The Failure of the Xi Jinping Put

Since 12 June, the Shanghai Composite index has fallen by just under 29%, and the Shenzhen Composite has fallen by 33%.  Measuring in terms of market capitalization, the Shanghai Composite crash has cut 12tr yuan off capitalization, whilst the Shenzhen has cut 10tr yuan from capitalization.  China’s nominal GDP is currently around 64.4 tr yuan, so the combined loss of capitalization from these two markets alone is equivalent to slightly more than a third of annual GDP.

There are two chief methods by which such a crash is transmitted to the domestic economy: first, by a negative ‘wealth’ effect, and secondly, by its impact on those credit institutions which had been financing the run-up and the impact on their clients. To the extent that these two effects can be separated, the second is the most important. Probably no-one, including those inside China’s banking system, really knows the extent to which recent bank lending has been used to finance stockmarket positions. However, the really explosive phase of China’s stockmarket frenzy started in November, and between November 2014 and May 2015, new bank lending amounted to 6.84tr yuan.

Even at the latest valuations, Shanghai and Shenzhen index levels are approximately 50% above end-Oct 2014 levels, soon paper that leaves plenty of scope for margin positions to be paid down without catastrophic pain. But of course, that’s not how margin-position finance works - their very essence is leverage and concentration of positively correlated risk. We can very confident that at least some financial institutions will be in deep trouble, and it be a brave analyst who asserted that none of those risks would develop into systemic threats.

The need to respond to this market disaster finally brings into focus the traditional monetary policy trilemma which Beijing has successfully finessed over the last decade. The monetary policy trilemma is that it is in theory impossible at the same time to pursue a currency target, an independent monetary policy (or, to put it another way, to use monetary policy as a purposeful and effective instrument of economic policy) and to maintain a free capital account.

Over the last 10 years or so, China’s preference was to allow financial repression sufficient to fund an extraordinary growth in the stock of fixed capital, whilst keeping the currency weak enough to allow it to find overseas markets for the resulting surplus production. In response, once-strict capital controls were gradually eroded (both officially and unofficially) as investors sought to buy the undervalued currency, and in response, China both amassed nearly US$4tr in foreign reserves, whilst partly sterilizing the capital inflow by raising reserve ratios on Rmb deposits from 7.5% in 2006 to a peak of 21.5% in 2011.

This strategy was not able to remove the trilemma, but it took the sting out of it, by granting policymakers time to react to changing conditions.  But what was gained in policy-flexibility was lost in policy-clarity. Essentially, different financial system actors were independently free to pursue policies which were not necessarily complementary.

That fundamental lack of policy clarity was publicly visible only times of economic stress, when PBOC’s monetary policy were abruptly overturned by State Council decisions - the most obvious example being the credit-splurge mandated at end-2008/early 2009.

It is in this strategic context that China’s stockmarket collapse can be understood. During the first half of the year, policy aims included;
i) maintaining a stable Rmb in order to hasten the day when it is included in the IMF’s SDR;
ii) loosening capital controls whilst sequencing a gradual liberalization of banking and financial markets;
iii) ensuring a sufficiently loose monetary policy to allow nominal growth to sustain the sort of growth previously financed via the financial repression which was in the process of being dismantled.

Even in the best of circumstances, these divergent priorities would bring the policy trilemma into sharper focus. But the trilemma has become increasingly urgent owing to the extraordinary strength of the dollar (and thus the Rmb) between October 2014 and May 2015: the priority of maintaining stability in the Rmb meant there were strict limits on the ability to loosen monetary policy aggressively enough to maintain economic momentum, whilst all the time, the sequencing of loosening capital controls meant the policy mismatch became increasingly obvious.  The initial response was logical: ignore the trilemma and buy time by selling foreign reserves (which fell US$238bn between August 2014 and March 2015), and inject cash back into the financial system by cutting reserve ratios by 2.5pps to 17.5% by end-May, with each percentage point cut releasing approximately 3tr yuan back to banking markets.   In addition, PBOC put in place schemes extending finance to banks on the basis of specified lending criteria.

Into this environment emerged a stockmarket frenzy. This rapidly became at the very least a useful tactical adjunct by which the policy trilemma could once more be finessed. Specifically, an irresistibly-booming domestic stockmarket to which the authorities could gradually grant foreign access would generate a predictable capital inflow which would allow the pursuit of the Rmb’s inclusion in the SDR to be maintained with rather less negative stress on domestic monetary policy.  In addition, of course, growing the stockmarket’s role as an allocator of savings is consistent with the broader policy of a phased dismantling of the structures of financial repression.  As time went on, it even became possible to imagine, or at least hope, that the wealth-effect alone might mitigate the dour economic consequences of monetary policy settings.

