China On Monetary Easing Binge, Expect More

Over the weekends on Sunday, Beijing lowered its 1-year benchmark interest rate by 0.25%, marking the third time the PBoC has lowered interest rates and the fourth time it has eased monetary policy so far this year. It seems the PBoC is keen to join the global group of dovish central banks - and it has its good reasons too.

Readers recall that just last month, the PBoC announced a 'surprise' RRR cut (second this year) to a record low after Chinese stocks took a slight bashing.

Fast forward one month, and many dismal economic data releases later, the Chinese are at it once again. The current phase of monetary easing by the PBoC is one of the more aggressive bouts in the last couple of years. This comes amid strong signs that the Chinese economy has been slowing since mid-2014. All in all, another reason to engage that short-China trade.

Stocks Not Allowed To Fall

While rumors of QE by the PBoC have so far proven untrue, it is getting obvious that every time Chinese stocks take a dip, some kind of potent monetary concoction would be cooked up and announced over the weekend when the markets are closed. 

When trading resumes the following week, the markets seemingly shrugs off the reason for selling off and rallies higher. Rinse and repeat, and there you have your centrally planned casino, err pardon, market.

This leads us, and probably even the layman, to believe that monetary policy in China is now very much dictated by how the market performs, and less on how the economy is actually doing. The fact that China is seeing a tepid patch of economy activity whilst its stock markets trade turbulently, wriggles the line even more.

Regardless whether the PBoC, whose strings are inextricably pulled by the Politburo, takes its cues from the market or not, one this is very certain: There will be plenty of rate cuts to come. This view is not only echoed by us, but also by just about every investment bank with a sell-side desk. 

And therein lies the rub. With market expectations so centered on further monetary policy easing by the PBoC, failure to deliver on those expectations would result in a very rough patch in the markets. 

For every basis point of marginal (out)performance, the government would either have to leak rumors of an outright QE, or actually ease even deeper into the central banking twilight zone, until like the BoJ, it too runs out of room to ease further, though we suspect that is still a long long way to do.

More Easing Almost Guaranteed

Persistent downside growth risks and the continued elevated lending rates point to the need for additional monetary easing. Despite recent policy moves by the PBoC, interest rates (nominal and real) remain high for the economy. Real lending rates and bond yields are still trending upward given subdued inflation.  Note that as the bank’s lending rate is fully liberalized, the pass-through of the lending rate cut is limited, which points to the need for further monetary easing to guide rates lower.  The PBoC's Monetary Policy Report published in 1Q15 showed that the average lending rate was 6.78% in March, only 15bp lower than that in December despite 4 counts of policy easing so far in 2015. It is also worth noting that the PBoC has been guiding the interbank rate lower since March. The 7-day repo rate fell sharply to below 2.5% following the 100bp RRR cut (to 18.5%) on 19 April. Chart courtesy of Barclays

Persistent downside growth risks and the continued elevated lending rates point to the need for additional monetary easing. Despite recent policy moves by the PBoC, interest rates (nominal and real) remain high for the economy. Real lending rates and bond yields are still trending upward given subdued inflation. 

Note that as the bank’s lending rate is fully liberalized, the pass-through of the lending rate cut is limited, which points to the need for further monetary easing to guide rates lower. 

The PBoC's Monetary Policy Report published in 1Q15 showed that the average lending rate was 6.78% in March, only 15bp lower than that in December despite 4 counts of policy easing so far in 2015. It is also worth noting that the PBoC has been guiding the interbank rate lower since March. The 7-day repo rate fell sharply to below 2.5% following the 100bp RRR cut (to 18.5%) on 19 April.

Chart courtesy of Barclays

Amongst the reasons which we believe have shaped China's monetary policy, we feel that the most compelling of them is the latent risks that would materialize should economic growth slow below the government's 2015 forecast of 7%. Policy makers have clearly realized that too much rests on a high growth rate for the economy to disappoint.

Besides cutting interest rates by 25bp, the PBoC also lifted the ceiling of deposit rate to 1.5x of benchmark rate from 1.3x in the past. Some analysts speculate that in the future, this ceiling could be removed completely. 

Sell side desks anticipate anywhere from 1 to 3 rounds of interest rate cuts and RRR cuts in the remaining 7 months of 2015, with months of June and September being the median estimate.

