China's Frantic Policy Pulse and the Inflation Threat

The recent stop-start yo-yo of China’s monetary policy reflects not just the attempt to keep policy loose enough to stabilize the economy without fundamentally de-railing the strategic necessity of fundamental reform. It also reflects the fact that China’s inflationary potential is far greater, and is looming far sooner, than is recognized. So far, in a world concentrated on deflationary threats, an inflationary outbreak is on virtually  no-one’s horizon. Except, perhaps, in the People’s Bank of China.

Financing slowed very sharply in April: the addition to aggregate financing was a mere Rmb751bn, which was the lowest monthly gain since October 2015; bank lending slowed to Rmb 556 bn, on a monthly movt which was 0.6SDs below consensus.  Over the last four months, the monthly aggregate financing total has been  unprecedentedly volatile: January’s Rmb 3,425bn feast was followed by February’s Rmb 825bn famine; in turn that was followed in March by surprise gains of Rmb 2,336bn, whose largesse was revoked by April’s shockingly feeble Rmb 556bn.

This yo-yo accurately reflects the unprecedented volatility of PBOC’s open market operations. The chart below shows PBOC’s weekly interventions, and it resembles nothing so much as a cardiac arrest followed by defibrillation. It is a mistake simply to view this volatility primarily as a seasonal phenomenon, although the need to finance the end of the tax year, and then Lunar New Year holidays does drive some of the volatility. But even accounting for these flows, the volatility of the last few months is unprecedented. Twice PBOC has flooded the market with liquidity (end-January, middle of April), only subsequently to claw back the money over the succeeding weeks.

There are two main reasons why the central bank is unwilling to commit to the sort of grandiose monetary relaxation we’ve become used to elsewhere in the world, and indeed, in China during the slowdown of 208/09. First, there are the well-rehearsed set of strategic reasons why no repeat of the credit splurge of 2009/10 is to be expected. An excessively generous monetary policy do nothing to foster the transformation of the economy from an excessive investment/low return on capital model, to a model based on improving returns on capital and sustained growth in consumption. And in practical terms, it probably wouldn’t deliver the goods: in the 12m to December, the efficiency of finance had deteriorated sufficiently so that Rmb 100 of new aggregate financing was associated with only Rmb 25 of extra GDP growth. So not only would a 2009-style credit splurge subvert core strategic policy goals,  it wouldn’t even work particularly well. 

At the same time, however, China’s authorities have long blamed the collapse of the USSR on the disruption caused by the ill-considered and clumsy haste of structural economic reforms, and the need to avoid anything similar is axiomatic. As a result, in order to advance the long-term strategic goals, sufficient support must be given by monetary and fiscal authorities in the short term to sustain the economy in reasonable health. Whilst in the West there is a tendency to see the policy choice as binary (either tough reforms or monetary accommodation to flunk them), the Chinese authorities say they see things very differently: accommodation now in order to underpin the viability of reforms in the medium term.

There is, however, an additional factor which circumscribes how generous PBOC can be: inflationary pressures have to be contained, and they are stronger than consensus wishes to acknowledge. A previous post explained how the absence of viable savings products and vehicles was driving surplus savings into real assets, notably real estate and commodities, in a way which was already producing speculative bubbles. This highlights the need to accelerate financial reforms, including effective regulation. But these speculative bubble are also hinting at the likely emergence of wider inflationary pressures. 

This is only just beginning to surface in the data. April’s CPI stayed steady at 2.3% yoy, and the current deflections against trend suggest that it will stay above 2% throughout the year. This will be a surprise to a consensus which still expects it to fall to around 1.8% by 3Q.  A more worrying straw in the wind was China’s PPI, which  fell only 3.4% yoy in April, with consumer goods down only 0.2% yoy.  Not only was this less deflationary than expected, but looked at more closely, the index rose 0.7% mom, which was the steepest rise since Feb 2011, and was 2.9SDs above historic seasonal trends. 

But this may be only the tip of the iceberg. Historically, the relationship between China’s CPI and monetary policy has centred on growth in M1, with inflections in M1 growth coming usually around six months before inflections in CPI. In momentum terms, M1 growth bottomed out in the middle of 2015, and has been accelerating moderately at first, but quite vigorously since the latter part of 2015. By April, M1 growth was running at 22.9% yoy and the underlying momentum was still accelerating sharply, with April’s monthly gain 0.9SDs above seasonalized historic trends.  Unless the relationship between M1 And CPI breaks down, we should now be expecting inflation to pick up by 4Q to nearer 4% than 2%.  

Will it be different this time? Currently, the consensus apparently thinks so. That’s where the risk lies. 

What would an unexpected outbreak of accelerating inflation do to China’s policy choices? It would produce the worst of all possible world for China. To be very blunt, it would compel exactly the combination of necessary credit crunch and subsequent hard landing, followed by far-reaching structural reform, which China’s leaders are so keen to avoid. Perhaps it is this realization which is behind the dramatic gyrations of monetary policy. 

China's Balance of Payments - The Gaps Telling the Story

China has published its 1Q balance of payments data, and it’s fairly obvious that the most interesting element of them is the billions of dollars missing. In fact, the gap between what’s claimed in the balance of payments and what’s revealed in the movement of China’s foreign reserves would itself be the biggest single line-item in the presentation.  And there is an even bigger gap between the cashflows implied by the private sector savings surplus - which is partly calculated via the current account - and the cashflows reported by China’s banks.