The crash not only wipes out that way of finessing the monetary policy trilemma, but by generating a whole new generation of yet-to-be-calculated bad loans and savings-destruction, it makes it a whole lot worse, a whole lot sharper, and a whole lot more urgent to recognize. 

This is why an almost full-deck of policy measures were announced in the hope of shoring up the market. What one might call the Xi Jinping Put consisted not only of last weekend’s 25bp cut in deposit and lending rates, and a 50bp cut in deposit reserve ratios for commercial banks stretching to a 300bp cut in RRRs for finance companies and non-bank companies, but also the State Council unveiling a draft law to remove the 75% loan-to-deposit ceiling for commercial banks, and official draft guidelines allowing the official pension fund to invest up to 30% of its net assets in equities.

But so far the Xi Jinping Put has failed: on Tuesday, the Shanghai Composite rallied 5.5%, but gave back the entire gains on Wednesday. By end-Friday, the market was down 13.8% from Tuesday’s highs, and - as is usual at this stage of a crisis - the hunt is on for ‘market manipulators’ to blame.   Most probably it failed because at some level the market recognizes that whilst the trilemma is unresolved, the Xi Jinping Put cannot be definitive.

One way to see this is to ask: ‘what is missing from the package?’  One thing which is conspicuous by its absence is PBOC injecting money into the market. Weekly totals of PBOC’s open market operations show that from end-April to mid-June PBOC was entirely absent from the market - its net injections of liquidity were . . . zero. Only in the last weeks has PBOC injected cash into the market, adding a paltry Rmb35bn in June 25th auction, and Rmb50bn in the July 2nd auction. 

Rather, the job of supplying liquidity to the private sector has been quietly subcontracted out to the Ministry of Finance, which has almost entirely checked the usual seasonal growth of the deposits it keeps in PBOC. In the 3m to May, central government’s deposits in PBOC were down 7.4% yoy , doing this, effectively releasing approximately 250bn yuan of cash to the private sector directly, although the opportunity-benefit in the form of reduced treasury takings will be higher.

So what happens now? The logic of the situation is that the damage inflicted on the financial system will force a clarity of policy which finally over-rides the deep desire to ignore the monetary policy trilemma.  In short, monetary policy can become truly expansionary, in which case there is a sacrifice to be made either of the short-term stability of the Rmb, or the phased dismantling of capital controls and other structures of financial repression.  The alternative is that the damage to the financial system is unrelieved by monetary policy, but policies to open the capital account and sustain the stability of the Rmb are maintained. Almost certainly that will now entail a hard landing. 

In short, the choices have suddenly got both hard and urgent.

Innocence & Experience & 'The Wealth Effect'

One of the popular and current rationales for why the US economic expansion has never quite developed the normal panoply of cyclical accelerators is that the ‘wealth effect’ of a surging stockmarket has been far less than previous calculations suggested.

The observation is important, because as of March 2015, the US household sector was keeping 31.1%  of its total financial assets in equities or mutual funds, compared with only 19.5% in bank deposits & credit market instruments. In fact, the proportion kept in equities and mutual funds is the highest since end-2000.

Now, the S&P500 has attained a CAGR of 14.7% over the last six years, and as it has done so, the amount of wealth households have tied up in the S&P has risen from $8.2tr in 1Q2009 to $21.56tr in 1Q2015.

How much is that? Well, in the national accounts, compensation of employees currently runs at $9.477tr pa, and it is growing at about $380bn pa.  Given the tally of of equities and mutual funds held by households, it would require a rise in equity values of just 1.75% a year to generate that $380bn pa pay rise.   Or put it another way: the $13.36tr rise in the value of households’ equity and mutual fund investments is equivalent to just over one and a half year’s worth of average employees’ compensation during the same period.

So how households’ do with that new wealth plainly matters, a lot, to the economic cycle.

Looking through the literature on why the wealth effect is failing, I’m struck first by the certainty which allowed economists and econometricians to assume that ‘the wealth effect’ would be stable over time.  I’m also struck by the absence in the literature of any reference to the permanent income hypothesis  (the idea that a person will adjust his spending according to the his life-time income expectations  - or alternatively that his spending pattern will itself reveal that life-time income expectation).

