China's falling interest rates

Expectations are building up that China's central bank will continue announcing further easing actions.

But it's not what the PBoC is saying that matters to the economy as much as what's actually going on in the short-term rates markets. And short-term rates continue to fall. This is a form of easing without the central bank announcements.

Overnight interbank rate (Source: SHIBOR)

Here is the 7-day repo rate - a fairly liquid short-term secured lending market in China.

Source: Chinamoney

Note that even the 1-year SHIBOR, to the extent it represents an actual lending rate, is falling (though remains elevated relative to inflation).

1-year interbank rate (Source: SHIBOR)

China's rates continue to decline and the PBoC will support this trend - with or without policy announcements.

On a related note, one of the reasons China needs to lower interest rates is to help the nation's strapped municipalities refinance their debt. Currently a great deal of the debt is structured using off balance sheet bank products and Beijing's goal is to shift to the muni market. That process however will take some time.

SourceL @Callum_Thomas, @prchovanec 

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An Offshore Swan: Could the next financial crisis be sparked by China being pulled into the Currency War?

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Guest post by Matthew Garrett
@MattGarrett3

The Context

• For nearly a decade, China’s maturation from a major exporter into a global economic dynamo has occurred with the embedded assumption that CNY will continually strengthen. This made sense given the backdrop of a currency that has been held well below a market driven rate by the peg to the USD and then managed float. China’s Yuan policy also included strict foreign capital controls that significantly limited outside investors’ avenues to partake in this compelling carry-trade.

Outperformance of CNY Carry Trades (Sharpe Ratios)

Source: Bloomberg

• China has begun to liberalize its financial system and Yuan policy. One major step was greatly relaxing restrictions on the Hong Kong based offshore Yuan (CNH). While this currency is somewhat tethered to the onshore Chinese Yuan (CNY), it is at the end of the day a market driven currency. The CNH became the funnel for foreign money to participate in the carry and for onshore entities to borrow in foreign currency.

CNY-CNH Spread

Source: Bloomberg

The Currency War Stresses

• As the PBOC pursues internationalization of the CNY, the currency has been freed to appreciate in increasingly looser trading bands, currently 2% from the fix. This has occurred while the Chinese economy attempts to pivot from largely being export and investment driven to more consumption and services driven.


• Currently China’s export sector is under significant pressure from some of its largest trading partners via the BOJ and ECB’s forward balance sheet expansion, driving down their currencies. Exacerbating this move is the FED ending QE and speaking to further policy normalization putting upward pressure on the USD and by extension CNY.

The chart below shows CNY’s spot return (%) against major trading partners

Source: Bloomberg

• The stresses from exchange rates are likely not in synch with the PBOC’s timeframes for allowing services and consumerism to fill the gap left by exports.


• This puts direct pressure on China’s exports during a time when aggregate demand out of EU is weak and Japan is very shaky. That said, China’s pivot in trade and economic ties is directed at AXJ (Asia ex-Japan).

Internal Credit Market Stresses

• The PBOC has gone to great lengths to provide funding facilities to the overextended and cycling down credit markets while avoiding a wholesale policy cut (benchmark rates and required reserve ratio). The latest iteration, the Medium-Term Lending Facility, provided 3-month liquidity at 350bps to the tune of 769.5B Yuan in Sept and Oct.


• The heavily levered Chinese corporates (w/ debt-GDP levels of 124%, as noted by BAML) have increasingly turned to USD bond issues.


• A continued deterioration in credit markets would warrant a move on benchmark rates and required reserves. As this possibility grows it is likely to be reflected by higher vols.

Positioning and Market Structure Risks

• Given the long running, strong performance of the CNY and CNH carry trades over the past few years and the rapid growth in the offshore currency market, it is reasonable to expect net exposure is large and leveraged with investors and financial institutions. Furthermore, the size of cross border trade with China has led RMB to be the 2nd largest trade finance currency. This leads me to believe that foreign corporates may have large exposure to the carry via RMB trade finance arrangements and is evidenced by over-invoicing. Furthermore, this could be resulting in a favorable and potentially fleeting skew to the underlying economics of trade with China.


