Strong Dollar Sends Yuan To New Lows, And No One Is Bothered

THE YUAN HAS fallen to a record low against the US dollar since it became internationally convertible in 2011 when Beijing allowed some overseas fund-management and securities firms to invest their yuan onshore.

This point has been coming. The People’s Bank of China has been letting the currency fall, managing only the speed of the descent with its trading band mechanism.

With inflation relatively low by world standards at 2.5% in August, China has the headroom to take the inflationary hit from a depreciating currency that makes imports more expensive. The intention is that the boost the falling yuan will give to exporters will revitalise an economy whose growth has slowed.

However, exports now account for only around 20% of the economy. A cheaper yuan will go only some of the way to offsetting the effects of zero-Covid lockdowns and a deeply troubled property market that is looking more and more like a structural, not cyclical, problem.

Raising interest rates to defend the currency would only worsen the property sector’s malaise. To the contrary, cutting them has been part of Beijing’s stimulus toolkit.

The yuan is far from the only currency to be battered by the US dollar’s strength. The euro, yen and British pound are all reeling from the US Federal Reserve’s aggressive raising of interest rates to bring down US inflation that has proved more persistent than expected.

The Federal Reserve will not abandon that policy soon. So far, US exporters have not been squealing about how the strong dollar is hurting them, as happened in the run-up to the Plaza accord in 1985. That international agreement to the US dollar led to the endaka shock to the economy of Japan, then playing the role China has recently taken as exporter to the world.

We are not at the point of a re-run of that yet. Neither China nor the United States have a short-term incentive to alter their currency’s trajectory. That point will come, but the question is whether it arrives before or after the Fed thinks it has tamed inflation.

However, just recall, a decade ago Beijing was being accused of being a currency manipulator for keeping the yuan low.

Rate Cuts Highlight Tricky Growth Balance China Has To Strike

CHINA HAS CUT interest rates for the first time in two years as the property sector debt crisis and a resurgence of Covid-19 weigh on the economy.

Fourth-quarter GDP growth came in at 4.0% year-on-year, its slowest pace of growth in 18 months. Quarter-on-quarter growth was 1.6%, up from the third quarter’s 0.7% but still far from robust.

While both the y-o-y and q-o-q numbers slightly exceeded consensus expectations, they confirm the return to the trend slowdown in growth seen before the distortions of the pandemic.

Year-on-year growth slowed in each quarter last year, although the economy expanded by 8.1% for the full year as it bounced back from 2020’s initial outbreak of Covid-19. The official target for 2021 was ‘over 6%’.

Retail sales rose by only 1.7% in December, much less than forecast, as new Covid-19 outbreaks forced new lockdowns in several cities. Investment also slowed, although industrial output rose.

The interest rate cuts by the People’s Bank of China signals a more assertive monetary approach than the easing already seen in the third quarter with the lowering of banks’ reserve requirement ratios.

Today’s cut in the benchmark one-year loan prime rate by ten basis points to 2.85% and the rate on seven-day reverse repurchase agreements to 2.1% follows December’s five-basis-points cut in the one-year policy loans rate. The five-year loan prime rate, the benchmark rate for mortgages, was left unchanged, but a reduction in that sooner rather than later would not be a surprise.

The reverse repo rate cut is the more unexpected of the latest cuts. It reflects authorities intention to stabilise the economy well ahead of the Party congress later this year when President Xi Jinping will likely be anointed to a third term.

A managed slowing of growth to rebalance the economy is politically tolerable, providing it comes with no social disruption. However, a property sector collapse with widespread developer defaults and the financial and social risk that would bring would not be.

The debt overhang remains serious. Corporate debt was still 156.8% of GDP in the second quarter of 2021. That is down from 163.4% a year earlier but still high enough to complicate the way forward for policymakers aiming to stimulate growth while reducing the economy’s reliance on debt-fuelled infrastructure investment and export-oriented manufacturing.

PBoC Indicates Careful and Selective Easing in 2022

THE PEOPLE’S BANK OF CHINA (PBoC) on December 24 provided support for those who think that the central bank’s monetary policy will be more expansive early next year so that the slowing economy does not get ahead of its intended orderly decline.

