Central Bank Will Bolster China’s Financial Markets Ahead Of Reopening

THE PEOPLE’S BANK OF CHINA will inject a single-day record 1.2 trillion yuan ($170 billion) into the economy on Monday to ensure ample liquidity in the financial system when financial markets reopen after the extended Lunar New Year holiday.

The net number will be closer to 150 billion yuan because short-term funds worth some 1 trillion yuan mature tomorrow. However, the move reflects the growing concern about the economic impact of the Wuhan coronavirus outbreak.

The tourism and travel industries have been hardest hit with the clampdown on travel over the Lunar New Year holiday. Numerous businesses, domestic and multinational, have shut retail outlets and suspended factory production.

The central bank says it stands ready to make further liquidity injections in coming days if necessary.

Other economic support measures include relaxing tariffs on imports of medical supplies, central bank support for lower bank lending rates to support companies and delayed introduction of new asset management regulations that were part of the crackdown on shadow banking.

It is far too early to estimate the economic impact of the outbreak. Public health emergencies such as this tend to cause short-term economic dislocation but little long-term damage. As the control measures for the coronavirus outbreak have been so draconian, the near-term economic costs could be severe, depending on how long the outbreak continues. Some economists have predicted that it could shave as much as a percentage point off economic growth in the first quarter.

Update: Chinese stocks closed down 7.9% on February 3 after financial markets reopened following the Lunar New Year holiday. The fall in the CSI 300 index of Shanghai- and Shenzhen-listed equities wiped out some $358 billion of market capitalisation.

As of the end of February 2, there were 17,205 confirmed cases of the Wuhan coronavirus officially reported in China and 361 deaths.

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.

China Readies A New Era In Financial Policymaking

THE GOVERNANCE REORGANISATION rubber-stamped by the recently concluded National People’s Congress has significantly changed the policy-making and regulatory landscape of the financial system.

As with other parts of the administration, it has consolidated agencies and strengthened the Party’s leading role over state administration.

The People’s Bank of China (PBOC) has emerged as the institutional lynchpin of the system with the banking and insurance industry regulators merged into the new China Banking and Insurance Regulatory Commission (CBIRC) and now reporting to the PBOC.

The central bank will be headed by Yi Gang, previously deputy to Zhou Xiaochuan, now 70 and who is retiring after 15 internationally respected years as governor. Yi nominally reports to the Standing Committee of the NPC but in effect to Liu He, long President Xi Jinping’s closest economic advisor and now elevated to vice-premier in charge of economic policy.

This all leaves China’s prime minister, nominally the country’s second-ranking official and customarily the one responsible for running the economy, pretty much out of the picture. That has been the de facto case for some time as Liu has been steering financial and economic policymaking from the leading group on the economy.

As vice premier, his remit will run to the financial sector, state-owned enterprise reform, industrial policy and relations with the United States. The remit underlines the twin challenges that China faces from a level of debt approaching 300% of GDP and in dealing with a United States that seems ready to start a trade war if that is what it thinks will let it get the upper hand in what the Trump administration sees as the United States existential struggle with China.

Liu’s academic credentials and worldliness are immaculate for a policymaker. However, his bureaucratic experience does not match. Yi’s promotion at the PBOC signals not only policy continuity at the central bank as it tackles deleveraging but the need for operational expertise, which Yi, a 21-year veteran of the central bank, brings.

Similarly, the appointment of Guo Shuqing as the Party boss in the central bank, and thus Yi’s senior in its political hierarchy, adds another experienced and tough-minded financial regulator to the mix — not to mention another ally of Xi’s.

Guo also heads the new CBIRC, previously having been chairman of the China Banking Regulatory Commission where he led the crackdown on shadow financing and helped clean up the interbank lending market. He has also been prominent in taming the more ambitious overseas acquisition ambitions of some Chinese companies and has experience as a stock market and foreign exchange regulator.

How the duopoly at the head of the PBOC will work in practice is illustrated by the fact that Guo also becomes deputy governor, with the ‘reform’ mandate, while Yi has been appointed deputy Party chief.

Zhou combined both the Party boss and governor’s role (although the foreign ministry has a similar split arrangement.)