• Anecdotally, having spoken with a businessman who imports from China, I sensed more excitement about his exposure to the currency than the underlying business.

Summing it up

• As described above, a confluence of events and circumstances exist that cause me to be wary of the engrained (but increasingly questioned) assumption of a one-way path (and trade) for the Chinese currency. In fact, I would put a far better than 50/50 chance that the CNY and CNH will experience a period of unprecedented depreciation and volatility over the next 12 months. Future volatility will likely exceed the bout of volatility experienced in 1Q2014 brought on by the PBOC to shake out one-sided bets. The implications would be hugely disruptive to global markets.

USDCNH 2 week historical volatility vs. 1 month implied volatility

Source: Bloomberg

• Implied vol rerated higher with the PBOC doubling of the USDCNY trading band to 2% on March 17, 2014.

Possible Triggering Scenarios for Disruptions

1. An external market shock- This could be broad market volatility brought on by the FED’s positioning away from ZIRP that will have spillover on the EME’s and carry trades. Market volatility (risk-off environment) could also come in the form of credit market contagion stemming from the energy space (which makes up ~18% of N.A. HY).


2. PBOC broad based monetary policy loosening (this includes changes to FX trading bands, new cheap money lending programs and aggressive use of their balance sheet)- This can come in response to; (a) further credit market deterioration; (b) weak economic and inflation prints; and (c) pressures exerted by the current round of currency devaluation by other central banks.


3. Emergence of an alternative regional or global currency scheme, outside of the existing system

Potential Mitigants

1. Large pools of incremental foreign capital that would find local currency products attractive if a risk-on environment firmly takes hold


2. Strong growth in Chinese consumption and services sector offsetting export weakness


3. Remaining policy levers at the PBOC’s disposal

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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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From our sponsor:

China about to miss the 7.5% GDP growth target

Economic reports from China continue to disappoint. Here are three recent data points:

1. Fixed asset investment growth, while still quite strong relative to the rest of the world, continues to fall.

Source: Investing.com, National Bureau of Statistics of China

2. Retail sales year-over-year growth fell below 12% again, making the switch from export-based economy to domestic consumption more difficult.

Source: Investing.com, National Bureau of Statistics of China

3. More importantly, China's industrial production growth is at the lowest level since the financial crisis.

Source: Investing.com, National Bureau of Statistics of China

Analysts are suggesting that China may now miss its target of 7.5% GDP growth unless Beijing puts in place outright stimulus programs.

FT: - ANZ said the data “reinforced our view that China’s growth momentum has decelerated faster than anticipated” on the back of a sluggish property market and slowing credit expansion. It added that China generally needs 9 per cent industrial production growth to boost the economy by 7.5 per cent. “Short of outright policy easing, China will likely miss the 7.5 per cent growth target this year, and a sharp economic slowdown will endanger the undergoing structural reforms,” Liu Ligang and Zhou Hao, ANZ economists, wrote in a research note. “Chinese authorities should further relax monetary policy as soon as possible to prevent the growth momentum from decelerating further.”

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From our sponsor:

PBoC follows other central banks in suppressing volatility

Staying with the theme of central banks dampening market volatility, China's central bank (the PBoC) has learned this game as well. China's short term rates had experienced enormous volatility last year, and the PBoC has been focused on suppressing these fluctuations.

Reuters: - China's decision to ease rules used to calculate loan-to-deposit ratios for Chinese banks (LDR) will moderate spikes in seasonal cash demand from regulatory requirements and thus help stabilise money market rates, traders say.

Regulators have been moving to stabilise money market rate volatility after a severe market squeeze in June last year rattled markets around the world, who misread a short-duration rise as a harbinger of money tightening.

It worked. The 7-day repo rate, which represents a fairly active secured lending market in yuan, has seen a substantial decline in volatility.

China 7-day repo rate

The combination of this policy to ease LDR rules and other stimulus efforts from Beijing has resulted in substantial increases in credit growth (see story) and quickened the expansion in broad money supply (see chart). It also translated into lower volatility in China's stock market.

