Looking at some of the recent moves in commodity prices and the CSI 300 index, it would be easy to construe that China is at the epicenter of global tightening.
While the People’s Bank of China has been altering its monetary policy, other factors such as a closer regulatory scrutiny of shadow financing and stock market investment funds are playing their part. But the sell-off in Chinese bonds is only a normalization from very low yields.
There appears to be multiple forces acting at present in China. Separating fact from fiction is not necessarily easy but in essence the introduction of new regulations for both banks and stock investment vehicles has come alongside natural policy tightening by the PBoC.
Monetary policy moves in China are never really “tinkering”. The best analogy is similar to controlling the thermostat of a shower that operates either “hot” or “cold”.
It should be remembered that in the early second half of 2015 China was facing a deflationary threat. From late 2016, the economy was clearly exporting inflation while both the Consumer Price Index and the Producer Price Index were strong.
Moreover, we pointed out that in the run-up to the recent session of the National People’s Congress, monetary and fiscal policy was one of the loosest in the past 20years.
The question for global investors is whether the PBoC will be able to “fine-tune” monetary policy given that the bulk of the M2 growth came from China rather than the United States in the past five years.
Firstly, there has been pressure on banks to clean up their lending policies, and this has squeezed the onshore bond market and put pressure on corporate re-financing.
Meanwhile, China will further regulate local government debt issuance and financing. The ramping up of regulatory checks on investment vehicles such as wealth management products has also undermined stock market sentiment.
The new head of the China Securities Regulatory Commission is seeking to crack down on equity market infringements.
Secondly, the PBoC has been tightening policy by decelerating the pace of lending to commercial banks through its “backdoor QE” while interbank rates have been climbing for quite a few reasons.
The Shanghai Interbank Offered Rate (SHIBOR) has risen as banks have had to become more disciplined in managing their liquidity needs.
This has become more important as the PBoC has moved towards open-market operations. Indeed, the yield curve shifted slightly into inversion since the Chinese New Year as SHIBOR climbed.
Thirdly, the long end of the Chinese bond market appears to have simply “mean reverted” after a period of abnormally low yields in the face of higher inflation.
Real rates in China are negative based on producer and corporate prices.
Fourth, the recent dollar weakness and stable foreign exchange reserves have reduced the need for the PBoC to continue to introduce money into the system to replace US-dollar liabilities.
How will the changes in interest rates effect listed companies? With most of CSI 300 companies having reported their full-year results, the trend in deleveraging and improving cash flow continued through 2016.
Just as the central bank eased policy in 2015-16, the corporate sector sought to improve its solvency and cut its capex to improve cash flow.
Approximately 60 percent of the CSI ex-financials demonstrated net debt-to-equity less than 50 percent while just under 50 percent of the CSI 300 companies (ex-financials) had credit scores that were in the “safe zone for corporate solvency”.
In turn, the free cash flow forecast for the CSI 300 ex-financials is close to its record high since 2006.
We would keep a close eye on M1 growth as a sharp drop would run the risk of further spikes in interbank rates.
Secondly, the shape of the yield curve should be monitored. It would need to naturally steepen as US long rates also move up.
Lastly, we would expect the central bank to ease in the short end if indeed the regulatory regime forced liquidity conditions to tighten dramatically.
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