China has no truck with Western notions of central bank independence as given to the US Federal Reserve, the Bank of England or the European Central Bank. The PBOC is subordinate to the government, which in the Xi era means evermore to the Party as he strengthens the Party’s leading role.

In that light, it will be Liu who will be setting the direction of, and Yi who will be running China’s financial and monetary policy with Guo ensuring regulatory and supervisory coordination on the one hand and political coordination on the other.

All three men are long-standing advocates of financial liberalisation. However, there are urgent short-term issues to resolve, notably the United States and debt, that will slow progress toward liberalisation. Cautious opening up of access to the financial system to foreign investors and more internationalisation of the yuan will continue, albeit not at the cost in either case of deregulation elevating financial risk.

One of the reasons for the consolidation of the supervisory agencies is to cut out as much as possible the regulatory fragmentation that has allowed the shadow banking system to take root. Financial stability is the political priority right now. The marching orders from the trio’s now all-powerful boss are to clean up the debt and rebalance the economy without crashing it — or having the United States crash it for them.

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.

Yuan Marches On Towards Reserve Currency Status

THE INTERNATIONAL MONETARY Fund’s staff have recommended that the fund includes the yuan in the basket of currencies that constitute its Special Drawing Rights. The IMF’s board is likely to endorse the staff’s view at its November 30 meeting, agreeing that the currency meets the test of being ‘freely available’, a test that it failed in 2010 when the IMF last reviewed its basket. The yuan would then become a reserve currency from September 2016.

The staff recommendation is not unexpected, but it marks another milestone in the Chinese currency’s internationalization — and more significantly its full convertibility. As we have noted before, the contingent opening of the capital account is an important policy priority for rebalancing the economy.

Recent changes to that end, but also to address specific IMF concerns, have included overhauling how the central bank sets its reference rate for the currency in foreign-exchange markets, letting foreign central banks trade China’s onshore currency products and improving the short-term yield curve through the issuance of  three-month debt.

The People’s Bank of China said in a statement that it welcomed the IMF staff’s recommendation, trotting out that making the yuan a reserve currency would be “a win-win result for China and the world” and avowing its commitment to financial reform and opening-up.

None of that makes pushing ahead with either any less urgent, or any easier.

China’s Currency Depreciation Is Not An Opening Salvo In A Currency War

HAVING SIGNALED AS recently as late last month a widening of the yuan’s trading band, authorities have opted for a ‘one-off’ devaluation of the currency. The People’s Bank of China on Tuesday set its daily fix 1.9% lower than the previous day, its biggest daily shift since introducing the system, and taking the currency to a three-year low.

At the same time, the central bank said that future fixes would pay more heed to both the previous evening’s closing price and movements in the foreign-exchange markets. It will also seek to drive closer convergence between on- and offshore exchange rates.

This Bystander retains the view that these changes are primarily steps in the direction of eventual full convertibility of the yuan rather than a ‘currency-wars’-sparking devaluation to bolster exports and thus boost the slowing economy. Rebalancing the economy and securing IMF SDR status remain higher policy and propaganda priorities. Both require liberalised foreign-exchange markets.

As the chart above shows, the currency has been moving modestly lower against the dollar since the beginning of last year having seen a steady appreciation for the previous eight and a half years. However, as the chart also shows, the central bank has been holding a lid on that depreciation most recently, probably for fear of destabilising capital outflows.

In the short term, the central bank’s unexpected policy change will likely let the currency drift lower than it would otherwise have done. But the key point is that depreciation — and its reversal if and when it comes — will be driven more by market forces than administrative fiat.

China’s Interest-Rate Liberalization Takes A Sideways Step

IS THE PAST prologue when it comes to China’s interest rates? For two years, the answer was no. Late last week, that answer changed with the central bank’s surprise cut in its benchmark one-year lending rate by 40 basis points (bps) to 5.6% and the matching deposit rate by 25 bps to 2.75%, its first cuts since July 2012. More to come is the question now.

An across-the-board measure is at odds with the targeted approach to managing the economy’s slowdown hitherto pursued by the People’s Bank of China. In September, it had injected 500 billion yuan ($81 billion) of liquidity into the five big banks to support credit and growth. Earlier in the year, it had cut reserve requirements for rural commercial banks and credit cooperatives.