The Shanghai Composite Index - see chart for historical daily volatility

Suppressing volatility has become a trend that is no longer limited to developed economies. Of course lower volatility is sure to result in declining return expectations and increased risk taking.

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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:

PBoC's cold turkey approach to China's credit addiction

It seems that aside from halting the yuan appreciation (see discussion) Beijing has decided to use fiscal rather than monetary tools to stimulate the economy.

Bloomberg: - Chinese Premier Li Keqiang said the nation will speed railway construction, especially in central and western regions, adding support for an economy that’s set to expand at the slowest pace in 23 years.

The State Council also yesterday approved tax breaks for small companies and reduced fees for exporters as it pledged to keep the yuan’s exchange rate “basically stable at a reasonable and balanced level,” according to a statement after a meeting led by Li. China plans a railway development fund, the government said.

Once again, the rationale to maintain a relatively tight monetary stance is to make sure that the shadow high yield deposit business and property speculation doesn't grow out of control (see post). Applying the brakes too suddenly however is quite dangerous, particularly for a nation that in recent years has become addicted to credit. The broad measure of credit (sometimes called "social financing") is now nearly double the GDP.

Source: JPMorgan

Tight and uncertain monetary policy could have a severe adverse effect on China's weakened economy by forcing an uncontrolled unwind of credit. And PBoC's policy remains both tight and uncertain. The overnight interbank (SHIBOR) rate has risen by 35bp in the past week. Most central banks would spend months fretting over such an adjustment. Other short-term rates have risen even more.

PBoC's attempt to force an abrupt end to credit addiction could easily offset any economic benefits of speed railway construction or tax breaks. Bursting such a massive credit bubble is a delicate process, which China's central bank is not executing in a controlled manner.

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From our sponsor:

Yuan daily volatility hits record levels

Over the past few weeks, the daily volatility in the dollar/yuan exchange rate hit record levels.

Yuan FX volatility

China's authorities have tight controls over the yuan's longer term level but they have a more "relaxed" FX exchange rate policy over shorter periods. While the specific transactions causing this volatility are not known, a couple of trends seem to be contributing to larger fluctuations in the exchange rate.

1. Exporters who submitted fake tickets for sold inventory to allow them to take speculative currency positions (particularly with respect to the HK dollar, which is linked to USD) have been precluded from continuing this activity (see post). Some had to unwind positions in the spot market.

2.  Borrowing US (or HK) dollars in order to short them now requires additional collateral, which makes bets against the dollar more expensive. That increased collateral rule went into effect a couple of months ago, but some of these forward trades are just now maturing.

3. The forward and options markets have seen a spike in trading volumes, as investors take bets on China's economic trajectory.

Bloomberg: - Volume in options on the dollar-Chinese-yuan exchange rate amounted to $3.83 billion, the largest share of trades at 19 percent. ... Dollar-yuan options trading was 101 percent more than the average for the past five Tuesdays at a similar time in the day, according to Bloomberg analysis. 

And that derivatives activity is also adding to the volatility in the spot market.

Recent short-term fluctuation in USD/CNY (source: Investing.com)

The currency has weakened a bit recently (see story) as well. At least some of this volatility and currency weakness underscores the rising uncertainty with respect to not only the direction of the economy, but also to the PBoC's policy and regulatory framework going forward. Furthermore, this is an indicator of increased concerns about China's wealth management products (see story) and the risks associated with potentially unwinding this massive credit market.

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From our sponsor:

New threats to China's property bubble

In late 2011 many were expecting China's property bubble to burst. It looked as though housing prices had peaked and signs of stress were beginning to appear (see discussion). But the correction turned out to be quite shallow and in spite of China's government's multiple attempts to arrest housing price appreciation (and partially succeeding - see post), house prices went on rising.

