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.

SoberLook.com

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.

SoberLook.com

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.

SoberLook.com

From our sponsor:

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 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

SoberLook.com

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.

SoberLook.com

China stimulus kicks into gear

As China's monetary policy committee changed its language from "maintaining" last year to "stable and appropriate increase" this year, the policy of easing has become more visible. We started with this official statement earlier in the year:

China's government statement: "We will employ a full range of monetary policy tools, appropriately adjust the supply and demand of money and credit, and maintain proper growth of financing from nongovernment sources. The broad money supply [M2 - which China is now targeting] is projected to increase by 14%. "

Signs of easing were already in place back in January. But more recently the PBOC likely realized that credit conditions were too tight and there is a significant risk of a "hard landing". With inflation measures coming in stable to lower, they started injecting incremental liquidity into the banking system, easing availability of credit. In addition the China Banking Regulatory Commission lowered the loan-to-deposit ratio requirements for the larger banks. The new loan volume in March came in strong and materially above expectations.

Source: Credit Suisse (click to enlarge)

US equities are up today in spite of the of the abysmal US initial jobless claims. The market is looking for incremental stimulus no matter where it comes from. It hasn't been getting it from the Fed, but stimulus from China seems to be just as good.

SoberLook.com

Premier Wen's GDP surprise

The Chinese Premier Wen surprised everyone a bit when his annual government report included a 7.5% GDP growth target for 2012 and 7% for the "5-year plan". After all this number has always been the "lucky 8". His goal however is to attempt a shift away from the export-led expansion and move toward a more sustainable growth path. In order to achieve this, the economy will need to be restructured to increase domestic consumption. It is not at all clear this can be accomplished using central planning, particularly when China's exporters still have a substantial pull over many regional and even central bureaucrats and politicians.

To get to their goal of a more sustainable growth, the authorities want to focus on containing unemployment by trying to create new jobs (9 million targeted this year), maintaining household income growth (both urban and rural), and creating more affordable housing (7 million new units this year). At the same time they want to maintain 10% growth in exports. These are ambitions goals and a somewhat new fiscal policy direction that is likely to have some unexpected knock on effects on the GDP growth. It is viewed as "growth-friendly" but may involve increasing the budged deficits and raising new government debt (centrally and regionally) in order to fund the new programs.

Source: JPMorgan

The risk of missing the GDP target (a number watched closely around the world) because of these new policies is not acceptable - it would cost a few people their jobs and possibly their careers. The Party officials would therefore rather understate the forecast than overstate it. After all, the GDP has come in above target since the late 90s.

Source: JPMorgan

That means they view the 7-7.5% China's GDP growth as achievable. If the plan is not working, the authorities have other tools in that "growth toolbox". In addition to the fiscal policy changes that the markets have been focused on today, there are also monetary goals that the PBoC wants to reach. The monetary authorities will be targeting 14% growth in the M2 broad money stock. That measure has been declining since reaching its peak of close to 30% in 2009. This could potentially involve adding liquidity to the banking system.

China's M2 money stock growth rate (Bloomberg)

So the stimulus from China is alive and well but it's taking different forms going forward, including targeting the money supply growth. The authorities there have tremendous resources (such as selling more government debt) in order to avoid a hard landing and meet the now less ambitious growth targets. But China's export dependence should be difficult to reduce and will continue to present risks arising from economic disruptions elsewhere in the world.

SoberLook.com

China's CPI disappoints

An unexpected move to the upside in China's CPI has surprised economists and market participants. The 4.5% actual number is higher than the expectation of 4.1%. Normally this would not be an issue, but China is now at a critical juncture.

China CPI

This elevated inflation is one of the reasons the PBoC has not moved aggressively on easing, focusing instead on targeted programs. The higher inflation levels will constrain the central bank from significant further stimulus, risking a "hard landing". This would typically be a negative for global equity and commodity markets. So far however, neither the Shanghai Stock Exchange Index (below) nor oil prices are reacting to this news. Europe nearing the Greek solution and the US "robo-signing" deal seem to be taking the center stage now.

Shanghai Stock Exchange A Share Index

SoberLook.com

People's Bank of China tries to prevent asset bubble

Here is a quick follow-up to our post on China called Fresh signs of China's asset bubble. Looks like the Chinese government is taking this potential bubble issue quite seriously. They've been forcing banks to significantly cut lending to reduce all the liquidity making it's way through their economy, manifesting itself in asset inflation. People's Bank of China even issued a low yielding note and forced some banks to buy it to limit cash on their balance sheets.

It worked. Here is the recent lending amount statistics from China:



This reduction in liquidity is showing up in the stock market as well.



This was a timely and prudent move on China's behalf, as the asset bubble was clearly beginning to build. Let's see if they can maintain the discipline going forward.