkage, including China's wish to make the yuan part of the so-called Special Drawing Rights (SDRs), a basket of currencies constructed by the IMF and held by various central banks. Beijing reasoned that the yuan's stability would help them with that cause.

Source: barchart

However, yesterday we got this headline.

Source: Reuters

Time to give up the peg? There are of course other reasons China may want to maintain the link to the dollar - one of them is to continue "rebalancing" the economy.

Source: MRB

This policy however could prove to be too costly, as competitors whose currencies have been devalued may take market share from China. Here is how the yuan has appreciated against the Mexican peso for example (chart below). With margins tightening in a number of industries, when a manufacturer decides where to build a factory, Mexico (and a number of other countries) may now be a cheaper solution.

It's unclear if China will ultimately let the peg go or if the yuan will continue tagging along with the US dollar. Will China want to wait until the 2016 IMF decision on the SDR inclusion? With the Fed getting ready for "liftoff" in September while most central banks are easing, the dollar could continue marching higher. This could slow China's economic growth materially below the current ("reported") 7% per year. In effect the tightening of monetary conditions in the US will be transmitted to China via the peg. If the dollar indeed moves higher as US rates rise, will Beijing finally run out of patience?



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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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Eurozone manufacturing expansion accelerates; risks remain

We've had some significant moves in the currency markets this morning. In particular, the euro rose quite sharply on the back of some strong manufacturing numbers out of the Eurozone.

Source: Investing.com

Germany remains the euro area's powerhouse, with manufacturing expansion there accelerating further, driving up the aggregate measure.

Source: Investing.com

European stock markets (followed by the US) however fell in spite of this seemingly good news.

The primary reason for the equity markets' sell-off was the weak manufacturing signals out of China (see Twitter post). As discussed here, China's near-term economic trajectory presents the greatest risk to global growth - particularly for the Eurozone.

The equity markets were also uneasy with the euro strength, which could choke exports from the area. Furthermore, Draghi struck a cautious tone with respect to the area's economic recovery, saying: "All in all, the risk of setbacks is large. I would be very careful not to give an overly optimistic outlook."

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More bad news on China's economy

The widely followed Markit PMI report of China's manufacturing for July was disappointing, coming in at an 11 months low.

Source: Econoday

Growth across developing economies has become a problem, and China is no exception.

Source: Markit/HSBC

HSBC: - The lower reading of the July HSBC Flash China Manufacturing PMI suggests a continuous slowdown in manufacturing sectors thanks to weaker new orders and faster destocking. This adds more pressure on the labour market. As Beijing has recently stressed to secure the minimum level of growth required to ensure stable employment, the flash PMI reinforces the need to introduce additional fine-tuning measures to stabilise growth.

The "fine-tuning" that HSBC is referring to is some type of stimulus from Beijing. The PBoC however has trouble introducing additional liquidity. The central bank views such action as conducive to more shadow banking, which the authorities have been trying to curb (see post). Any significant "fine-tuning" is therefore unlikely - in fact money market rates are no longer declining (chart below). With exports remaining weak (see post) and no central bank easing, growth is expected to be anemic - at least by China standards.

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China's economy: new warning signs

China's consumer confidence declined sharply in May to 99.0 from 103.7 in April. Of course household spending in China represents only around 35% of the GDP (according to the World Bank), while the US consumer is over 70%. Nevertheless taken together with China's manufacturing PMI, we may be seeing signs of renewed economic weakness.

Source: National Bureau of Statistics of China, Markit

China's stock markets also sold off in the last few weeks (now at a 6-month low). These are all indicators of potentially slower growth ahead. And slower growth poses a number of risks that have been masked by the nation's booming economy. One of the key risks of course is the size and health of the shadow banking system. Fitch in particular has been ringing some alarm bells with respect to China's private credit growth.

Forbes: - With a shadow banking system that is becoming increasingly prominent, the rise of bundling of assets and securitization, and an acceleration of policy tightening, over-indebted local governments and institutions will feel the pain of a rising cost of capital, prompting Fitch Ratings to raise red flags about the future growth prospects of the Chinese economy. At Nomura, where they noted that liquidity tightening is dangerous in a highly leveraged economy, they increased their probability that a risk scenario could push GDP growth below 7% this year, threatening social stability.
...
A major problem is that much of this incredible surge in credit has been channeled through the shadow banking sector, which is very closely connected to the banks. Total non-loan credit hit $5.6 trillion in 2012, with nearly $2 trillion of that credit extended by opaque non-bank financial institutions, Fitch’s research shows. Furthermore, more than $2 trillion were connected to informal securitization of bank assets in so-called wealth management products (WMP).

