As readers will recall, only too painfully, fears of a hard landing of China’s economy traumatised global markets in the first quarter of 2016.
China - a major role in the 'global reflation show'
In mid-2016, when it became clear that economic conditions in China were improving, the stage was set for the opening of the ‘global reflation show’ (still running – despite occasional doubts, it seems its run is likely to be extended).
Donald Trump (having been in the right place at the right time) initially stole the lead role, somewhat overshadowing the crucial contribution made by China's economy as GDP growth picked up in the second half of 2016.
Two consecutive quarters of GDP growth in China bolstered sentiment on global growth
After five years of falling growth China's GDP rose in both the fourth quarter of 2016 and first quarter of 2017 (the first back-to-back acceleration in seven years).
This news gave a major fillip to sentiment about prospects for global growth and reflation. The angst about China’s economic challenges (particularly the excessive use of credit to bolster GDP growth leading to a possible mis-allocation of capital and accumulation of bad loans by China’s banks) that gripped markets in the first part of 2016 dissipated.
In the first quarter of 2017 China’s economy was certainly firing on all cylinders. Real GDP rose by 6.9% year-on-year (YoY) in Q1 while nominal GDP soared by 11.8% YoY (see exhibit 1 below), thanks to the ending of producer price index (PPI) deflation in late 2016, which boosted the GDP deflator. Even net exports, which had been a drag on GDP growth since 2009, once again contributed to growth. The nominal growth recovery was positive for corporate profit growth and fuelled expectations that stronger wage and consumption growth would follow. In short, it was full steam ahead for the global reflation show with the spectators rocking in the aisles.
Exhibit 1: Fourth quarter 2016 and first quarter 2017 saw two consecutive quarters of accelerating GDP growth in China after five years of slowing nominal GDP growth
China's economy remains on course for solid GDP growth in 2017
Recently, fears that China’s GDP growth is slowing have resurfaced. The chain reaction was a sell-off in the prices of commodities and jitters about the prospects for emerging markets. Data released on 15 May showed slower growth of factory output, retail sales and fixed-asset investment in April, so China’s growth in 2017 may have peaked in the first quarter. Nonetheless, the growth target of 6.5% for the full year is still attainable.
We know that:
- The global reflation show is dependant on a certain stability in China's economic growth
- China's authorities intend to support growth through stable monetary policy,
So why has the People’s Bank of China (PBoC) raised official rates in 2017?
In answering this question it's crucial to understand the factors driving Chinese growth and the People’s Bank of China’s (PBoC) monetary policy.
The policy complication behind Chinese economic growth
Monetary policy does not appear to be the primary driver of Chinese economic growth. The benchmark lending rate and bank reserve requirement ratios, which are the two most direct monetary policy tools, have not been moved in over a year, while aggregate financing (including bank loan) growth has been constrained in a narrow, flat range.
The People's Bank of China (PBoC) has raised its reverse repo rates and lending facility rates twice (by 10bp on each occasion) since February this year, leading to jumps in money-market rates by more than the official rate increases. Some onlookers interpret this as the start of a monetary tightening cycle in China with the potential to slow economic growth excessively.
This concern is, in my view, unjustified, as the growth momentum is not strong enough to warrant a shift towards monetary tightening. Despite seven months of a strong economic recovery, producer price inflation (PPI) has failed to trickle down to consumer price index (CPI) inflation, so the annual rate of core CPI inflation remains around 2% (Exhibit 2). The recovery in China’s PPI may even have peaked (Exhibit 3) in the wake of the recent fall in global commodity prices and bottlenecks in the supply of commodities within China have eased.
Exhibit 2: Despite seven months of a strong economic recovery consumer price inflation in China remains well contained
Exhibit 3: 2016 saw the recovery in China's producer price index. Factory-gate prices turned positive for the first time since 2012. The ending of the period during which China exported deflation removed a significant disinflationary force from the global economy (graph shows changes in China's PPI index over the period from 1997 through April 2017)
To understand why, in these circumstances, the PBoC is raising official rates, we need to remind ourselves that the PBoC is juggling with dual policy objectives of simultaneously supporting GDP growth while enforcing financial debt reduction. Juggling these two objectives is a tricky exercise and at times there are inevitably concerns that the PBoC is on the point of commiting a policy error.