It seems to me very likely that the proportion of the ‘stockmarket wealth’ a person is prepared to spend will not be stable, but rather will be informed by (and reveal) his underlying expectations about the likely volatility of those holdings.  If a person’s long-developed experience is that the stockmarket only goes up, he is likely to spend a higher proportion of the gains than if his experience has led him to believe that a significant portion of it is likely to be given back in the near future.  In other words, people will only ‘believe’ a portion of the increase in their wealth. How much they ‘believe’ it, will depend on their recent experience.

Now these ‘beliefs’ are likely to be developed as a result of long experience, and are likely to change over time as those experiences change. Here’s a  very simple (primitive, even) model: the ‘belief’ in the secure return of stockmarket investments is formed over a 10yr period, with more recent years having greater weight than in previous years. In the chart below, I’ve averaged a straight-line declining balance of years, so the change in the most recent year has 100% weight, the year before than 90%, the year before 80% etc.

What this chart suggests is that very sharp stockmarket falls may have a strong and long-lasting negative impact on people’s beliefs about what proportion of a stockmarket’s subsequent gains can be ‘believed’. And in turn, those beliefs may be incorporated into permanent income calculations, and hence spending/saving decisions.  Thus in 1999, the experience of the previous 10yrs would have led to an expectation of ‘safe’ gains of 11.1%, during a year in which the S&P rose 19.5%.  By contrast, in 2014, the previous 10 years would have taught that only 5.7% gains were ‘safe’, and any excess gains were unlikely to be factored into spending/saving decisions. Adjusted for the changing base, one would thus expect the impact on consumer spending of a rise in the stockmarket in 1999 to be approximately double what it was in 2014. 

If expectations are formed over a long period of time, no-one should expect ‘wealth effects’ from the stockmarket to be stable. But they might, given more investigation along these lines, be not entirely mysterious. 

Meanwhile, the other insight into how households actually think about their ‘wealth, or financial situation, is revealed in the household saving rate.  One would expect that when lengthy experience has led households to believe more strongly in the security of their stockmarket gains, their saving rate would decline; when they become more sceptical, one would expect the savings rate to rise. And, in general, this does appear to be the case. 

What can one conclude? That stockmarket investments are not money in the bank, and repeated warnings that prices can go down as well as up are understood, albeit that belief is moderated by experience over an unknown length of time. If that time is lengthy, as one would expect, then the impact of a sharp fall in equity values, or a series of sharp falls, will compromise the ‘wealth effect’ of subsequent rises for years to come.  In 1999 the S&P rose 19.5%, and households perhaps ‘believed’ that 11.1% of the rise in wealth would stick, and could thus be spent. In 2014 the S&P rose 11.4%, but households perhaps believed that only 5.7% of it would stick.  And one other thing. . . given a fair wind and no catastrophes (how I wish!) the wealth effect of a rising stockmarket is likely to gradually recover, but only as the disasters of 2008 recede from memory.

US 1Q Stumble : A Bigger Hit to Profits

Observations and Conclusions
What is one to make of the state of US GDP growth after the stumble to 0.2% annualized of the advance estimate for 1Q?  The immediate causes for the slump are known and have been tracked here repeatedly for the past few months, including: the unexpected rise in the personal savings rate, the opening up of a supply/demand disequilibrium in the industrial sector, the deterioration in inventory ratios both for manufacturers and wholesalers and the stalling of capital goods spending.

Some of those are clearly transitory disruptions generated by a completely unexpected shift in relative prices, notably the fall in energy prices. And in at least two cases, the most recent monthly data suggests that there is some reversion to previously-experienced ‘normality’ is already underway. For example, it is likely that the fall in petroleum prices gave households an unexpected windfall which they initially banked rather than spent. This ratcheted the personal savings rate  from 3.9% in November to a peak of 5% by February, but this retreated to 4.6% in March. The dynamic may now be changing but even so, personal savings jumped 16.2% yoy in 1Q, whilst personal spending growth slowed to 3.5% in 1Q from 4.1% in 4Q14.  Secondly,  by February, the unexpected climb in manufacturers’ inventory/shipment ratio which had taken it from 1.3 in September to 1.36 in January seems already to have peaked, falling to 1.35 in February.

Whilst we can watch some of these transitory dynamics develop and begin to resolve themselves, the1Q stumble reveals deeper weaknesses which cannot be resolved so quickly.

Those weaknesses show up when we subject the US economy in 1Q to a Dupont-style breakdown in an attempt to identify factors affecting growth, return on capital and cashflow.