Source: JPMorgan

With real rates on deposits remaining in negative territory for years, there were few places to turn for wealthy savers. Property became one of the primary vehicles to put away excess cash to escape inflationary pressures. Moreover, municipal governments made large sums of money selling land to developers, while banks ("encouraged" by municipalities) have been happily lending. And in many cases lenders and developers have set up arrangements that are a bit closer than "arms length" (see discussion). Except for ordinary families who got shut out of the housing markets, everyone benefited from this rally.

Housing investment as percentage of GDP has been growing unabated, and in recent years started approaching levels that other nations experienced at the height of their property bubbles.

Source: Credit Suisse

Now, based on the house price to wage ratio compiled by the IMF, China's large cities have the most expensive real estate in the world. Beijing is particularly expensive, as party officials deploy their "hard-earned" cash.

Source: Credit Suisse

And while Western economists debate if China's property market is truly a bubble, major Chinese developers are openly admitting it.

South China Morning Post: - China Vanke [one of the largest developers in China] chairman Wang Shi said the mainland's property market faces the risk of a "bubble", reiterating concerns the developer raised three months ago.

The bubble is not "light", Wang said at a conference in Shanghai yesterday. "If the bubble lasts, it will be dangerous."

Home prices have been increasing even as the government in March stepped up a three-year campaign to cool the market.

The measures have included raising down-payment and mortgage requirements, imposing a property tax for the first time in Shanghai and Chongqing, and enacting purchase restrictions in about 40 cities. New home prices jumped 6.9 per cent in May, the most since they reversed declines in December, SouFun Holdings, the mainland's biggest real estate website owner, said.

But bubbles can last for a long time. Are there indications that this market may have peaked? Two key economic developments point to rising risks to this multi-year housing rally.

1. Real rates on deposits have turned positive in China recently, which will reduce incentives to use property markets as a savings tool. If rich savers make more on interest than they lose to inflation, they are less inclined to look for alternatives to bank deposits.

Source: Credit Suisse

2. The recent madness in China's money markets and PBoC's "delayed reaction" to tight monetary conditions (see discussion) could potentially spill over into the broader credit markets, resulting in increased lending rates and tighter credit conditions in general. That's not great news for property markets.

JPMorgan: - We expect liquidity conditions to ease in July, but in the near term, there is a risk that the tough line taken by the PBOC will create an artificial liquidity squeeze and cause an increase in the lending rate to the real sector (the SHIBOR rate also increased significantly, to 5.4%), putting further pressure on already-weak economic activity. In our view, the PBOC should reintroduce reverse-repo [injecting liquidity] operations very soon to calm the panic in the interbank market.

These threats to China's property markets, combined with weakness in manufacturing, do not bode well for China's near term growth prospects.

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From our sponsor:

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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From our sponsor:

Markets' addiction to central bank stimulus dominates financial headlines

Financial markets' addiction to central bank stimulus is out of control (see previous post). Below are some financial media headlines from the last few days discussing market moves - in no particular order. The news driving markets now constantly originates from central banks (or related government entities) - with earnings mixed in here and there. Central banks' actions (or inaction) are often the major factors in securities valuation. What is not clear however is if market participants and the public understand that this is not how financial markets have typically operated in the past (even though central bank actions were always a component of valuations) and is not how free markets should operate.

We go from this one day:

Reuters: - U.S. stocks rose modestly on Tuesday on investor confidence that Federal Reserve stimulus would underpin equities and purchases by money managers wanting to touch up portfolios before the quarter's end.

... to this the following day:

WSJ: - The Standard & Poor's 500-stock index dropped nine points, or 0.6%, to 1447. The Nasdaq Composite fell 29 points, or 0.9%, to 3131.

Federal Reserve Bank of Philadelphia President Charles Plosser said the U.S. central bank's new mortgage bond-buying program is unlikely to boost growth, and that the effort could harm the Fed's credibility.

"There are many investors who think the Federal Reserve was the catalyst for this latest move," said Michael Shea, managing partner with Direct Access Partners. "If you have another Fed governor dissenting with what the Fed's doing, you're going to spook some people."

And it just keeps going.