The statement issued after its quarterly monetary policy committee meeting echoed the view of the Central Economic Work Conference earlier this month that:

The external environment is becoming more complex and severe and uncertain, and the domestic economic development is facing the triple pressure of demand contraction, supply shock and weak expectations.

In response, the PBoC foreshadowed its greater and pro-active support for the real economy through a more forward-looking and targeted monetary policy.

Small and micro businesses are one set highlighted for support. However, this came with the rider that the central bank will ‘strive to ensure that financial support for private enterprises is compatible with the contribution of private enterprises to economic and social development’ — a reminder that private enterprises must remember they are expected to contribute to common prosperity.

Two other stated objectives are to use monetary policy to realise the national goals of carbon peaking and carbon neutrality through developing green finance and safeguarding what the PBoC describes as ‘the legitimate rights and interests of housing consumers’. For those who track such things, the phrase ‘healthy development’ of the real-estate market preceded ‘virtuous circle’ in the statement.

GDP growth is likely to have slowed to 4-5% in the fourth quarter, although it will still come in above the 6% target for the entire year. Sub-6% growth is likely planned for in 2022, even if monetary (and fiscal) policy is carefully and selectively loosened, as the central bank indicates. Economic stability is the watchword for the coming year.

China’s Central Bank Eases Towards And End To Easing

AS EXPECTED, THE People’s Bank of China (PBOC) has made a modest reduction to the amount of cash that banks must hold in reserve in an effort to boost lending to small businesses.

The central bank will cut the reserve requirement ratio by half a percentage point, effective from July 15, taking the requirement to 12% for large banks, 10% for smaller banks and 5.5% for rural commercial banks.

The easing will inject around 1 trillion yuan ($154 billion) of long-term liquidity into the economy. It may also be a sign of concern that the recovery is faltering.

Rising commodities prices and supply chain interruptions are increasing input costs for manufacturers while local lockdowns to counter occasional Covid-19 outbreaks and still-subdued consumer spending have hit the services sector.

Second-quarter GDP figures due next week may confirm that. Consensus forecasts are for 8% year-on-year growth, down from the first quarter’s 18.3% growth, although the comparison means little because the first quarter last year was the first to be hit by the pandemic and contracted 6.8%.

As first into the pandemic, China has been first into recovery with the PBOC leading its peers in scaling back stimulus and now starting to tighten monetary policy, albeit ever so slightly and even while insisting there has been no change of stance.

China’s Debt Hits Close To Home

THIS BYSTANDER HAS been far from alone in highlighting the tightrope that China’s policymakers have to walk between stimulating growth and accumulating more debt as they manage the structural slow down of an economy switching from industrial to services-led growth and facing adverse demographic changes.

Thanks in  part to the People’s Bank of China (PBOC)’s counsel of restraint, driven by the central bank’s twin concerns of the debt bubble bursting and inflation getting out of hand and its measured but steadfast drive for financial sector liberalisation, Beijing has been selective in its stimulus measures to keep a slowing economy expanding at a sufficient pace to hit the official 6% GDP growth target for this year and the larger one of doubling total and per capita GDP between 2010 and 2020.

While the plan has always been to manage a slowing of the economy as it rebalances towards a more sustainable long-term growth model, the impact of the trade and technology disputes with the United States on world trade have put at risk the 5.5-6.0% growth China needs to achieve in 2020 to hit the overarching decade-long goal.

Earlier this month, the central bank cut its lending rates for the first time in three years. The cuts were a token five basis points for the five-year, one-year and seven-day loan rates. There remains plenty of headroom for further monetary stimulus, but not the appetite, on the central bank’s part at least, to occupy it.

Taking a barb at the United States, PBOC Governor Yi Gang said in September that “unlike central banks of some other countries, we are in no hurry to resort to a considerable interest rate reduction or QE policy”. Yi is keeping his powder dry, in the event that significant rate cuts do become necessary to provide monetary stimulus. Yet his priority is to deleverage the economy, or at least in current circumstances to maintain a “stable leverage ratio…to ensure the debt sustainability of the entire society”, as he put it at the same press conference.