The core problem is that there is more to worry about than merely 1Q’s stagnant topline growth (nominal GDP was stagnant). In addition, the first quarter saw stagnation in the previously-improving terms of trade, and an unexpected and unwelcome return to deleveraging strategies.

The result is that even though household savings rates and tallies rose, the private sector savings surplus for the economy as a whole almost certainly sank into deficit in 1Q. This is an unexpected result which strongly indicates that corporate profits must have been hit hard during 1Q, with asset turns, margins and leverage all contributing to a fall in return on capital. And whilst one should certainly expect some topline relief in 2Q, there seems no good reason to expect either a further boost to terms of trade, or an early willingness to change leveraging/deleveraging behaviour.  The logical conclusion from that is that the current weakness in the capital goods cycle is unlikely to reverse sharply in the near future, and consequently that the business cycle is similarly unlikely to bounce in the near future. At present, consensus expects a rebound to 3.1%  annualized growth in 2Q: the risk to that consensus, I’m afraid, is probably on the downside.

Let us look at these components one by one.

ROC and Capital Stock. The 1Q stumble has, of course, hurt the ROC directional indicator (generated by expressing GDP as a flow of income generated by a stock of fixed capital, with that stock estimated by depreciating gross fixed capital formation over a 10yr period). That downturn has now lasted two quarters, which is the longest fall since the financial crisis. Despite this, the indicator remains at historically very high levels (better than anything achieved in the 1990s) and capital stock growth is still extremely muted at just 2.6% yoy.  The current deterioration is only a modest decline from a propitious starting point, so unlikely by itself to be sufficient to be itself the cause of further deterioration. 

This does not necessarily point to a new slowdown in the capex cycle since a) there is usually a lag between the downturn in the return on capital indicator and a clear downturn in investment spending and b) the ROC indicator remains at historically very high levels. However, this two-quarter fall in the ROC indicator is consistent with the uninterrupted decline decline in capital goods orders seen since August. 

For labour, the data makes easier reading: in yoy terms, the number of employees rose 2.3% yoy and real GDP rose 3% yoy, so output per worker rose 0.7% yoy in real terms. Perhaps surprisingly, this is the highest yoy rise since 4Q13. With capital per worker rising 0.4% yoy, output per worker adjusted for changes in capital per worker still showed a rise of 0.3% yoy. This is hardly inspiring, but is probably sufficiently positive to maintain positive momentum in labour markets.

The rise in output per worker has been running ahead of capital per worker now almost uninterruptedly since 2010. However, it is worth noting that even now capital per worker also rose 0.2% qoq and 0.4% yoy, which is the highest it has been since the Great Recession.  In the immediate future, this combination of rising output per worker (deflated by capital per worker) and (probably) still rising capital per worker is likely to sustain both labour markets.

Terms of Trade.  Difficult this: the improvement in terms of trade which accompanied the fall in petroleum prices was sustained between July 2014 and January 2015, and lifted them by 5.5%.  Such an improvement should have resulted in improved trading and profit margins for companies, and for households, reduced energy bill. Both should have improved cashflows into the financial system.  If it did, what happened to that money? Also note that in 1Q15, that that improvement stalled, which will have removed that stimulus (if any).

Leverage and Money. When we look at banks’ loan/deposit ratio we can see precisely what happened: the extra cashflow was banked. A relatively modest rise in bank loan/deposit ratios which emerged in 2Q14, fractionally reversing a decline in the ratio virtually uninterrupted since the financial crisis. The LDR rose from a low of 74.8% in April 2014 to a peak of 76.2% in October 2014. But there it peaked, and retreated very modestly to 75.6% in March. In short, the trading gains from the rise in terms of trade were banked (as the rise in the personal savings rate suggested) and the timid releveraging of early 2014 was snuffed out. 

The same story materializes when we look at the relationship between money and the economy. Two things are evident. First, in 1Q the recovery in liquidity preference (M1/M2) which had been quite dramatic since 2008  flattened out in 1Q15, suggesting a reduced transaction and speculative demand for money - consistent with a reduced eagerness to spend money. Second, the decline in monetary velocity (GDP/M2) which had been arrested during 2014’s brief flirtation with re-leveraging, bit back again with a vengeance in 1Q.  In plain terms, when falling energy prices delivered a windfall from trading margins (companies) or budgets (households), those gains were banked in deposits not spent (hence souring trends in liquidity preference and monetary velocity), which in turn reduced 1Q GDP.

