05-09-2016, 03:24 PM
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What is the problem?
For well over a decade, China's economy has been powered by two main engines: its
enormous export-oriented manufacturing sector and its scramble to build cities from
scratch, even if no one actually wants to live in them.
In the aftermath of the 2008 crisis, as China’s exports collapsed, the government ordered
its state-owned banks to unleash a wave of credit that has been described by economists
as the greatest loosening of monetary policy in history.
Total debt in the Chinese economy quadrupled from $7tn in 2007 to $28tn by the middle
of last year, according to the McKinsey Global Institute. At 282 per cent of gross
domestic product and climbing, China’s debt load was already bigger last year in relative
terms than those of Germany and the US.
What is the Reason?
1. Property Woes
A few months back, the People’s Bank of China pumped nearly $100bn into two
state-owned “policy banks” that will fund local government infrastructure projects. The
central bank has also allowed these banks to issue trillions of RMB in bonds to support
lending.
Beijing has launched a huge programme that some describe as “quantitative easing with
Chinese characteristics”, to swap short-term local government debt for longer-term,
lower-cost bonds. But even after this debt swap, local governments will have to make
Rmb1tn ($156bn) in interest payments on their existing debt this year alone, according to
estimates from JPMorgan.
Yet income from land sales, which had accounted for an average of 40 per cent of local
government revenues, has plummeted in the past year. This means local governments are
struggling just to service their growing debts and pay for basic public services.
Despite a rebound of housing transactions and prices in recent months in larger cities, the
downturn is expected to continue because 70 per cent of property investment happens in
smaller cities and places with chronic oversupply such as Jingjin New City.
Even with a recovery in major cities, the property sector will probably subtract 1.5 per
cent from GDP growth this year, according to estimates from Wang Tao, chief China
economist at UBS.
Ghost Cities
It seems perverse that developments such as these should exist in the world’s most
populous nation, where land is scarce and many people are still too poor to afford decent
housing.
The Jingjin New City project and many others like it exemplify the government’s
dilemma as it tries to keep growth from tumbling below its annual target of around 7 per
cent.
What Can Be Done?
1. Steps Taken By The People's Bank Of China (PBOC):
The People’s Bank of China (PBOC) announced it would cut:
•One-year lending rate by 25bp to 4.60%
•One-year deposit rate by 25bp to 1.75%
Effective August 26, 2015
There was a 5th consecutive interest rate cut in the current easing cycle, which started
with a 40bp rate cut on November 21, 2014. Also announced a 50bp Reserve
Requirement Ratio cut for all depository financial institutions, an additional 50bp RRR
cut for qualified financial institutions with a focus on rural and/or SMEs loans and an
additional300bp RRR cuts for financial leasing companies and auto financing companies,
effective September 6,2015.
A 50bp cut in RRR results in injection of around US$104.5 billion in liquidity in the
banking system.
This is the third universal RRR cut in the current easing cycle, lowering RRR for large
and small/medium financial institutions to 18.0% and 16.0%, respectively.
Analysis of the Steps taken by PBOC:
As a strong policy signal, the combined interest rate and RRR cut suggests the policy
makers are intensifying easing efforts to address the increasing concerns on growth
amidst a volatile market.
All growth indexes have fallen in August, underlying the difficulties for small and medium-sized companies due to weak demand growth.
According to the PBOC, the weighted average lending rate edged down slowly to 5.97%
p.a. in July from 6.04% p.a. in June. However, in view of the deeper PPI contraction in
July, the funding cost in real terms remains elevated.
PBOC will have to use more significant RRR cuts to stabilize liquidity and economic
growth. As this move came on the heels of sizable liquidity injection via MLF(Rmb 110
bn) and open market operation (Rmb150bn last week and another Rmb30bn injection this week), suggests that potential capital outflow has likely increased and is likely to persist, which warrants long-term liquidity injection.
2. Removing Inflow Barriers
China broke open its interbank market to selected foreign investors thereby removing most barriers to investing in China’s bond market.
The US$5.7 trillion interbank market is the larger of the two formal bond markets and
accounts for approximately 95% of total trading volume.
It should be pointed out that the interbank market is regulated by the PBOC which has
been spearheading the overall relaxation of interest rates and the capital account.
There is now a high probability that China’s bond and equity markets will both be opened up by year end. This would mean that China’s equity market by market cap would rank as
number two while its overall bond market would be the third largest behind the US and Japan according to BIS data.
Yuan Devaluation
China has lost about USD350bn reserves despite running a current account (CA) surplus; this is unusual.
This also off sets any attempt to reflate the sagging economy through RRR cuts.
China’s export share in world trade is at an all time high and does not warrant a weaker
currency.
In our view, the Yuan devaluation attempts to:
i. Regain control over monetary policy by moving (hopefully) to a market-determined
rate.
ii. Trigger Yuan’s inclusion in IMF’s basket of currencies it uses for SDR calculation.
iii. A minor 4% move will probably reinforce expectations of more devaluation.
iv. China’s economy is under BoP stress for the past 2-3 quarters with net capital outflows surpassing current account surplus.
v. Given that the country’s current account surplus is now small (~2% of GDP), capital
account dynamics have become crucial for overall BoP.
vi. Thus, due to the capital outflows, the RMB has been under pressure. In this classic
situation of BoP stress, central banks have to choose between currency devaluation
and forex intervention through use of reserves, which is nothing but domestic
monetary tightening.
vii. So far, China’s central bank PBoC has been defending the RMB through the use of
reserves, but recently it allowed its depreciation to avoid too much tightening of
domestic monetary conditions.