Tuesday, 14 April 2015

Can China's Bad Monetary Data Really Be Good News?

There’s a usually-lucrative understanding that bad economic news can be good news because of the positive policy response it provokes. This works so often one can forget that the belief assumes that the news is not so bad that it is telling you events are spinning out of control, and/or that there’s nothing going on that an early policy easing won’t fix. But if these don’t hold, bad news can be just that - bad news.

And so to China’s March’s monetary and credit data. As bad news goes, this was nearer to the real thing than is comfortable.

Purely in measurement terms, China’s March M2 and M1 data was the weakest I’ve seen, (excluding obvious holiday-related anomalies). M1 growth slowed to 2.9% yoy on a monthly movements a full SD below historic seasonal trends, and the weakest since 1996 at least (with the exception of Jan 2014 - a holiday anomaly).  M2 growth was worse, slowing to 11.6% yoy on a monthly movement which was 1.4SDs below trend, and the slowest growth in more than 20 years (holiday anomalies excepted). Bank deposits growth slowed to 10.1% yoy, and again, the monthly movement was 1.5SDs below trend.

But the weakness of the monetary and credit data isn’t the only thing weighing on Chinese monetary conditions. In addition, the Rmb has tracked the dollar higher, actually rising 0.1% yoy against the dollar in March,  whilst the dollar was up 13.6% yoy against the SDR.  And with 10yr government bond yields of 3.5%% and CPI inflation of only 1.4%, the 2.1% real yield is 0.6SDs above historic seasonal trends. It is this combination of factors which means that, from an empirical point of view, the current deterioration in monetary conditions is unprecedented for China. 

As one would expect, such monetary constriction is hurting the rest of the economy (regardless of what tomorrow’s 1Q GDP result might show). 

The data suggests that monetary conditions have deteriorated beyond the point in 2008 when it was deemed necessary to rescue the economy. The wider data (particularly March’s trade data, with its collapsing exports and collapsing trade surplus) is also consistent with the worry that negative feedbacks from the real economy to the financial economy are beginning to re-inforce the monetary constriction. Whilst we are (probably) not yet in the maelstrom, I’d say it is visible from the deck. 

So the first requirement of bad news being good news is plainly present: the data of the last couple of days is surely bad enough to provoke an early and more vigorous policy response. 

The question then becomes: can the policy tools available easily fix the problem? And here I have two combined worries. The first is simply political and strategic: an effective policy response would almost certainly involve at least a partial repudiation of the reform strategy to which Xi Jingping has dedicated his presidency. Clearly, it will be he rather than the PBOC who will determine policy, but how can he square the major reliquefication the economy needs without setting back the process of improving capital allocation, upon which the necessary strategic change in China’s growth model rests? From this strategic point of view, a reprise of the 2009 credit splurge is almost unthinkable. (Isn’t it?)

The second problem is that at this stage we simply do not really know what sort of damage is growing inside the banking system, or how the rapid diversification and elaboration of China’s financial systems will affect how the system as a whole works. But we do know there are multiple potential sources of bad loans in the system: real estate loans; local authority financing vehicle loans; commodity finance loans (both domestic and international). And, of course, on top of that there’s straightforward commercial and consumer lending that’s going bad. 

Although we can’t know the details, we can see plenty of signs that concern is mounting. At the highest strategic level, February’s decision to re-define China Development Bank as an official policy bank is at least consistent with the possibility of problems in its domestic real estate and international commodities-project loans. Similarly, the central government’s decision to allow local authorities to replace expensive financing vehicle bad debt with centrally-backed bonds is also a plain acknowledgement of their financing problems.  But on a more mundane basis, we have Dagong Rating’s warning of problems in the internet-based P2P lending market, with their report raising the prospect that losses to creditors (mostly small investors) could reach Rmb 100bn. And we have the suspension/near collapse of Hebei Financing, which is carrying approximately Rmb 50bn loan guarantees.

The third problem complicates the situation further: because China’s debt problems are no longer merely domestic, any monetary rescue package which significantly undermines the international value of the Rmb is problematic by itself. We touched on this yesterday. 

And it is in this context that we should consider China’s other piece of ‘bad news’: China is losing its fx reserves even faster than we had thought. In 4Q, we saw that despite a US$67bn current account surplus, China’s foreign exchange reserves fell US$44.7bn, implying a capital outflow of  US$112bn during the last three months of 2014. Now figures for 1Q show foreign exchange reserves falling by a further US$113bn in the first three months of 2015, despite writing a trade surplus of US$123.8bn during that period! Bear in mind that this massive net capital outflow happened at a time when China’s stockmarket was on the sort of tear which normally attracts capital inflows.  It raises the question: what level of reserves is China already devoting to maintain the value of the Rmb? 

All of this leaves us in a less comfortable position than normal. Generally speaking, my default bias in China is one of comfort verging on complacency. The system has an extraordinary level of resources, both financial and political, that it can deploy if necessary. And this has been bolstered by a belief that provided China's domestic cashflows remain strongly positive (as they have been historically), then ways can and will be found to finesse balance sheet problems, even if it takes some time for the political fix to be found. I also think that China's leading bureaucrats are exquisitely alert to the potential problems of their economy and financial system - I genuinely think there is a level of senior administrators who spend huge amounts of time and mental energy obsessing about these problems. Similarly, I have little doubt that China's banks are better run than at any time in the relevant past. But conversely, experience tells us that PBOC can be dangerously slow to recognize when its policies are inflicting real damage - remember, it was still raising rates in summer 2008!

The problem now is two-fold: PBOCs responses have already been dangerously slow, and, worse, capital outflow has, at least for now, denuded the financial system of the positive cashflow which the rest of the economy is being forced to generate, and which is needed to cover any spike in non-performing assets. So at this stage, I fear that what we're seeing is just what it seems to be: bad news.

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