22 January 2020
Since 2015, China's central bank had altered its monetary tools to ensure that liquidity is delivered to the right areas of the real economy. Photo: Reuters
Since 2015, China's central bank had altered its monetary tools to ensure that liquidity is delivered to the right areas of the real economy. Photo: Reuters

China: Time to open the monetary tool box

The swift move in CSI 300 shares year to date appears to have wrong-footed investors, given that economic data releases are still poor. Meanwhile, authorities have begun to expand their monetary tool kit to ensure the real economy can obtain funding. The move in cyclicals versus defensives and the high excess returns of high beta shares in January points to a definitive change in risk appetite. History suggests not to be underweight ahead of the March 5 NPC meeting.

Aside from the series of reserve requirement ratio cuts (the market expects four more this year), and a targeted medium-term lending facility (TMLF) to facilitate financing for micro, small and private businesses, authorities have also widened the collateral that can be accepted at the PBOC window. Even this has not been enough and the PBOC has been injecting money to guide down interbank repo rates while three-year government bond yields have dropped by over 80bp since mid-September.

However, just before the Chinese New Year, Bank of China issued an inaugural perpetual bond in the interbank market (40 billion yuan) that can be accepted by the PBOC’s bill swap operations. In essence, the funds from the exchanged central bank bills can be used for mortgages and collateral in the PBOC’s broader monetary operations. While there are strict rules on the issuance, it is an extremely powerful tool for the big four banks.

It should be remembered that from 2015, the PBOC also altered its monetary tools to ensure that liquidity was delivered to the right areas of the real economy. The PBOC introduced Pledged Supplementary Lending (PSL), which means the central bank directly lent to the banks that had promised to use the funds for social housing (shanty town development).

The PBOC bank bill swap program is essentially a way for the banks to underwrite each other’s bond issues and then use the proceeds to obtain PBOC bank bills which can then be pledged as collateral at the PBOC window.

China seems to have experienced its own version of Draghi’s 2012 ‘We will do whatever it takes’ moment last October with measures to relax monetary policy and support the stock market. In retrospect, this policy U-turn coincided with the epicenter of the Pledged Equity Financing (PEF) problems as margin calls were forced on many CEOS who had pledged their company shares in return for capital.

With no doubt one eye on the PEF fiasco, the securities regulator announced a relaxation of restrictions on brokerages by lowering the capital ratio on perceived risky assets while also scrapping a mandatory margin call on short-selling. Coincidentally, stock market turnover to market cap is near its lows while the Chinese brokerages have begun to break out versus the main index.

In summary, bifurcation is the theme for 2019. Firstly, the China bond bull market is ending and this ought to underwrite the banks. Secondly, the old economy is still benefiting from government directed financial support while the private sector is suffering from the contraction in the shadow financial system. Lastly, the PBOC has opened its balance sheet while the government has relaxed its fiscal stance (at last).

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Chief Global Equity Strategist at Jefferies