The motivations of future cuts might pivot on the Politburo's reluctance to admit that sub-7% GDP growth will be sticky until the global economy cycles into an accelerated pace of expansion, but those outside China's inner circle will never know for sure. There also seems to be a panicked impetus within the PBoC to ease financial and monetary conditions.

So far, it's approach has been to spur private credit creation by lowering interest rates and freeing up the banking sector of capital - through RRR cuts and the debt swap program it announced 3 weeks ago, to lessen encumbrance on FI's balance sheets.

Further supporting the easing cycle is the relatively high nominal effective lending rate of 6.78% in 1Q15, as officially reported. Despite the previous 2 cuts to the RRR (now at a record low), the real lending rate remains elevated in the private sector thanks to less than goldilocks warm inflation in March and April, even in light of the recovery in global oil prices and a rangebound Yuan.

Official CPI and PPI inflation has tended to be on the cool side through April, missing expectations more than not; another reason to stick the the current path of loosening financial conditions. 

Chinese policy makers also highlighted that it needed to "more efficiently channel monetary policy to support the real economy" in recent times. For them, lowering the 1-year benchmark interest rate serves this purpose.

Like any other central bank, the PBoC's decision to cut rates might also be an attempt to signal its propensity to lower rates even further

While the effects of lower benchmark rates on borrowing costs in the corporate sector might not be as efficacious as policy makers have planned for, the PBoC hopes that by doing enough, easier financial conditions will eventually filter down.

A Balance Between Growth & Prices

The Bloomberg Commodity Index, a composite of various commodity prices, found a cycle low in Febuary 2015. This coincides with the first bottom in crude oil prices which we correctly called (see our 27 January note) . With many commodity prices now on the up tick, it should be safe to expect inflation and inflation expectations to warm up going forward. This should force the PBoC to tone down on its aggressiveness towards easing in the latter half of the year to avoid the risk of overshooting its inflation targets. Chart courtesy of Zero Hedge

The Bloomberg Commodity Index, a composite of various commodity prices, found a cycle low in Febuary 2015. This coincides with the first bottom in crude oil prices which we correctly called (see our 27 January note) . With many commodity prices now on the up tick, it should be safe to expect inflation and inflation expectations to warm up going forward. This should force the PBoC to tone down on its aggressiveness towards easing in the latter half of the year to avoid the risk of overshooting its inflation targets.

Chart courtesy of Zero Hedge

As to how much further can the PBoC ease (lowering interest rates in specific), it depends on the upside risks to an aggressive policy stance - namely inflation. As we have spoken, official CPI inflation reports show that prices have remained relatively cool leading up to 2Q15. Analysts expect inflation to pick up in the second half of the year. 

We believe that a lot of the low inflation has to do with the aftermath of a low oil price shock. This is not endogenous to China; we are seeing this effect manifest all across the emerging and developed economies from India and Indonesia, to Europe and America. 

Past May, it is not ambitious to expect actual and expected inflation rates to warm up as prices of most commodities including oil and natural gas have bottomed in March and seem to be on an upwards trajectory. Our view is echoed by various central banks in Europe as they too expect inflation to stabilize by end May to June and increase towards 3Q15. We feel this is a reasonable expectation, and are already seeing developments in this direction.

There will likely be 2 more interest rate cuts in the rest of 2015. This should be the balance the PBoC is among to strike. Anymore than 2 cuts might actually lead to an overshooting of inflation targets. In line with our view that prices should rebound post June, due to supply and demand factors, the PBoC might not be willing to wager too much in the quest of achieving a 7% and over growth rate for 2015.

The limiting reagent in this concoction is inflation. The key issue is whether CPI inflation will rise in the rest of 2015. As we believe it will in the second half of 2015, it should be safe to expect a less aggressive stance on he easing front by the PBoC going forward. In other words, we might be at the climax of the current protracted phase of intervention.

Dismal Economic Data Expected To Improve

Data coming out of China in the last 3 months haven't been pretty. Official GDP growth floats just over 7%, the slowest in almost 25 years. Trade figures for April released last Friday disappointed even the lowest estimates, with both exports and imports declining YoY. The official PMI stands at 50.1, a hairline above contractionary activity; while the HSBC Flash PMI already signals a decline in manufacturing activity at a 12-month low of 48.9 in May. 