In its latest annual financial stability report released this week, the PBOC gave a stark warning about the potential systemic risk in the buildup of household debt, whose total now equals total household income. One figure that caught this Bystander’s eye was the central bank saying that household leverage had hit 60.4% of GDP at the end of 2018. The Bank for International Settlements had pegged the ratio at 54% (four percentage points higher than in the EU, by way of comparison).

The PBOC is particularly concerned about the growth of mortgages and consumer loans. It has warned previously of the buildup of corporate and local-government debt, but turning its spotlight on household debt is a notable change of focus. Easing of mortgage lending standards to boost property investment and the use of consumer credit to increase retail sales have been the main stimuli of growth in recent years. Rising household incomes make the rise in consumer loans manageable for now, although further buildups would test that assumption, especially among low-income households.

A new IMF working paper on China’s household debt notes that

High household indebtedness could constrain future consumption growth and increase financial stability risks…we find that low-income households are most vulnerable to adverse income shocks which could lead to significant defaults. Containing these risks would call for a strengthening of systemic risk assessment and macroprudential policies of the household sector. Other policies include improving the credit registry system and establishing a well-functioning personal insolvency framework.

Regardless, further consumer-focused fiscal stimulus is likely, perhaps a second income tax to follow last year’s 420 billion yuan ($59 billion) one, and the reintroduction of subsidies for electric and hybrid vehicles.

It is the rise in mortgage loans that more concerns PBOC policymakers. Mortgages account for more than half of all consumer debt. There is evidence that they are inflating a speculative bubble, as well a making affordable housing a politically sensitive issue. Nearly two-thirds of outstanding mortgage debt is accounted for by families owning at least two properties. Some of last year’s tax cut has gone into savings rather than retail consumption, with the saving being in the form of property investment.

This all comes against the background of the crackdown on shadow banking, which included unlicensed digital-payments businesses, online lending and other internet finance companies, in the process shutting down all cryptocurrency trading platforms and more than two-thirds of online peer-to-peer lending platforms.

This has split over into the formal banking sector. Three regional banks, Baoshang Bank, Hengfeng Bank and the Bank of Jinzhou, have needed bailouts this year. Up to 30 more have been late in filing financial accounts required by regulators, suggesting further bailouts to come. In addition, corporate bond defaults this year will likely exceed last year’s record.

The ‘big-four’ state-banks are financially robust enough that any such losses can be absorbed without systemic risk. However, having spent several years engineering higher bank asset quality and lending standards, the PBOC will not want to put the big banks in the position of having to underwrite other institutions’ bad debts. Yi has been clear that any can carrying at a troubled financial institution should be done by its shareholders, not the state via the big-four banks.

Part of the exercise in risk management will require financial-markets reform and further opening to foreign investors. China has moved steadily but cautiously on that. The addition of Chinese stocks to MSCI’s benchmark indices and the likelihood that other index providers will follow suit, adds new urgency.

The changes will bring an inflow of foreign capital into Chinese equities of at least $40 billion this year and, on best guesses, a further $30 billion in 2020. That will provide a welcome influx of capital, particularly for companies in the private sector. It will also offer some relief for a central government whose consolidated deficit, the IMF forecasts, will grow to 6.1% of GDP this year and next, from 4.8% of GDP in 2018. As the late US banker Walter Wriston famously said, “capital will go where it is wanted, and stay where it is well-treated.”

Interest Rate Liberalisation Is Key To Making RRR Cuts Effective

THE PEOPLE’S BANK of China has reduced the amount of capital banks need hold in reserve against bad loans for the second time in ten days. The required reserve ratio (RRR) has again been cut by one-half of a percentage point, with the central banks’ governor, Yi Gang, hinting there could be further cuts to come.

The two-phase cut on January 15 and 25 had been announced on January 4, when the RRR stood at 14.5% for large banks and 12.5% for smaller ones. It is the fourth cut in the RRR in a year, lowering the large banks’ RRR from 17%. The central bank estimates that the latest cuts will free up about 800 billion yuan ($115 billion) for new lending. 