Private Sector Savings Surplus

But now we come to a conundrum: all this suggests cashflows should have been very positive, and that the private sector would have generated a rising savings surplus in 1Q. But unless there is a sharply more positive current account position reported than seems likely from Jan-Feb data, this simply didn’t happen. Rather, the currently available data for federal debt and likely current account balance point to a small deficit (US$20.6bn) in 1Q, sharply reversing the $186.8bn surplus achieved in 1Q14, and cutting the surplus to a meagre 0.3% of GDP for the 12m to 1Q15.

How could this possibly be consistent with the rest of what we think we know about the economy? There are two potential sources of savings surpluses: household savings and corporate profits. Since we know from the personal income and spending data that household savings rose sharply during 1Q, assuming the 1Q estimate of the PSSS is not badly awry, the numbers must point to a far sharper downturn in corporate profitability than the ROC directional indicator suggests. This is, of course, consistent with the sharp downturn in orders of capital goods, and the way export growth has stalled in recent months.  

There is a further implication: movements from private sector savings surpluses to deficits generally tend to put pressure on bond yields and fx rates. 

Likely Near-Term Trajectory of the Cycle

Two of the three factors affecting return on capital seem unlikely to be helpful in the near term. First, last year’s jump in the terms of trade is unlikely to be extended or repeated, and this is likely to compromise margins and cashflows. Second, it is difficult to find a good reason to expect the current deleveraging will be once again be reversed in the near term.  There is, however, a third factor which should improve: the energy price windfall isn’t getting any bigger for households, but conversely, spending/savings patterns are likely to revert to normal (which means more spending). The net impact is probably neutral to positive for on household spending. 

But if corporate profitability has already been hit more than is immediately obvious (which seems to be the lesson from the private sector savings deficit), then the removal of terms of trade gains and sustained deleveraging will put more pressure on the capital goods cycle. And that, of course, puts pressure on the dynamic of the business cycle, and consequently on the prospects for a 2Q rebound.

The Hong Kong Connection: Postscript

The role played by Hong Kong's banks in the outflow of capital from China over recent months has a further consequence which is worth pointing out clearly. Very regularly, when faced with unexpected surges in China's trade balance, analysts scrutinise trade flows between Hong Kong and China particularly closely, looking for (and often finding) evidence of over-or-underinvoicing for exports and imports. 

The point to make is this: even if this succeeds in inflating China's overall trade surplus, if at the same time it inflates Hong Kong's trade deficit, then that will erode the very private sector savings surplus upon which Hong Kong relies to fund (or even maintain) its net bank lending to China.  In this symbiosis, the trade money flows to China, but that generates a demand by Hong Kong's banking system to claw it back by cutting credit lines to China. 

It didn't always work this way: when Hong Kong had a regular major savings surplus, or when net lending to China wasn't virtually the whole of Hong Kong's net foreign lending, the relationship would have been contingent, mild and even effectively non-existent. But that's not the case anymore: if China swells Hong Kong's trade deficit, Hong Kong will (must) get the money back by cutting lending to China. That's the symbiosis.

China's Capital Outflow: The Hong Kong Connection

A squeeze on lending to Chinese banks by Hong Kong’s banking system has been a primary, and perhaps even dominant factor in the capital outflow which has eroded China’s foreign reserves over the last six months.  Net foreign currency lending to China by Hong Kong’s banks contracted by HK$555bn (US$71.5bn) in the four months to January 2015 - a fall of 21% over those four months. So far, though, there has been no reciprocal significant withdrawal of Chinese bank liquidity from the Hong Kong dollar market.

The core fact needing explanation are these:  between the end of August 2014 and the end of March 2015, China’s fx reserves dropped by US$238.8bn, despite having recorded a US$67.021 bn current account surplus in 4Q, and a US$123.8bn trade surplus in 1Q15.  In 4Q14 China recorded a capital and financial account deficit of US$30.5bn, and the deficit was certainly much larger than this in 1Q15.

How was Hong Kong involved in those outflows? Was it a beneficiary of deposits moving from China to Hong Kong, or was it a protagonist, clawing back credit previously extended to China? More, has the decrease in China’s foreign exchange reserves meant any alteration in the extent to Chinese banks’ involvement in Hong Kong’s money markets?

We can find the answers in the changes in the net external position of Hong Kong’s banking system, and specifically the net position with China, both in Hong Kong dollar markets and in foreign currency markets. Within this, it is the foreign currency position which matters most,since the Hong Kong dollar position accounts for only about 22% of Chinese entities deposits in Hong Kong’s financial system.