PBoC:

Reuters: - Mining stocks .SXPP rose 1.2 percent after China's central bank injected cash into its money markets and traders speculated it may also take steps to boost the country's weak stock market, to arrest a slowdown in its economic growth.

ECB:

Reuters: - Global investors staged a tentative return to euro zone stocks and bonds this month following the European Central Bank's bond-buying rescue plan and credit easing from the U.S. and Japanese central banks, a Reuters poll showed on Thursday.

BoE:

Reuters: - Traders said talk of new central bank stimulus measures from the likes of China or the Bank of England was preventing equity markets from sliding 

BOJ:

WSJ: - European stocks rose and the euro nudged up against the dollar Wednesday, after the Bank of Japan jumped on the stimulus bandwagon by announcing an expansion of its asset-purchase program.

The BOJ said it will increase it asset purchases to 80 trillion yen ($1.01 trillion) from Y70 trillion, just one week after the U.S. Federal Reserve announced another round of quantitative easing.

RBI:

The Hindu: - After surging 250 points in anticipation of a rate cut, the Sensex on Monday closed only 78 points higher - registering 9th straight day of gains - as investors were not excited at RBI just reducing CRR by 0.25 per cent and keeping key interest rates unchanged.

And it's not just about the equity markets:

SF Gate: - The yuan climbed to its strongest level since 1993 on speculation China will step up efforts to arrest a seven-quarter slowdown in the world’s second-largest economy.

Of course like any drug, the high wears off quickly.

Bloomberg: - Asian stocks fell amid concern stimulus measures by central banks won’t be enough to boost global economic growth ...

Investors are “finally realizing that recently announced liquidity injections from central banks will do nothing to address the structural issues,” said Matthew Sherwood, Sydney- based head of markets research at Perpetual Investments, which manages about $25 billion.

Until the next fix...

TheStreet.com: - The U.S. equity market next week will start the final quarter of 2012 with a heavy schedule of reports highlighting conditions in the U.S. economy, with all leading up to figures that will show if there’s been any improvement in the shaky labor market.

The action starts Monday with Federal Reserve Chairman Ben Bernanke slated to deliver a speech on monetary policy.

SoberLook.com

PBoC managing China's rising interest rates

Interest rates in China have been on the rise. The 7-day repo swap rates have been increasing across all tenors. These swaps exchange the 7-day repo rate (reset weekly) for a fixed rate over a longer period (such as 2 years) - thus providing a window into the market's long-term expectations of repo rates. The increase is an indication of tightening liquidity conditions in the interbank market.

2-year fixed for floating  (7-day repo) swap rate (Bloomberg)

China's central bank has been trying to add more liquidity to the money markets in order to stabilize rates (without adjusting the bank reserve ratio).

WSJ: - The People's Bank of China injected 220 billion yuan ($34.7 billion) into the money market Tuesday via reverse repurchase agreements offered in its regular open-market operation, continuing efforts to ease monetary conditions and bolster a slowing economy.

So far these liquidity injections have not worked, as demand for short-term money remains high and rates continue to rise.

Reuters: - China's key money rates ticked higher on Tuesday, with the central bank's largest fund injection since early July failing to ease conditions amid elevated month-end cash demand and corporate tax payments. The People's Bank of China injected 220 billion yuan into the banking system via reverse repos on Tuesday, against a net 87 billion yuan scheduled to be drained this week due to maturing bills, repos, and reverse repos.

That guarantees a net injection of at least 133 billion yuan for the week not including additional reverse repos likely to be auctioned on Thursday. Such an injection would be the largest since the week of July 2-6.

"The market demand is quite large. Monday's demand was really heavy. The central bank's action today basically just satisfied current demand, but didn't in any way exceed it in a way that would bring rates down," said a trader at a city commercial bank in Shanghai.

The PBoC has been cautious about flooding the market with liquidity due to risks it could reignite inflationary pressures. Yet left unchecked, rising interest rates could threaten growth, given that the GDP is already growing at the lowest rate since 2009. This will require a delicate balance for the central bank going forward.