The easing of monetary policy in this way is part of authorities’ moves to increase commercial banks’ lending to the private sector as a way of stimulating a decelerating economy while not easing up too much on the campaign to deleverage it that has been underway since 2017.

Providing the banks can pass it on to borrowers, particularly the in the private sector. In tandem, the finance ministry is instituting massive tax cuts to stimulate consumption and thus drive demand for the loans — cuts of 2 trillion yuan this year, up from 1.3 trillion in 2018, which will be matched by a similar increase in off-budget bond issuance by local authorities.

Private company borrowers have in the past had to rely on the shadow banking system because the big state-owned banks have largely shunned them. The crackdown on the shadow banking system to tackle the country’s debt problem has dampened shadow banking lending but not necessarily switched it all to the formal system.

The difficulty of the balancing act involved in cracking down on the shadow banking system without cutting off credit expansion is that after more than a year of the campaign, the debt-to-GDP ratio although decelerating was still 253% last June, according to Bank for International Settlements, the central banks’ central bank, against 231% at the end of 2015.

Progress in being made, however. Last month, the expansion of total social financing, the broad gauge of aggregate credit, at 9.8%, was lower than overall bank lending, indicating that lending is switching back to the banks, but the sag in fixed-asset investment last year suggests that unmet demand for credit is still there.

Authorities are guiding the policy banks to step up their lending to smaller private firms, not just their traditional customers, state-owned enterprises. This will continue, but the reform that is needed to make that effective is the further liberalisation of interest rates so banks can better price the risk of loans to private businesses, rather than just follow the central bank’s rate sheet.

Until that happens, regulators are in the contradictory position of wanting banks to increase their lending to inherently risky small businesses while at the same time lowering the overall levels of risks in their loan books.

Short-Term Stimulus Trumps Long-Term Risk

THERE IS MUCH to digest in the official reports of the annual Central Economic Work Conference just concluded in Beijing.

In short, every available policy tool will be thrown at stabilising slowing growth in the short-term while attempting to keep a clear eye on the long term goal of rebalancing and deleveraging the economy and establishing China’s greater role in global economic governance, the unstated part being that the successful execution of the long-term plan is what will ensure the Party’s continued monopoly on power.

For now, keeping the economic ship stable in turbulent waters in 2019 will demand bigger tax cuts, no tightening of monetary policy and easing as needed, particularly to keep liquidity flowing to small and medium-sized enterprises in the private sector, and a significant expansion of special-purpose local government bond issuance to pay for the old stimulus standby, more infrastructure investment.

This all adds up, if not to a full-blown stimulus package then at least a considerable expansion of this year’s targeted measures.

The downside is that it will slow the long-term structural reforms needed to move the economy up the development ladder and to defuse the country’s underlying debt bomb. The trade tensions with the United States are lengthening the fuse, and that may do more damage to the economy than tariffs themselves.

Deleveraging the economy while simultaneously stimulating it is a difficult balancing act, and the more so in a global economic environment that is more unpredictable and unfavourable to Beijing that any recent leadership has experienced.

China Can Now Rattle Global Markets With The Best Of Them

BOTH LAST YEAR and early this, global stock markets were fazed by a sharp fall in prices on the Shanghai and Shenzhen exchanges. Chinese equity and currency movements are having an increasing impact on investors everywhere. A new working paper published by the Bank for International Settlements, ‘the central bankers’ central bank’, suggests that China’s influence in this regards is rising to the level of that of the United States in some circumstances.

Market moves in China no longer reverberate just in Asia, the authors argue. However, the growth of financial and economic linkages within Asia raise questions about the pace and extent of financial market spillovers in the region and whether there are substantive differences in those flowing out of China to those from the United States.

Empirical study is only starting in this area, though the anecdotal evidence of the effects of financial market shocks is growing steadily. Chang Shu and her colleagues in the bank’s Monetary and Economic Department conclude that China’s influence in this regard has been growing significantly in recent years. This is especially true of equity and currency movements, as increasing financial linkages supplement extensive trade ones established by China’s central position in Asian supply chains.

