John Authers

The China Trade May Be Just Starting to Unravel

What RRR the Chinese Authorities Up To?

The biggest financial news to start the week is that China is cutting its reserve requirement ratios, or RRRs, for all banks. This means that they can lend more, and so injects more money into the Chinese economy. It is a loosening move that means more liquidity.

It is of greater significance, as the following chart from Jens Nordvig of Exante Data Inc. shows, because this is the first RRR cut since the darkest days of the pandemic last year, and because it means that the authorities are as lenient toward the banks as they have been since 2007. At that point, China had to deal with a burst bubble in its domestic stock market and then to cope with the global financial crisis. Perennially since then, the authorities have been anxious to avoid a Chinese “Lehman moment”; so an RRR cut becomes that much more meaningful.

The official statement presents this as primarily a technical move, driven by the need to replace liquidity that has been coming until now from medium-term lending facilities, or MLFs. As this chart from cross-asset research at Societe Generale SA shows, a lot of these facilities are due to expire between now and the end of the year.

It may cheer investors that China is pumping out liquidity, having been more conservative. More money in circulation will have to find a home somewhere. But on balance, there is no question that a RRR cut is an unwelcome development. The Chinese authorities dislike easing, and even with the MLFs due to expire as an excuse, they can only be doing this because they have good reason to fear an economic slowdown. This is how Wei Yao, China economist for SocGen, summarized it:

The past history of RRR cuts (of any kind) suggests that this tool is never used when the economy is doing well. So now that the trigger has been pulled, two things are clear. - First, the economy is not doing well, and this will likely be confirmed by next week’s 2Q GDP data….
Second, China’s easing cycle has started... We now expect another RRR cut of 50bp in 4Q. Based on our current economic projection and bearing in mind the PBoC’s dislike of excessive easing, we do not think the economy would warrant an interest rate cut this year yet. Next year looks more likely. However, even without a policy rate cut, the PBoC will probably drive down interbank rates with more generous liquidity injections from here.

The news adds to what was already an obvious incipient loss of faith in the Chinese economy and assets. For one indicator, the S&P/BNY Mellon index of China American depositary receipts (large Chinese companies quoted in New York) had led the rest of the world comfortably ever since the nation’s stock market hit bottom early in 2016, after its mismanaged currency devaluation. That has now been punctured in spectacular fashion. The MSCI World index of developed market stocks has now overhauled the Chinese ADRs.

Naturally, this has much to do with concern over politics. What is euphemistically referred to as China’s corporate governance problem is growing acute. The Didi affair has driven the last leg down. It continues a string of incidents, including the scuttling of Ant Group Co.’s IPO and antitrust action against its parent Alibaba Group Holding Ltd., which show that when Chinese authorities have to choose between politics and free markets, politics will win. This is a communist regime that embraced the profit motive as a way to get things done and fulfill five-year plans; but its greatest concern is the survival of the party, and it will behave opportunistically to protect itself.

The regulatory probe against newly listed Didi also demonstrates a critical element of Chinese weakness, as Niall Ferguson comments elsewhere; pulling the likes of the ride-hailing company and Alibaba to heel will help the Communist Party to maintain control, but it will also shackle the profit motive. Open hostility to listings in foreign countries also opens up the risk of some form of “capital protectionism,” which could easily take hold, in the days of passive investment, if global investors simply shift to indexes that exclude China. In the longer term, these developments are concerning for the long-term growth prospects of China and therefore, by extension, the world.

There is ample room for the China trade to unravel further. The regime’s growing hostility to the private sector did nothing to deter foreign investments in either Chinese stocks or bonds during much of the pandemic period, as this chart from BofA Securities Inc. demonstrates. Foreign ownership of both equities and bonds rose impressively during the period (although the beginning of a withdrawal from equities is visible).

Meanwhile, there are growing concerns about Chinese corporate credit. Not coincidentally, yields on China’s high-yield indexes spiked higher just as US equities sold off last year, and the two had roughly recovered together. Now, as this Longview Economics Ltd. chart demonstrates, Chinese credit investors appear to be losing their nerve again, even though there are no such concerns in the West. This suggests deeper concern about the health of the corporate sector.

There are plenty of factors roiling the bond markets of late, of which China is only one. However, at the margin, this is plainly bad news for the reflation trade, of which more below. No indication that Beijing is clamping down on private capital is welcome. Beyond that, China’s role as the first to recover from the pandemic is important. Many investors are wagering that people will enjoy spending money once they are free to do so in the West. Any support from China for the historical evidence that pandemics make people lastingly more cautious and conservative with their money would be most unwelcome. Further, the country remains relatively unvaccinated.

With a slower China, there is that much less reason to expect dramatic increases in inflation, particularly as easier monetary policy in Beijing should all else equal weaken the country's currency and make Chinese imports elsewhere cheaper. At the margin, which is where everything in markets happens, the latest Chinese developments should increase demand for bonds, and diminish enthusiasm for “risk-on” trades.

Inflation Indicators
Our latest inflation heat map is now available. The picture from earlier weeks is if anything solidifying. The bond market, after a startling rally last week which was only partially reversed on Friday, now registers minimal concern that the inflationary environment ahead will be any different from the “low-flationary” environment of the last decade. For those technically minded and prepared to look closely at our heat map, the 5-year breakeven, predicting average inflation for the next five years, is now within two standard deviations of its mean for the last 10 years. That is why it is now a paler shade of blue, in the market indicators line. For the full interactive explanation of the heat map, go here.

Meanwhile, lumber futures have also come down to earth, in the other major statistical landmark. They are now right back in their range of the last decade, having entered the stratosphere earlier this year. This is important, as the rise in lumber costs, driven by the hot US housing market, was taken as a big indicator earlier this year that inflation was a problem. That rise has now been proved to be transitory, as many thought all along, and that helps to ease worried about inflation.

Next week, with a new month’s worth of official US CPI data, may well see some big changes in the map. In the meantime, the summary change is below.

In short, the markets remain convinced that inflation will stay much as it has been for a while — high enough to avoid an outright slump and deflation, but not strong enough to suggest any new secular inflationary paradigm.

Survival Tips
Sports events can be bad for your heart rate. Trying to write a newsletter like this while paying attention to a big moment in your home country’s sporting history is unadvisable. A large chunk of the readership will have their own views of what just occurred at the Euro 2020 soccer final in London. So, some quick thoughts.

First, it’s amazing how sports can suck you in, as Bloomberg Opinion’s Matthew Brooker writes. Even in advancing middle age, it's exciting and it matters. Second, sport remains independent of politics, despite all attempts to ram a political narrative on to it. I continue to think Brexit was a terrible idea; but I really, really wanted England to win. And third, there is much to the arguments about activity bias in penalty shoot-outs that I wrote about earlier in the tournament. Jordan Pickford, the England goalie, dived to execute two great saves; but he also dived out of the way of one that had been whacked straight down the center. That should be a greater part of the narrative than it is.