Nonetheless, the central bank says that its rate move does not represent a change in monetary policy. In as much as the benchmark lending rate is largely symbolic, that may be true in a perverse way. The bank also lifted the maximum permitted deposit rate to 1.2 times the benchmark from 1.1 times. That is another incremental step in the direction of interest-rate liberalization. However, it will also largely negate the effect of the newly announced rate cut on the economy.

If anything the asymmetric cut will amplify the narrowing of the gap between lending and borrowing rates that has been going on for some time. That, we think, is more likely to cool the home-building market, as it will make home-buying loans even less profitable for banks than they are now, than to stimulate it.

If the economic mood music does not seem to presage further cuts, this Bystander suspects that factional infighting is underway, with the State Council leaning on the central bank to cut corporate borrowing costs. That mostly benefits the politically well connected large state-owned enterprises, who do not particularly need to borrow money, but will be happy enough to see their profit margins expanded through lower financing costs. As we have noted before, there are still vested interests providing considerable obstacles to the drive for economic reform.

The language of the central bank’s explanation of its rate move is telling. It is casting the cut in terms of financing costs, especially for small businesses, rather than a need to stimulate a slowing economy. However, if it is serious in what it says about guiding market rates lower, it would be best served by advancing the cause of interest-rate liberalization.

In its statement explaining the cut, it says:

Market-oriented interest rate reform is a systematic task, and calls for coordination with other reforms. Therefore we need to strengthen the coordination of various reform measures, unite those together as a force, and in the end finish building the mechanism and system to fully allow for the market’s decisive role in resource allocation and better allow the government to function.

The central bank has been a leading proponent of financial reform. Those measured words sound like it is on the back foot at the moment in the broader political debate.

The Appearance and Reality of Resisting Stimulus In China

NEW MONTHLY ECONOMIC indicators confirm the slowing of China’s economy. Growth in retail sales, industrial production and fixed-asset investment all decelerated in October. Nonetheless, central bankers are likely to hold fast against calls for across-the-board stimulus.

A political and an economic reason underpins that view. The first is that old-school pumping of money into the economy that will only flow through to infrastructure investment runs counter to top leadership’s plans to redirect the economy away from investment- and export-led growth to domestic consumption. The People’s Bank of China is a champion of economic reform. It does not wish to be seen to be falling back to the old ways any more than it can help.

The second is that even if it cut interest rates or lowered the banks’ capital reserve requirements, the money freed up is unlikely to find its way to where it could do most good, privately owned small and medium sized businesses. Such businesses don’t have access to the corporate bond market and rely on banks for financing. However, banks have become wary lenders except to the largest and state-owned enterprises that don’t need the money.

The central bank has the room to ease should it choose to do so. Inflation remains subdued, and the economy grew in the third quarter at its slowest rate since the 2008 financial crisis. Against that, the unemployment rate, more closely watched than the GDP number in Beijing these days, is steady. And growth, though slowing, as expected, is not threatening a hard landing.

Targeted stimulus will continue, regardless. The National Development and Reform Commission, the top economic planning agency, has put 21 projects worth $113 billion, including 16 railways and five airports, on the fast track.

The central bank has also quietly been making liquidity available to the banks through its medium-term lending facility. Such loans are a back-door way to push down interest rates without sending an easing signal. It is also three-month money that disappears after that time without also sending a countervailing tightening signal.

The central bank can always roll over the loans after three months should it choose to do so — although by the time they mature the economy may have gotten back on track through the simple expedient of lowering the official GDP target.

China Adds More Speed Bumps To The Road To Rebalancing

THE PEOPLE’S BANK of China has reportedly injected some 500 billion yuan into the five biggest commercial banks in the form of short-term low-interest loans. This can best be regarded as a targeted monetary easing to perk up an economy at risk of falling short of its official target of 7.5% annual growth following a run of soft monthly economic indicators. Four months of a weakening property market, in particular, has culminated in noticeable economic sluggishness since mid-August.

Taking such action ahead of the October national day holiday, during which the banks traditionally face high cash withdrawals, gives the central bank a fig leaf from behind which to claim, should it be of a mind to explain its motives, that it is not indulging in old-school stimulus. Much of the new loans is likely to end up in the real estate sector and funding new infrastructure, however, and thus lay down more speed bumps along the road to rebalancing the economy.