Perhaps the most ominous indicator of China's potential slowdown is the nation's inverted long-term interest rate curve. The chart below shows the latest quotes on domestic interest rate swaps. Inverted yield curves often signal an economic downturn in the near future.

Just to put things in perspective, this is what the US treasury curve looked like about 9 months prior to the start of the Great Recession.

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China's short-term rates spike to multi-year highs; SHIBOR and repo curves become inverted

China's interbank rates have unexpectedly spiked last week as the SHIBOR curve (China's LIBOR equivalent) became highly inverted. Given that there have been no indications of a change in policy by the PBoC (the central bank), there is only one thing that can cause such a move: a liquidity squeeze.

Source: Shanghai Interbank Offered Rate

China analysts point to a number of possibilities for this spike, including some action by the authorities to curb FX speculation or other trading activities. The best explanation however was that a panic ensued among China's banking institutions due to a rumor that several banks were about to fail. This rumor, though unverified, caused banks to cut lending to each other, creating a liquidity squeeze. The squeeze was exacerbated by China's markets being closed this Monday through Wednesday for the Dragon Boat Festival and liquidity already being tight coming into last week.

Reuters: - Early Friday, rates skyrocketed from already-high levels the previous day. Rumours that several mid-sized banks had defaulted on interbank loans added an element of fear to an acute liquidity shortage related to a coming national holiday and a slowdown in capital inflows. The rumours couldn't be verified.

The stock market tanked in response.

Shanghai composite

It is thought that the PBoC has stepped in on Friday afternoon to ease liquidity conditions. The spike in short-term rates was not limited to SHIBOR, as the repo rates (secured lending) have been on the rise in recent days as well (with the repo curve now also highly inverted).

Reuters: - The weighted-average one-day repo rate closed at 8.68 percent on Friday - the highest since October 2007 - from 6.15 percent on Thursday. It's extremely unusual for the one-day rate to move higher than the seven-day rate.

Dealers said the central bank had likely conducted short-term repos with selected banks, who were then able to transmit funds to the rest of the market.

Even the one-year government-issued bill rate spiked, indicating that the short-term liquidity concern has spilled over to some longer term instruments.

Source: Investing.com

This is a dangerous development, particularly when China is already struggling with a relatively weak (by historical standards) growth. While the nation's PMI numbers indicate an ongoing expansion on the whole, it is quite a slow one.

A spike in short term rates could dramatically dampen bank lending and slow growth even further. A prolonged spike could even put China into a recession. Many are hoping that the PBoC will deal with this issue aggressively by injecting more liquidity into the banking system in order to reduce the risk of a major credit contraction.

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China' weak credit transmission

China is awash with liquidity. New domestic bank loans have seen some of the strongest growth in years and broad money supply is increasing at nearly 16% per year. Furthermore, property loans have risen 16.4% from the previous year to 13 trillion yuan ($2 trillion).

Source: FocusEconomics

 The increased liquidity is now visible in China's money markets, with short-term interbank rates declining in recent months.

Source: SHIBOR

Capital is also pouring in from abroad as investors attempt to escape the zero-rate environments many developed nations are facing. The demand for yuan has been quite strong, driving CNY to new record highs.

CNY per one dollar - spot rare
(chart shows CNY appreciating/dollar depreciating; source: Bloomberg)

In the past, improved credit/liquidity conditions would result in stronger economic activity, particularly in manufacturing. That's no longer the case.

Source: HSBC/Markit

It seems that China has caught a developed nations' disease in which stimulus no longer translates into improved growth. As was the case in the Eurozone (see discussion), China is suffering from what economists call "weak monetary transmission", a condition in which credit/liquidity is not getting to the areas of the economy where it's most needed (and in some cases there is simply no demand for credit).

DB: - The divergence between hard economic data and the enormous expansion of liquidity since the beginning of the year suggests that credit transmission mechanisms have broken down and the chances of a credit crunch are growing.

DB calls this the "law of diminishing returns" - more credit doesn't mean stronger growth:

Source: DB

All this liquidity (which started last year - see post) may have avoided a "hard landing", but the bet on China's stimulus nurturing a renewed growth spurt has not worked out so far.

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The slowdown in economic activity is right on schedule - for the 4th year in a row

The "spring slowdown" is here again. As discussed earlier (see post), the previous three years saw a strong start in the US, followed by a slowdown in economic activity, particularly in manufacturing.

What's especially troubling this year is that we are also seeing a corresponding slowdown in other major economies that were thought to be in good shape, namely Germany ...