A working paper from the IMF published last month came to a similar conclusion.

However, that has not diminished the importance of the United States, which also has impact across all asset classes including bonds, and particularly at times of market stress. China’s global financial linkages, though growing, remain modest compared to the United States’ not least because China’s capital account is not fully liberalised. Chinese monetary policy is nowhere near as potent a driver of global liquidity as the US Federal Reserve’s.

For investors, the implication of the work is that diversification of portfolios through Asia investment is becoming less effective at mitigating risk because Asian market movements are now driven by external factors to a greater degree than before.

For regional policymakers, the findings pose the challenge that yield-seeking capital flows to their country (and their exit) will be driven by developments in both Chinese and US financial markets, often in a mutually reinforcing way that could undermine macroeconomic and financial stability in vulnerable economies. It will likely take the emergence of intraregional institutional investors to weaken that linkage.

Markets Expose China’s Inherent Economic Contradiction

THE RECENT VOLATILITY in financial markets has brought into question the capacity and nerve of China’s policymakers when confronted with variables they cannot control politically. This heightens concern not so much about the gathering pace of the economic slowdown as about the country’s prospects for the next stage of the economy’s d development, ‘rebalancing’ away from export and capital investment-driven growth and towards domestic consumption.

In what was mostly a closed economy, policymakers had relatively few monetary and fiscal levers to pull, but they were effective when yanked. Administrative guidance was particularly efficient. As the financial system has been opened up, the less guidable animal spirits of market forces have come more destabilisingly into play. The new tools to control them have arrived piecemeal, an inevitable consequence of the deliberately measured pace of financial-sector liberalization.

The currency has been in the vanguard of the reforms in lockstep with freer capital flows, moving steadily along the path of full convertibility, whose final destination has allowed the yuan to achieve the accolade of inclusion in the International Monetary Fund’s basket of reserve currencies.

The People’s Bank of China has a deserved reputation in financial circles around the world for the high calibre of its officials. But even their competency has been questioned following their uneasy and unexpected guided devaluation of recent weeks and their attempts to bring the tightly managed onshore and market-driven offshore exchange rates into alignment, a move undertaken for SDR-related reasons as much as currency management, but done with a tin ear for timing.

The central bank’s switch to managing the yuan’s value against a basket of currencies was both poorly signaled and sent mixed signals to investors, who tend to focus on the exchange rate against the dollar.  If investors lose confidence in the central bank’s effectiveness in the execution of monetary policy, it will only feed the volatility of the equity markets, where officials have already revealed a far from sure touch in their attempts to stabilize the markets.

While it may be virgin territory for many of them, policymakers clearly miscalculated the linkage between tumbling equity prices and speculative pressure on the currency, and how quickly the currency would become the focal point of market unease about China’s economic prospects among investors. It also says something about how the world has changed that the competency of Chinese policymakers has supplanted U.S. monetary policy as the primary determinant of global investor sentiment.

It is the nature of financial markets to be volatile in greater or less degree. Policymakers will learn by experience the limits of their reach in such an environment. Three decades of history will have left them more naturally inclined to intervene than not, which will make that learning painful and slow — last summer’s lessons from the mishandling of the stock-market plunge were clearly not well learned this most recent time round.

However, the broader concern to this Bystander is that financial-market turbulence will encourage Beijing to backslide on further financial-sector reform and more broadly on rebalancing. For some months, it has been dialing back on talking up the need to reduce government intervention in the economy. The third Party plenum at which the top leadership pledged to give market competition a decisive role in the economy seems longer ago than the 30 months it was.

Similarly, the notions that powerful bureaucrats can be a panacea for all economic ills and that the state can trump the market are fading. With that will come doubts in the some senior minds that the Party can pull off the unprecedented trick of liberalizing China’s economy without doing the same to its political system, unacceptable to the Party though the later is.

The certainty that state control provides versus the benefits that free markets bring is the inherent contradiction that may have been manageable for the past 30 years of the economy’s modernization but which, as Japan and South Korea have shown on a smaller scale, becomes more not less contradictory as an economy advances and becomes too big and complex to answer to political imperatives — and to the bureaucrats imposing them.