Looking at the foreign currency position (which includes the Rmb position),  liabilities to Chinese banks rose by HK$138.6bn and to non-banks by HK$36.5bn in the four months to September, whilst foreign currency claims on Chinese banks fell by HK$379bn, and by HK$2.5bn to non-banks.  Overall, this means that Hong Kong banks’ net claims on Chinese entities diminished by no less than HK$554.8bn (US$71.5bn) in the four months to January. That’s a fall of 21% in the net position in four months!

Crucially, HK$515.8bn of that withdrawal from Chinese positions was attributable to closing positions with Chinese banks, with loans to Chinese banks being withdrawn far faster than Chinese banks raised their deposits: foreign currency claims on Chinese banks fell by HK$379bn, whilst liabilities to those banks rose by HK$136.6bn.  What is more, it is plain that the withdrawal of net foreign currency loans by Hong Kong banks has (so far) been specific to Chinese banks: to net lending to foreign banks (including China) fell by HK$99bn only in those four months, whilst net loans to foreign non-banks rose by HK$44.3bn.

Why have Hong Kong’s bankers cut their China loans? There are at least two ways to look at this. Most obviously, Hong Kong’s banks may have cut their risk profile with Chinese banks in response to concerns about China’s economic slowdown and the deteriorating credit quality.  

(One interesting question is: do China’s banks themselves share this perception of increased risk, and if so, will (are?) Chinese bankers taking a similar view of their customers’ prospects?  Given the concerted efforts made by banks to improve their abilities to assess risk and price for it, one would expect so.

For example, this week the results of a survey of 200 bank branches in 12 cities by Rong360 found no banks were offering first-time buyers the 30% discount on mortgage rates recently allowed by the government, or were giving discounts on second home loans, despite policy relaxations by central bank.  Rather, a majority of the banks were charging rates above the benchmark rate.  There were a couple of bankers’ quotes accompanying the report which bear repeating: 'It's difficult because our margins are already squeezed, there isn't much differentiation in the market, so our focus is on how much our capital costs are.'  Another: 'Banks look for good investment return, so they'd rather invest in the stockmarket.')

But there is a second reason: Hong Kong’s economy is no longer producing savings surpluses which need to be re-invested in foreign assets.  Historically, the massive build-up of net foreign assets of Hong Kong’s banking system have been a result of a massive sustained private sector savings surplus. Between 1990 and 1994 this averaged 6.6% of GDP, but in the  pre-handover boom years before 1997 this deteriorated into a private sector savings deficit of around 5% of GDP. That deficit was swiftly and dramatically rectified: from 1999 to 2009 the savings surplus was back, averaging onwards 8.4% of GDP. 

However, over the last three years, there has been a further reversal, with minor savings deficits emerging: there were deficits of 1.1% of GDP in both 2012 and 2013, followed by a surplus of 0.8% in 2014 which has probably dipped back into a deficit of around 1.4% in the 12m to 1Q2105. (Caveat - the 1Q15 result in the chart below is an estimate only.)

A sufficiently sophisticated financial system will, of course, find ways to finesse these underlying cashflow dynamics in the short to medium term. However, the erosion and disappearance of Hong Kong’s private sector savings surplus has capped the overall amount of net foreign assets Hong Kong’s banking system carries. The current US$288bn in net foreign assets is, for example, lower than the amount carried in 2007. 

Moreover, the dramatic concentration into China assets which mushroomed so dramatically after 2010 means that if cashflow concerns dictate that asset holdings have to be cut, then unavoidably it will be Chinese assets which are offloaded.

So far, Chinese banks have not really responded to the withdrawal of foreign currency lines from Hong Kong’s financial system by scaling back their own position in Hong Kong.  Indeed, so far this has had made almost no impact on Hong Kong’s HK$ banking liquidity, to which China is a major supplier. Taking the position in Hong Kong dollars,  between Sept 2014 and Jan 2015, HK$ liabilities to mainland banks fell by HK$9.3bn to HK$112.7bn, whilst HK$ liabilities to Chinese non-banks rose by HK$10.5bn to HK$205.4bn. However, HK$ claims on Chinese banks rose by HK$768bn and Chinese non-banks they rose by HK$9.32bn.  On a net basis, the total net HK$ exposure of Hong Kong banks to the mainland went from a net liability (deposit) of HK$73.1bn in Sept 2014 to HK$64.1bn in January 2015.  In the scheme of things this is a relatively minor change drop in China’s provision of HK$ liquidity to the system. 