China GDP YoY (Bloomberg)

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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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AUD below parity points to China-Australia link

China's one-year SHIBOR swap, an instrument that works just like the LIBOR based USD rate swap, provides a window into near term market expectations of rates in that country. And these expectations have adjusted down sharply in the past few days, revisiting the December lows.

1-year SHIBOR swap rate

After a string of weak economic numbers from China, PBoC cut the bank reserve ratio. It is fully expected that the interest rate will be cut as well (as the SHIBOR swap rate shows), but that requires authorization from the central government and takes time. For now PBoC will keep cutting the reserve ratio - possibly quite aggressively.

But there is something familiar about this SHIBOR swap rate chart above. It happens to look similar to the chart below of AUD/USD exchange rate - which just broke parity. And that's not a coincidence.

AUD/USD FX rate

The currency markets are concerned about a material decline in investment growth in China. The resource focused Australia is particularly vulnerable to China's fixed asset investment trends.

The Australian: - The lowest investment growth in China in a decade, reported on Friday, along with other data issued last week showing the weakest industrial production, retail sales and trade growth for more than a year have forcefully brought the Chinese slowdown to the market's attention.

China Fixed Assets Investment (Excluding Rural Households) Cumulative YoY

Some have been refusing to believe that fixed investment growth in China will stall, although this has been expected by a number of economists (see this post on forecast from CS and one from Capital Economics). It was hard to imagine that the good times may end - particularly in Australia, whose economy benefited tremendously from this growth. But now Australians can wake up to read the following the the paper:

The Australian: - " ...China's share of global demand for such commodities as iron, cement and copper is completely disproportionate to its size and almost wholly a function of its very high growth in investment. As investment growth drops sharply, as it must, global demand for non-food commodities will plummet."

This prediction from Peking University's Michael Pettis would so transform the economic outlook for Australia, were it to come to pass, that it bears some reflection.

So what's the solution? China will obviously continue to try stimulating the economy (including lowering rates), but it's not clear just how much effect that would have on investment growth. Instead Australians are suggesting that China open up to foreign investments to allow Australian firms to potentially facilitate more commodity imports into China.

The Australian (different article from the one above): - As fears grow about the sharpness of the slowdown in the Chinese economy, Foreign Minister Bob Carr is pushing for the lifting of restrictions on Australian companies investing in China as he meets with senior leaders, including Premier-elect Li Keqiang, in Beijing this week.

Good effort on the part of Bob Carr, but is unlikely to yield significant results.

To be sure, relative to the rest of the world Australia's economy is still booming. And as AUD weakens, it may in fact provide further stimulus to the nation's near-term growth. The long-term outlook however has now become far less certain.

SoberLook.com

China's 2012 monetary policy: gradual easing

Traditionally after a regime change, Chinese authorities don't want to implement anything drastic. China's new leadership will therefore be moving slowly on monetary easing. JPMorgan expects a gradual reduction in the reserve requirement ratios (RRR) and a stabilization later this year.

RRR forecast by JPMorgan

Note that large banks have been required to maintain higher capital ratios since the 2008 crisis. China does not need to go to Congress, seek comments from the industry, hold numerous Congressional hearings, etc. in order to implement higher capital rules for their "too big to fail" institutions. These are the "advantages" of a dictatorship.

JPMorgan: We expect monetary easing in 2012 to be moderate, and mainly consist of quantitative measures, including RRR cuts, OMOs, and window guidance on bank lending. In particular, we expect four more RRR cuts (totaling 200bp) in 2012, three in 1H. New loan creation should reach 8.2 trillion yuan (or 15% increase), up from 7.47 trillion in 2011. Meanwhile, the policy rate will likely remain on hold unless economic conditions deteriorate dramatically.

The expectation is that the PBoC will continue keeping loan growth limits fairly tight at the beginning of the year to give themselves room, should a more drastic action become necessary later. Tightening in the property markets will also continue. In the mean time the stimulus will be focused on major national infrastructure projects, affordable housing, and small businesses.

SoberLook.com