Less than meets the eye…

When is policy easing not much of policy easing? In China.

The Chinese cut the prime rate and the reserve requirement for banks last week by 0.25% and 0.5% respectively.

That brings the rate cut to 1.25% for the year and the reserves requirement cut to 2.5%.

On face value, this is quite an aggressive move after a 2% devaluation in the exchange rate a few months ago.

However, in our view, there is far less to the easing than meets the eye.

Here’s why:

The deposit base of Chinese financial institutions is approximately $20 trillion. Up to the end of September, the reserve ratio (RR) cut will have released about $407 billion of liquidity into the system. This combined with an incremental $105 billion coming from last week’s cut gives a year-to-date injection of approximately $512 billion.

However, as the following chart (October’s reserve data is not yet available, this data only goes through end of September and thus does not include the impact of last week’s RR cut) shows, in the period through the end of September the central bank lost $329 billion of foreign exchange reserves as capital flowed out of the country.


A loss of reserves represents a loss of domestic liquidity that must be offset against the RR cut to see the proper extent of liquidity injections from the central bank. Quite clearly, in the first nine months of the year 80% of the People’s Bank of China’s (PBOC) liquidity injections from RR cuts flowed straight out of the door; just about $80 billion of liquidity appears to have been injected net from a relatively swift policy easing. That amount is actually irrelevant in a $10 trillion economy under such banking system stress. It is almost certain that reserves declined again in October, probably offsetting more than half of that month’s RR liquidity release.

Moreover, with the GDP deflator and the negative producer price inflation, the nominal prime lending rate has not declined at a pace to even match the price deflation, leaving real lending rates higher than they were at the start of the year.

In addition, despite the devaluation, the real effective exchange rate is also higher over the last twelve months and since the beginning of the year.

All in all, less than meets the eye when you look at the true nature of Chinese monetary policy. Higher real rates, a higher effective exchange rate and a trivial increase in domestic liquidity. Why might that be so?

Well one reason, perhaps, is that the PBOC is trying to fight two fires with one extinguisher. The capital outflow puts downward pressure on the yuan such that the PBOC must defend it if it is to maintain the dollar currency peg. It needs high real interest rates to hold capital in, but the consequence of higher real interest rates for horribly leveraged domestic corporates on wafer thin (if any) margins are painful. It appears that the rate cuts and the RR cuts are intended to show willingness to support the economy under stress without also compromising the peg.

As always, something must give. Will the Chinese allow the system to fail for the sake of the peg? No, we don’t think so. It reinforces our view that the yuan will be devalued significantly in coming quarters. The paradox is that the more they cut rates… the faster capital flows away, the greater the pressure on the peg and the greater the stress in the system that necessitates even more RR cuts. It’s a vicious cycle where cuts necessitate more cuts; easier to let the yuan weaken.

Of course, when you get almost 30% of your imports from China, and their currency weakens, the Japanese will come under increasing pressure for an even more aggressive QE stance to show that they are doing something, anything, to address a deflation storm heading their way. A weaker yuan also implies a weaker yen.


Why China really matters

Chinese nominal USD-denominated imports dropped 14% in the three months to September year/year (and 14% in the six months to September year/year) – the median growth rate since the end of 2008 has been +6% year/year in both cases.

  • In short, Chinese import growth has been strong since the onset of the financial crisis in 2008/9, reflecting a period of exceptional local policy stimulus.

To put this in to context, the chart below shows the proportion of the growth in world merchandise trade accounted for by various countries/regions since 2008:

  • China, an economy of approximately $10 trillion – about 12% of Global GDP – accounts for 32% of the growth in goods imports over the five years from 2008 – 13. China has been punching well above its weight.
  • The Asia region as a whole, so dependent on China, accounts for almost 70% of the growth in global Imports.
  • China and Asia accounted for 54% and 27% of the growth in exports over the same period.


Why is this so important? Well, the following chart shows domestic demand growth in the major regions/countries on a rolling five year annualised basis:

  • Real domestic demand growth barely hit 2% annualised at its peak over the period in Japan, the UK and the US and has not grown at all in the Eurozone.
  • When you have little or no demand growth you rely on foreign demand; in the case of the developed economies you rely on Chinese import demand to hold global growth up.


Collapsing import demand, as we have argued previously, is reflective of an alarming slowdown in Chinese manufacturing sector investment growth (as Chinese companies race to bring capacity growth more in line with the rate of growth in demand in the West):


This is not a cyclical but a structural adjustment – weak global growth, disinflation/deflation follow.

With the exhaustion of the effects of monetary policy, how long will it be before we hear arguments of the kind below from policymakers?

  • “look, government bond yields are near record low levels, we can borrow for ten years at rates of 2% or less (or thirty years at negligible rates), I think we should be issuing lots more debt to take advantage and invest that money in real, tangible things (like infrastructure) where surely we can find some projects with long run returns above the nominal/real cost of borrowing.”


  • “Bond yields are so low, let’s borrow money, build a ‘National Recovery Fund’ and invest all the proceeds in the equity market directly, the risk premium is positive and surely equity returns will exceed bond returns over the next ten to thirty years.”