The Chinese government often harmonizes monetary easing with other forms of stimuli. It is no exception this time. It is stepping up other loosening policies, such as increasing public expenditure; this was explicitly stated in the Politburo's announcement at the end of April. 

There is clearly a concerted effort to boost economic activity whilst improving liquidity and lowering borrowing costs. Nothing too esoteric or grand, but the current crop of measures should be well potent enough to turbocharge the Chinese economy. 

Unlike most economists, we dare go out on a limb to prime the rhetoric for upside surprises with respect to future Chinese data.

Iron ore prices have been a red herring for much of 2015, bucking the trend of the recovery in commodity prices. But this might not be a bad thing for China as it imports a majority of the ferrous metal from Australia, its largest import partner.  Lower iron ore prices should continue to suppress input costs to construction materials, servicing as a much needed discount to a key industry which is in structural decline. Chart courtesy of Zero Hedge

Iron ore prices have been a red herring for much of 2015, bucking the trend of the recovery in commodity prices. But this might not be a bad thing for China as it imports a majority of the ferrous metal from Australia, its largest import partner.  Lower iron ore prices should continue to suppress input costs to construction materials, servicing as a much needed discount to a key industry which is in structural decline.

Chart courtesy of Zero Hedge

Also looking at external sources of demand, we feel that these sources are going to form a larger part of Chinese exports as we journey forward. The combination of a cyclical recovery in Europe, relative stability in most of the developed sphere, and generally low input costs from Australia (China's largest import partner) should by even in the most conservative circumstances lead to a modest improvement in China's economy.

Domestically, some of the economic headwinds have been attributed to the government's draconian crackdown on corruption within the state. Under the current leadership of President Xi, the Politburo's anti-corruption campaign has been grabbing headlines for some time now. The lesser told economic consequences are also real. 

Traditional practices of giving gifts and bribery within closely kept circles of influence have seen declines, for obvious reasons. This has weighed somewhat on consumption, especially in luxury goods. With the gradual dissipation of these parasitic effects, these should be one less factor left to contend with.

The last topic we wish to highlight that has been a major impediment to the raging dragon is the set of economic and structural reforms (which includes the anti-corruption campaign) the current administration has been religiously following. China's transition into an economy which now aims to be driven more by its own people than on external sources has meant that the "fast and easy" growth is over.

Said transition has already been elapsing for at least 2 years now. We believe that most of the economy has adapted to the new dynamics, which are by no means radically different, and are much better position to take advantage of this new phase of developments than they were 1 year back.

The government recognizes that support, in the form of monetary policy, was necessary to preventing a so called "hard landing" and other systemic damages in the financial sector; and it has stuck to it till today.

Rate Cut Leaked Hours Before Officially Announced

Just for sheer entertainment, we should let readers know that many hours before the PBoC even announced its decision to cut rates, leaks of the decision were already being circulated rampantly on the Chinese social messaging network WeChat (China's version of WhatsApp).

This might be the reason why the PBoC often announces major policy decisions over the weekends when the markets are closed, instead of on weekdays when markets are opened. It turns out that officials are fully aware of the situation of this spoofed confidentiality but have openly done nothing about it. No wonder everyone is a 'trader' in the Mainland.

Reuters explains:

“More than two hours before China cut its interest rates on Sunday afternoon, the financially sensitive information was making its rounds among users of China's popular social messaging app WeChat.
The WeChat message, seen by Reuters at 2:41 p.m., was bang on the money; it said China would cut interest rates by 25 basis points and raise the ceiling for deposit rates to 1.5 times the benchmark.
The information was attributed to the People's Bank of China (PBOC), and the WeChat message, which redirected readers to an anonymous web page, did not carry the central bank logo or any official government stamp.
When the real announcement was released shortly after 5 p.m. local time, it matched word for word.
In China, information often leaks ahead of official announcements, and as the world's second-biggest economy, that can swing financial markets at home and abroad.
Song Qinghui, a prominent financial news commentator in China, said he had seen the leak "exploding" in WeChat circles as early as Sunday morning.
"There are so many such leaks in China. Although offenders can be sentenced to the stiffest possible punishment, no one investigates the leaks," Song said.”