Source: Markit

... and China.

China Manufacturing PMI (source: HSBC, Markit)

Treasury yields declined to the lowest level this year in response. This move reflects the bet that given the soft patch in the economy, the Fed will continue buying government paper for some time to come.

Source: Investing.com

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China's economic stabilization is now reflected in the equity market

China's business surveys continue to show stabilization in economic activity. The ISI Group's seasonally adjusted MNI Survey index (see discussion) shows some recent improvement. The survey is fairly balanced, with 75% from manufacturing and 25% from services.

Source: ISI Group

MNI: - Business conditions continued to expand after the lows of mid-summer, when they dropped to levels not seen since the height of the global financial crisis in late 2008 and early 2009. Key sub-indicators softened but mostly remain a few points into expansionary territory, still vulnerable to any external or domestic setbacks. Expectations for the future continued to improve in December at a faster pace but for the most part they too have not recovered very far into expansion.

Similarly the HSBC Manufacturing PMI (final measure from this morning) shows the bottoming out of manufacturing activity.

Source: Markit

HSBC/Markit: - Output at manufacturing plants in China expanded in December, and for the second month in a row. Although the rate of expansion was modest, it was the fastest in 21 months. Total new orders also increased but at a faster pace than in November, the quickest since January 2011. Exactly 15% of panellists noted increased order volumes, a number of which attributed growth to increased client demand. Meanwhile, new export orders fell slightly following a modest increase in November. Just over 12% of firms reported lower new export orders in the latest survey period. Fewer export sales were linked to weak demand in Europe, Japan and the US.

In response to these positive indicators, some of China's institutions and money managers continue to come into the equity market that was abandoned by the retail sector. The Shanghai Composite is up for the year after a 15%+ rally in December. Even in China the retail capitulation signaled the bottom (see this post on Nov 30th). It is important to note however that China's economic stabilization is still quite tenuous and heavily dependent on economic activity in the US (see discussion).

Shanghai Composite (source: Yahoo Finance)

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China's market responds to improving PMI; institutions getting involved

HSBC China PMI shows that manufacturing continued to expand in December. The rate of expansion is still low, but consider the fact that this last reading puts the PMI index at the highest level in 14 months. This confirms earlier indications of stabilizing growth (see discussion).

Source: Markit/HSBC

The equity market moved up sharply on the news.

Bloomberg: - The Shanghai Composite Index climbed 3.5 percent to 2,134.22 at 1:20 p.m. Trading volumes were more than double the 30-day average for this time of day. Anhui Conch Cement Co. and Sany Heavy Industry Co. jumped more than 3 percent after the preliminary reading for a manufacturing index by HSBC Holdings Plc and Markit Economics increased to 50.9. Citic Securities Co. rose among brokerages, while Industrial & Commercial Bank of China Ltd. rallied the most since May 2011.

Shanghai Composite (source: Bloomberg)

As discussed earlier (see post), with the retail investor having capitulated, institutions could take advantage of this market. And that's precisely what is taking place.

Bloomberg: - “The data show the economic recovery is on a solid footing,” said Wu Kan, a Shanghai-based fund manager at Dazhong Insurance Co., which oversees $285 million. “There’s speculation that Ping An Insurance is increasing its positions in Chinese equities.”

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Positive numbers out of China providing some support to risk assets

Risk assets are surprisingly stable at the open on Sunday night, in spite of the news out of Europe (see post). Key development providing support to markets is the positive economic news coming out of China. Here are some of the recently released indicators:

1. Inflation rate seems to be at the lowest level since early 2010.

Source: Tradingeconomics.com

2. The official manufacturing PMI shows expansion  - quite modest, but expansion nevertheless (>50 = expansion, <50=contraction)

China (official) Manufacturing PMI, seasonally adjusted (source: Li & Fung Research Center)

3. Services PMI is also shows some signs of life.

Source: Markit/HSBC

4. Industrial production is up some 10% YoY. Not great relative to recent history, but still an improvement.

China Industrial Production YoY

5. The equity market, which has become too scary for retail investors (see discussion), had its biggest rise in 13 months.

The Shanghai Composite (source: WSJ)

Clearly there are still some major problems. For example a "wealth management product" sold at a branch of Huaxia's Shanghai Branch defaulted last week. There is certainly more to come (see this story). People have been talking for some time now about China's shadow banking and Huaxia's product should be a wake up call.

There are also problems with the property bubble, as housing now grinds higher for a sixth straight month. So much for making housing cheaper.

In spite of these issues, at least for now it looks like China has been able to avoid "hard landing" and is beginning to show some recovery.

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