China’s State-Owned Debt Problem

WHEN, AS IS expected later this year, the U.S. Federal Reserve starts to raise interest rates, it will put renewed strain on emerging economies’ debt management. Those most vulnerable are countries with high levels of dollar-denominated external debt and those with high public debt.

Where does that leave China? As so often, slightly oddly placed.

China’s external debt exposure is low. Foreign debt is estimated to be equivalent to less than 10% of GDP. That modest figure by international standards is because China funded its infrastructure building domestically and not by borrowing from abroad. Thus it has avoided one of the textbook potential triggers of an emerging market debt crisis. It helps that China has a financial system that is semi-detached from global capital markets.

On the other hand, China’s domestic borrowing is huge. Total debt, including debt of the financial sector, nearly quadrupled between 2007 and 2014, by the reckoning of the McKinsey Global Institute (MGI), rising from $7.4 trillion to $28.2 trillion, or from 158% of GDP to 282%. This increase was a consequence of the investment-driven stimulus Beijing launched to offset the 2008 global financial crisis and which was funded by bank credit, albeit domestic not external borrowing.

That new debt was largely taken on by non-financial corporations. MGI calculates that that set’s debt accounts for 125% of GDP. Rating agency Standard & Poor’s estimates that China surpassed the United States as the largest corporate debt borrower in 2013.

China’s non-financial corporations are a broad church, however. Their debt is concentrated within state-owned enterprises, not anymore in private companies with the one significant exception of firms in the property sector. MGI estimates that approaching half of non-financial corporate debt connects in some way to real estate development, with 60 firms accounting for two-thirds of it.

An IMF Working Paper on corporate indebtedness in China published by Mali Chivakul and W. Raphael Lam in March puts it thus, “while leverage on average is not high, there is a fat tail of highly leveraged firms accounting for a significant share of total corporate debt, mainly concentrated in the real estate and construction sector and state-owned enterprises in general.”

Chivakul and Lam go on to argue that development and construction firms could withstand a modest interest rate shock, but other corporations in the wider economy would feel the knock-on effect of a slowdown in the property sector. “The share of debt that would be in financial distress would rise to about a quarter of total listed-firm debt in the event of a 20% decline in real estate and construction profits,” they say.

A separate report from economists at the Hong Kong Monetary Authority comes up with a similar analysis — that China’s debt problem is largely an SEO debt problem — and points the finger at  ‘policy driven lending’. “SOEs’ leveraging has been mainly driven by implicit government support amid lower funding costs than private enterprises,” they say.

There is now less such politically driven new lending than before. That partly reflects the passing of the post-2008 stimulus but also a recognition that private firms create the new jobs that are critical to social stability. It also reflects the shuttering, particularly since 2012, of small, inefficient and heavily polluting and indebted SOEs in industries such as steel, cement and mining.

A further round of such ‘SOE reform’ seems likely. And to this Bystander, the corruption investigations into SOEs seems in part an attempt to accelerate those reforms, given that  SEOs are seen as acting as a drag on the wider push for reform and economic rebalancing.

From SOEs it is but a short step to China’s other deep pool of domestic-debt concern — local government borrowing. Outstanding debt has reportedly reached 16 trillion yuan ($2.6 trillion), up 47% from June 2013. Overall, government debt is equivalent to 55% of GDP, again not a concerning high level by international standards. But it is concentrated in pockets, closely tied to real estate, and a further drag on an already slowing economy.

Beijing has both the political will and the financial wherewithal to underwrite local government defaults and forestall any threat of financial systemic risk. However, policy makers will use the mere hint of it to push local government finance reform and deepening municipal bond markets.

Local governments have relied on land sales for revenue, and also seek to turn a yuan from commercial activities conducted through captive off-balance-sheet special financing vehicles, which have borrowed heavily from both mainstream and shadow banks. So the threat of contaigion is real. Rising interest rates will only make it more so, and aid the cause of local government finance reform.