Overall, the PBoC’s monetary policy stance has been kept neutral while selective interest rates have been raised to force debt reduction in the wholesale funding market. This policy balance can be seen in the fact that there has been no change in the benchmark lending rates and bank reserve requirement ratios since 2016. Recent rate hikes have been 'surgical', affecting only the lending facilities and the interbank market which account for less than 5% of aggregate financing in the system (see exhibit 4).
Exhibit 4: China's 'surgical' rate hikes affect only lending facilities and the interbank market, these are marginal sources of aggregate financing relative to bank loans (the graph shows each as a % of aggregate financing)*MLF+SLF+PSL+net SLO
Source: CEIC, BNP Paribas Asset Management (Asia), as of December 2016
The targeted rate hikes are aimed at forcing the small and regional banks and the shadow banks to reduce debt. These institutions have increased their reliance on short-term wholesale funding, which comes from the interbank market and investment products that are issued by both banks and non-bank financial institutions (NBFI). They then use the funds to fund real economic activities, the much decried asset punting (including buying higher-yielding wealth management products (WMPs), issuance of high-yield corporate bonds with relatively longer maturity) and the fuelling of capital outflows (Exhibit 5).
These last two activities have raised policy concerns about the risks of balance-sheet mismatch, credit defaults and uncontrollable capital outflows. So the wholesale funding market is the financial stress point that needs to be addressed early.
Exhibit 5: Risk of wholesale funding lies with China's small and shadow banks
Source: BNP Paribas Asset Management, as of 26/04/17
A stealthy fiscal expansion
It is obvious that China’s growth has relied on fuel from the public sector (Exhibit 8). What is less obvious is that some stealth measures have provided an extra boost to Beijing’s fiscal prowess. The trick lies in the PBoC’s claims on other deposit-taking institutions, which include NBFIs and policy banks. These claims have soared since 2016 (Exhibit 6). Open market operations have accounted for about half of this surge (a monetary operation to offset the passive liquidity squeeze due to capital outflows on the back of a stable FX policy), while the rest has reflected the PBoC’s lending to the policy banks that finance public infrastructure spending (a stealthy fiscal operation).
Source: CEIC, BNP Paribas Asset Management, as of 26/04/17
Exhibit 7: PBoC's claims on other depository institutionsSource: CEIC, BNP Paribas Asset Management, as of 26/04/17
In the first four months of 2017, as growth concerns eased, debt reduction has moved up the agenda of policy priorities. This is apparent in the PBoC’s continued efforts to use the stabilisation of economic growth as a cushion to force deleveraging through small, “surgical” tightening operations.
In addition, the PBoC started to implement its Macro Prudential Assessment (MPA) framework in the first quarter this year (setting parameters, including capital adequacy ratios and lending standards, for assessing banks' total credit growth, including their off-balance-sheet activities such as WMPs and lending to NBFIs and shadow banks).
Banks that fail the quarterly MPA test will be disqualified from using the PBoC's lending facilities or be hit with significantly higher interest rates from the facilities. Hence, many banks have scaled back lending to the NFBIs in order to comply with MPA, leading to a liquidity squeeze in the wholesale funding market and a reduction in overall credit growth.
However, it is unrealistic to expect a swift decline in China’s debt-to-GDP ratio because it would be an impractical policy option. China’s aggregate financing growth has outpaced nominal GDP growth by an average of six percentage points since 2012 (Exhibit 8).
Exhibit 8: Total social financing (TSF) minus nominal GDP growth ratesSource: CEIC, BNP Paribas Asset Management, as of 26/04/17
If China's authorities were to cut the debt-to-GDP ratio abruptly it would mean that credit growth would have to drop by more than six percentage points below the nominal GDP growth rate. The result would be an abrupt contraction of China’s economy before the benefits of deleveraging could emerge (and a sudden end to the global reflation show).
Once, as I expect, the current jitters about China’s growth have blown over, we should reckon with further incremental, selective monetary tightening operations, against the background of a broadly neutral monetary stance. This is the tool that will continue to be applied to slow the pace of leveraging and set the stage for eventual deleveraging.
The pre-condition for outright deleveraging is unfolding as the gap between credit and nominal GDP growth is already narrowing. If, as I anticipate, the pace of China’s economic growth stabilises, then selective monetary tightening may even intensify (with one to two small rate hikes aimed at reining in the wholesale funding market possible during the rest of 2017) and fiscal expansion may be scaled back.
Conclusion: it will not, in my view, be China that pulls the plug on the global reflation show in 2017….
Written on 26 April 2017 Click here to read more analysis on China from our teams
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