In fact, movements in these gaps during 1Q tell us a great deal about China’s current position and policy choices. They are suggesting that:

• China has had a degree of success in stemming the outflow of cash which peaked in 3Q15 and 4Q15, but also
• With most domestic savings avenues currently closed or discredited (equities, deposits, wealth management products, P2P vehicles), the flow of excess private savings are necessarily being pushed out of financial assets and into real assets, including real estate (again) and commodities (again).

If so, the conclusion is clear: the need for financial sector reform in order to deal with the savings surplus remains urgent, because the lack of viable savings vehicles not only generates bubbles in non-financial assets, but simultaneously puts pressure on PBOC to supply the liquidity private savers no longer wish to entrust to the vehicles available.

Last week brought two pieces of news from which to judge whether the flow of cash out of China seen since the middle of 2014 has been successfully checked. First, foreign reserves rose by US$6.4bn in April to US$6.4bn to US$3.219tr, the second consecutive monthly rise following  18 months of nearly-uninterrupted decline. Second, China’s 1Q current account balance was announced to have been a US$48.1bn surplus, which was roughly in line with what was expected in the light of 1Q’s US$125.7bn trade surplus, although down by US$37.2bn yoy.

The balance of payment data ought, in theory, be the place to start to assess whether the rush of cash out of China has been checked.  And on the face of it, the situation is encouraging: China reported a current account surplus of US$48.1bn in 1Q, with a goods trade surplus of US$104.9bn partly offset by a services deficit of US$57bn, and with net international income receipts of US$1.9bn almost fully offset by the US$1.7bn recorded in net transfers out of China. On this accounting, the current account surplus was equivalent to 2% of GDP in 1Q, with 12m surplus retreating go 2.7% in 1Q from the 3% recorded in 4Q15.

But the preliminary estimates also reported that the capital and financial accounts ran a US$48.1bn, completely offsetting the current account surplus. As a result, we should have expected no change in China’s foreign reserves during 1Q. But the reserves data shows China’s reserves fell US$117.8bn in the 3m to March.

The gap between the balance of payments data and the movement in reserves can be seen as one measure of the size and direction of movements of cash and capital into and out of China without attracting the attention of China’s central authorities. When China’s economy is under stress, this gets glossed as ‘capital flight’; when times are good, it tends to just get called ‘hot money’.  In most countries, these differences tend to get logged under ‘errors and omissions.’ In China, however, the amounts involved are now so large that such ‘errors and omissions’ would be the biggest line item in the balance of payments.

Between 2005 and the middle of 2014, this difference was almost always sharply positive; since the middle of 2014, when the dollar surged, the difference has always been sharply negative. This reached a peak in 3Q15 and 4Q15, with deficits ot US$243.1bn and US$225.1bn respectively. In that context, the US$117.8bn missing from the accounts in 1Q16 is an improvement. But the unacknowledged outflow is only moderated, not yet checked or reversed. 

The mild rises in foreign reserves during March and April suggest that the situation continues to improve.  

With all its faults, if one takes China’s current account data at face value we can do a second check, by comparing movements in China’s private sector savings surplus to the net flow of cash into (or out of) China’s banking system. The theory here is that if the private sector is generating a net flow of savings after having done all the consumption and investment it intends, the result is must be a flow of cash into the financial system. By definition, the financial system can use that cashflow only to buy public sector or foreign assets. 

During 1Q, the current account showed a surplus of 2% of GDP, whilst the government was also running a fiscal surplus equivalent to 0.6% of GDP (down from 2.4% in 1Q15). As a result, China’s private sector surplus can in a 1.4% of GDP, up from 1.1% in 1Q15, and stabilizing the 12m PSSS at 6.4% of GDP.   

• In Rmb terms, the 1Q PSSS surplus amounted to Rmb 220.8bn, and the 12m surplus came to Rmb4,400bn.. 
• In 1Q, banks saw a net inflow of deposits of Rmb 813bn, but during the 12m, there was a net outflow of Rmb4,731bn. 

In the 12m to March, the gap between the surplus savings generated (Rmb 4,400bn) and the net outflow of cash from the banking system (Rmb4,731bn) came to Rmb9,131bn. Taking an average Rmb rate of 6.32 for the period, that is an amount equivalent to US$1.445tr. Meanwhile, the amount ‘missing’ from difference between the balance of payments and movements in reserves comes to US$653bn. In other words, the balance of payments and reserves data may yet be understating the extent of capital outflow, quite considerably.

This is not the only explanation, however: deposits can rise in the absence of bank lending if the private sector becomes a net seller of non-financial assets (such as property) and banks the proceeds. Conversely, deposits can grow more slowly than lending if the private sector becomes a net buyer of non-financial assets, such as property or commodities. During 1Q, the turnaround in real estate markets in first and second tier cities has been marked, and the recovery in China’s commodity markets has been strong enough to prompt concern among regulators of China’s commodity futures’ market. 

At this point, it is surely clear that it is dangerous to reach firm conclusions. However, the balance of evidence suggests that the peak of capital outflow from China has probably been reached, but that China’s savers have yet to be persuaded that the products and services available to savers (deposits, equities, bonds, wealth management products) offer acceptable rates of return. Consequently, the hunt is redoubled for real domestic assets in which to invest the surplus savings the economy continues to generate. 

The case for continued financial reform could hardly be more obvious.