Last year, China’s revealed policy was to tolerate rapid overall credit growth to accommodate a ‘stealth liberalization’ of interest rates via the ‘shadow banking’ system, whilst letting a steady rise in the Rmb to do the heavy lifting in the fight against inflation. Now that policy has reversed, with accelerating interest rate reform, a continuing roll-back of the ‘shadow banking’ experiment, and the resulting financial squeeze mitigated via a weaker Rmb.
The implications for the rest of the region depend on how aggressively this policy reversal is pursued. At its simplest, it means China will be a tougher competitor in export markets. At the limit, a sharp depreciation of the Rmb could result in China exporting deflationary pressures to the rest of Asia and to the rest of the world, acting in much the same way as Japan’s post-1995 yen devaluation.
Four developments in China over the last couple of weeks demand a reassessment of assumptions about strategy and policy. The four developments are:
i) the belated but almost ritualistic repetition of annual targets for growth, trade, inflation and money supply, unchanged from 2013;
ii) the announcement of CPI and PPI numbers significantly below those targets;
iii) weak industrial, domestic demand and financial data for the first two months of the year; and
iv) an unexpected fall of the Rmb against the dollar, accompanied by PBOC doubling the daily trading band to 2% either side of a daily fixing, from the previous 1%.
Taken together, they point us to a changed understanding of China’s reform efforts, and a recognition that if the strategic aims remain the same, a U-turn in tactics is underway.
Let us first consider the announcement of formal economic targets for 2014 made by premier Li Keqiang in his work report to the National People’s Congress: GDP target of about 7.5%, CPI around 3.5%, M2 growth of around 13%, trade volumes to grow by around 7.5% and 10mn more urban jobs to be created, all accompanied by a ‘proactive fiscal policy and prudent monetary policy.’ The key point about these targets are that they unchanged from last year: for all the emphasis on reform at last November’s 3rd Plenum, Li Keqiang’s underlying message is that for the time being need have no macro-economic consequences at all.
This runs directly counter to the view that whole point of reform was to overhaul systems of political and financial patronage in order to discover a less-inefficient allocation of resources. Such a re-allocation of resources implies at the very least a transitional period of economic volatility, which in turn implies a toleration of slower growth in the short to medium term. Now that Li Keqiang has nailed his colours so firmly to the mast, those assumptions are fatally undermined.
At this point, it may be worth quoting an editorial in the CCP’s Global Times, which appeared right at the end of the NPC: 'Do officials at provincial and township levels have the same determination as the top leadership in carrying out comprehensive reforms? To be honest, society is not as confident as officials at the top. Reforms are bound to intrude into the interests of certain groups, and redistributing those interests is risky. Some senior officials are not able or willing to undertake the risks.
'When the public points their fingers at interest groups that stand in the way of reforms, they usually mean civil servants and SOEs. Actually, when reforms are carried out, they will touch upon the interests of nearly all Chinese people. The opposing voices will eventually mount for the govt.'
The reiteration of the usual economic targets also looks like a promise that the boat is not to be rocked too violently. And it is this light that we must look at the other three developments. First, the industrial, demand and financial data for Jan-Feb clearly shows a slowdown is underway. Industrial production growth slowed to 8.6% yoy (from 9.9% in the same period in 2013), and exports fell 1.7% yoy (vs a rise of 23.6% in the same period of 2013); for domestic demand, urban fixed asset investment slowed to 17.9% (21.2%), and retail sales slowed to 11.8% (12.3%); for finance, bank lending growth slowed to 14.2% yoy in Feb, and the monthly addition of total aggregate financing fell to Rmb 938.7bn yuan in Feb vs Rmb 1.066tr in Feb 2013. Although market reaction to these numbers was severe, it is worth trying to put the weakness in context: the chart expresses the 6m momentum trendline for industry (output, exports, electricity generation), domestic demand (retail sales, urban investment, auto sales, real estate conditions, passenger traffic), and monetary conditions (money growth, real interest rates, yield curve and currency movements). It confirms the slowdown, but also emphasises that, so far, the volatility remains, in Chinese terms, unspectacular.
Unspectacular, but this loss of momentum is still a threat to the Li Keqiang’s ‘normal’ targets, and so demands some sort of policy response.
This is where the next two developments come in. February’s CPI inflation retreated to 2% yoy, the lowest since Jan 2013, whilst PPI fell minus 2% yoy, the most disinflationary since July 2013. With money growth slowing, China’s 3.5% yoy CPI target for 2014 looks likely to be undershot: the trends of the last five months suggest inflation falling to around 2% for the whole year, at spending most of the second half of the year below that rate. So the 3.5% CPI target starts to reinterpret what a ‘prudent monetary policy’ might be.
Consequently, there is room to allow, or encourage, a depreciation in the Rmb to offset the tightening discipline in China’s broadening banking markets. For all the current unease about likely credit problems emanating from China’s ‘shadow banking’ system, it is worth remembering how and why its growth was tacitly encouraged last year. The rise of the ‘shadow banking system’ can also be seen as an experiment in banking reform, amounting to a ‘stealth liberalization’ of China’s interest rate regime, since trust loans and entrusted loans both escaped PBOC’s interest rate regime. China’s banks began to price credit whilst still conforming the formal policy-demands of PBOC, ensuring that there was no sudden diversion of resources away from the traditional recipients/beneficiaries of bank credit.
Whilst this allowed the experiment to be undertaken without disadvantaging core political clients, it also meant that total credit expanded fast – formal bank loan-growth rose 14.1% in 2013, but I estimate the stock of aggregate financing rose by 17.3%. Clearly, the heavy-lifting of inflation control was not being done by the banking system, formal or shadow: rather, that work was done by allowing the Rmb to rise unspectacularly but uninterruptedly. During 2013, the Rmb rose 2.8% against the US dollar, and about 3.5% against the SDR. The combination was evidently successful in taming inflation whilst maintaining economic growth.
And it is this tactical solution which is now being reversed. With formal interest rate reform now clearly fast-tracked over the coming two years (PBOC chief Zhou Xiaochuan: 'We will let the market play its due role in interest rate liberalization. That's for sure’), the ‘stealth liberalization’ no longer has a role to play, and can be wound back. Just as its expansion meant an overall loosening of credit conditions which needed to be disciplined by a strengthening Rmb, so the wind-down of the shadow banking system tightens credit conditions, and this can be at least partly offset by a depreciation of the Rmb, particularly given benign inflation trends. And so the combination of relaxed inflation prospects, foregrounding of interest liberalization and a determination that the current slowdown should not develop into something more threatening, reveals the change in policy.
For the rest of Asia, a weakening Rmb is a direct step-up in competitive pressures, since China now accounts for just under 59% of total NE Asia exports, and a weaker yuan will encourage China's exporters to cut prices to win market share and improve cashflow. Those of a nervous disposition will remember what happened when after the sharp devaluation of the yen post-1995 – at the beginning of which Japan accounted for about 51% of total NE Asia exports.
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