Background to China's Cut in Banks' Reserve Ratios

(This commentary was written for the Shocks & Surprises Global Weekly Summary before the announcement of Monday's cut in reserve ratios. It has not been altered, because it gives what I believe is useful background to that decision.)

If Chinese monetary policy is to be continued consistently in the practice of the last few years, an early policy relaxation achieved by cutting banks’ reserve requirement ratio is to be expected, with each 1 percentage point cut gifting banks approximately Rmb 1.25tr in deposits available for lending, but probably also draining money from government bond markets in similar amounts.
Just as reserve ratios were raised to limit the monetary consequences of the huge inflow of capital during the last eight years, so now as capital exits China (despite a frenzied stockmarket boom), banks’ liquidity needs boosting.

The week’s economic data leaves no room for doubt that the economy continues to weaken: early in the week it was revealed that March’s exports fell 15% yoy, cutting the month’s trade surplus to just US$3.1bn.  Later came the news that M1 growth had slowed to 2.9% yoy and M2 growth to 11.6% in March, and that aggregate new financing was weaker than expected at Rmb1.18tr. Still later, there were disappointments for industrial production (up just 5.6% yoy), for retail sales (up just 10.2% yoy) and for urban investment (up just 13.5% yoy ytd).  Taken together they reveal that the underlying loss of momentum intensified, perhaps dangerously, in the industrial sector, in domestic demand, and in monetary conditions.

The fact that 1Q GDP growth was reported to have slowed only very modestly, to 7% yoy, was undercut by the fact that nominal GDP growth had slowed to just 5.8% yoy. Worse, when one excludes the positive impact of a 1Q trade surplus equivalent to 5.4% of GDP, the resulting nominal domestic demand growth slumped to just  0.9% yoy (or 5.3% on a 12ma).

Consequently, policy-loosening is needed, and soon. What form should it take? When in early February PBOC cut reserve ratios, it it claimed the cut was to offset capital outflow, rather than open the gate for monetary easing. As the chart shows, this was China’s consistently applied policy between 2007 and the middle of 2013: as China’s reserve rose from US$1.1tr in January 2007 to US$3.55tr by July 2013, so the reserve ratios required of banks rose from 9.5% of deposits to 20% of deposits. During periods when the reserves build-up slowed or faltered in 2H2008 and again in 2011-2012, PBOC responded by cutting RRRs.

So far, however, it has not responded significantly to the far sharper falls in reserves seen during the last six months. In 3Q14 reserves fell by US$106bn, in 4Q14 they fell by a further US$45bn, and in the first three months of 2015 they fell by a further US$113bn.  1Q’s fall is the most worrying, since it indicates a heavy flow of capital out of the country. During 1Q, we know that China recorded a trade surplus of US$123.8bn, and that it attracted US$38.4bn in FDI whilst overseas direct investment out of China came to US$25.8bn - these flows add up to a net inflow of US$136.4bn. However, we know that foreign reserves fell by US$113bn, which means that the combination of the balance of services and net capital movements produced a deficit of US$249.4bn.  This is an extraordinary development, given the background of surging domestic stockmarkets, which one would normally expect to attract capital into China.

One explanation has it that the capital has merely migrated to Hong Kong in order to capture the profits from arbitraging between the different stockmarket prices of A-shares in China and Hong Kong. No-one doubts that this arbitrage has been enthusiastically pursued, but since Hong Kong’s foreign reserves rose only US$3.7bn during 1Q, such investment cannot be more than a footnote in the larger story of capital flight from China.

Now let us look at the impact these capital outflows have made on the cashflows of China’s banking system, counted as the change in deposits minus the change in loans. In this analysis, we also have to include one other policy initiative - the widening of the definition of deposits made in January 2015 which added approximately Rmb8.3tr to January’s deposit total. For the purposes of the chart below, these are excluded.

The chart shows how successful this flexible movement of reserve ratios has been in muting the financial repercussions of China’s foreign exchange build-up - typically during the heavy inflow years it halved banks’ net cash inflow, whilst in 2011 it engineered a genuine liquidity tightening.  However, it also shows that the huge capital outflows from China during the last year has completely changed banks’ cashflow situation: before changes in reserve ratios, the picture changed from a net cash inflow of Rmb2.02tr in the 12m to March 2014, to a net outflow of Rmb3.52bn in the 12m to March 2015. 

With PBOC having cut RRRs so far by only 50bps, the situation is hardly improved: the net cashflow moves from a Rmb214bn shortfall in the 12m to March 2014, to a Rmb4.395bn shortfall in the 12m to March 2015. Still, at this point, every percentage point cut in RRRs would free up approximately Rmb 1.25tr, potentially available for lending. 

It is in this context that the widening of the definition of deposits, which resulted in a book entry inflow of an estimated Rmb8.3bn deposits in January, and a positive cashflow for that month of Rmb 6.53bn, becomes so crucial. Looked at in the light of the pressure capital outflow is putting on China’s bank liquidity, this re-definition looks like a useful holding tactic of a central bank hoping to avoid significant cuts in RRRs (perhaps because of the negative impact cuts would make on government bond markets?).  If capital outflows continue to pressure banks’ cashflows - and it's difficult to believe it won’t, given the deterioration in China’s economic data - more and deeper cuts to reserve requirements will be expected and needed.

China 1Q GDP: The Cost of Financial Efficiency

China’s 1Q GDP growth of 7% is exactly as predicted/stipulated, and by itself tells us nothing interesting, except that it provides no cover for a much-needed relaxation of current policies.

More interesting is what happened to nominal GDP growth, which slowed to just 5.8% yoy. Although we do not have a quarterly breakdown by expenditure, I estimate that in nominal terms, China’s capital stock was growing by around 13.3% yoy in 2014 (based on depreciating gross fixed capital investment over 10yrs). If so, nominal growth of 5.8% means asset turns, and therefore returns on capital, must certainly be plummeting far faster than that 7% ‘real GDP’ suggests. 

But there is a second calculation to be made. Nominal growth slowed to 5.8% yoy even though the 1Q trade surplus of US$123.8bn is a multiple of the US$16.6bn surplus recorded in 1Q14. The trade surplus was equivalent to 5.4% of GDP in 1Q15 rather than the 0.8% of 1Q14, and that must make a major contribution to the overall nominal GDP growth. When one subtracts the trade balance from nominal GDP to estimate nominal domestic demand one finds China’s domestic economy already at a standstill - it rose only 0.9% yoy in 1Q15.

(Incidentally, I am  not straining for this result - I do these calculations every time).

We can also use the nominal GDP data to explore how money and finance are affecting China's economy. The relationship between money and the economy, and the Chinese population and money, has not yet stabilized, but neither is it deteriorating any more rapidly than usual. Monetary velocity (GDP/M2) continues to deteriorate, although given how badly asset turns must be falling, the deterioration is actually surprisingly modest.   Liquidity preference also continued to fall to new lows, but as with monetary velocity, the continuing fall is no worse than one would expect, extrapolating from historic seasonal trends. 

And finally, I am interested in the efficiency of Chinese finance, expressed as how much additional GDP growth is associated with an extra yuan of finance.  Recovering this efficiency of finance is, after all, an indispensable aim of any reform which hopes to rebalance the economy. For bank lending, over the last 12 months an extra 1 yuan of lending has been associated with only 0.44 yuan of extra GDP. This has not quite stabilized the fall seen between 2011 and 2014, but the rate of decline has clearly moderated.  What’s more, the last year (and in particular the last two quarters) have been marked by the government’s successful attempt to shut down several ‘shadow banking’ lines of finance and squeeze that financing back into straightforward ‘bank lending’.  In the year to March 2015, bank lending accounted for 67.5% of aggregate new financing, up from 54.6% in the same period last year.  Naturally, this shift in the form of financing will tend to produce a decline in the measured efficiency of bank finance. 

So the wider measure - the GDP gain associated with an increase in total new aggregate financing (including bank lending) - becomes the one to watch. And the news is good: the efficiency of finance is improving, albeit only marginally. In the 12m to March 2015, one yuan of extra total financing was associated with 0.302 yuan of extra GDP, up from 0.295 yuan in the 12m Dec 14, and 0.251 yuan in the 12m to Sept 14. In fact, the 12m to March 2015 was the highest reading since 4Q2013 - although it is still less than half the 0.77  yuan achieved during pre-crisis 2006-2009. 

The problem is that these small gains have been bought at an economic cost which is too great to sustain. We have previously laid out how China’s trade data, and its monetary conditions are deteriorating too rapidly for comfort. If in addition, we accept the extraordinary possibility that 1Q nominal domestic demand slumped to only 0.9% yoy, it seems inevitable and indeed unavoidable that some rather extensive belt-loosening will be needed and accomplished in the near future. At which point, we can expect the hard-won gains in financial efficiency to be lost once again.