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Chinese bonds signal early end to "tight" money
By Mark A DeWeaver
At the end of last year, the Chinese government's economic work conference
announced a major shift in monetary policy designed to bring down the 6%-plus
inflation rates of the preceding four months.
The meeting in Beijing on December 3-5 changed the primary monetary policy
objective from "preventing overheating", to the dual objective of
simultaneously "preventing overheating" and "preventing inflation". At the same
time, the stance of monetary policy was changed from "appropriate tightening"
to just plain "tightening" - the first time in 10 years that "tight" money has
been mandated.
While the conference made these changes official, it appears that they were
already being implemented by the People's Bank of China (PBoC) as early as
November, when the central bank is reported to have begun applying pressure on
the commercial banks to lower loan growth. Since then, the PBoC has also
announced two 50 basis point increases in the deposit reserve rate, on December
8 and January 16, and a 27 basis point hike in the benchmark one-year deposit
rate, on December 20. (One basis point is 0.01 percentage points.)
Surprisingly, however, China's bond markets seem not to have noticed the
monetary authorities' new inflation-fighting resolve. Since the beginning of
November, yields on exchange-traded government bonds have fallen for all
maturities, while the Shanghai Stock Exchange bond-price index has been in
record-high territory since the end of January. (Bond prices move inversely to
yields.)
None of this is consistent with expectations of tighter money. The drop in
yields seems to reflect not only a "flight to safety" following January's stock
market drop but also doubt that policy can be tightened given the recent cuts
in US interest rates, last month's snowstorms, and the worsening of the
"subprime crisis".
From appropriate to tight
Last year the PBoC's efforts to keep the money supply under control relied
primarily on central bank paper sales, deposit reserve rate increases and
interest rate hikes. The problem with these measures is that they do not
address the root cause of China's excess liquidity problem - massive inflows of
foreign exchange resulting from the trade surplus, foreign investment, and
currency speculation, which would require a stronger currency rather than
higher interest rates to correct. As it turned out, what would ordinarily have
constituted monetary tightening wasn't even enough to maintain the status quo.
Since January of last year, the PBoC has raised the one-year deposit rate six
times, from 2.52% to 4.14%. The central bank has also increased the deposit
reserve rate (the percentage of deposits that banks are required to hold as
central bank reserves) eleven times, from 9% to 15%, a 20-year high. And the
PBoC's most recent monetary policy report, for the third quarter of 2007,
showed a net withdrawal of 900 billion yuan (US$125 billion) from circulation
through central bank paper sales for the first nine months of the year,
bringing total CBP outstanding at the end of September to 3.9 trillion yuan.
Even after all this "appropriate tightening", the report revealed that the
banks held central bank reserves in excess of the deposit reserve requirement
equal to 2.80% of deposits, up from 2.52% a year earlier. The latest readings
on prices and the money supply are also now well outside the PBoC's comfort
zone. December consumer price inflation came in at an alarming 6.5%
year-on-year, up from the December, 2006 level of only 2.8%, while last month's
year-on-year (M2) money supply growth rate of 18.94% was up 2.22 percentage
points from December and 3.04 percentage points from January, 2007.
Under the new "tight" policy, the monetary authorities have now begun using
more aggressive "window guidance" to control lending. This year, new commercial
bank loans may not exceed total new lending for 2007, implying full-year loan
growth of 13.9% or less. (The figure for January was 16.7%, up from 16.1% in
December.) Unlike last year, this target is to be applied on a
quarter-by-quarter basis, rather than annually. And it has also been reported
that banks exceeding their quotas may be forced to buy central bank paper at
below-market interest rates in the amount of their excess lending.
The yield gap
But there are three good reasons to be skeptical that the new policy will be
continued for long. First, most of the world's other central banks are now
easing and, following 225 basis points of cuts by the Federal Reserve since
last September, US dollar interest rates have fallen considerably below many
comparable yuan rates. In the absence of significant yuan appreciation, this
can only lead to increased foreign currency inflows and continuing excess
liquidity, as anyone who can do so (eg Chinese corporates) will move funds on
shore to take advantage of both the higher rates and a seemingly one-way bet on
the currency.
While commentators often use the gap between Chinese and US policy rates as an
indicator of the dollar-yuan interest rate differential, this comparison is
misleading because the maturities involved are different. The PBoC targets a
one-year deposit rate, while the Federal Reserve is targeting an overnight
rate. The 114 basis point gap between the PBoC's benchmark (4.14%) and the
Fed's target (3.0%) is partly just a consequence of the general tendency for
longer maturities to enjoy higher rates - ie for the yield curve to be upward
sloping. (The yield curve shows the yields on a series of bonds as a function
of their maturities with the yields on the vertical axis and the maturities on
the horizontal.)
A better way to see the PBoC's dilemma is to compare rates on debt with the
same maturity and similar counterparty risk. In the case of the Fed funds rate,
a good comparison might be with the overnight Shanghai Interbank Offered Rate
(SHIBOR) while for longer maturities it makes sense to compare yields on
exchange-traded government bonds. From these, yield curves for both countries
can easily be drawn with six-month and one-, two-, three-, five-, seven-, 10-,
20-, and 30-year maturities. (The curves described below use data from the US
Treasury's website, which lack an equivalent for the Chinese 15-year maturity,
and the China Government Securities Depository Trust & Clearing Co's
chinabond.com.cn site, which lack equivalents for the US one- and two-month
maturities.)
Since the PBoC began implementing the new tight policy last November, the Fed
funds rate has been cut three times, from 4.5% to 3.0%, pushing down six-month
to seven-year US treasury yields by an average of 158 basis points from
November 1 to February 15. As a result, the gap between the short ends of the
US and Chinese yield curves has widened considerably.
At 2.1937% (as of February 15) overnight SHIBOR, although still well below the
Fed's 3% target, has gone from 158 basis points below the Fed funds rate (on
November 1) to only an 81 basis point discount. US six-month through seven-year
yields have fallen dramatically relative to the same Chinese maturities and
while US-China 10-, 20-, and 30-year yield differentials have risen, the
magnitudes of these changes are much smaller. The average yield for US
six-month to seven-year maturities was 8 basis points below the equivalent
Chinese average on November 1 but by February 15 this had fallen to a 123 basis
point discount. For the 10's, 20's, and 30's, the average US yield moved from a
discount to the Chinese average of 25 basis points on November 1 to a premium
of 12 basis points on February 15.
Snowstorms and subprime fallout
A second reason for skepticism is last month's snowstorms, which did
considerable economic damage - ruining crops, shutting down factories and
damaging vital infrastructure, particularly the power grid, which is not
expected to get completely back to normal until the end of next month. The
resulting reduction in first quarter GDP growth is expected to be in the area
of one percentage point. This is hardly the time to cut off lending to the
small and medium-sized enterprises of the affected areas and it is the smaller
companies that will be the first to suffer when the banks start rationing
credit.
Finally, the rapidly worsening world economic situation may well solve the
PBoC's dilemma for it. If reduced demand for Chinese exports and slowing
foreign credit expansion following the subprime crisis result in a big enough
decline in forex inflows, China's excess liquidity problem will go away by
itself without the PBoC taking any action at all.
This appears to have been the view of many of the respondents to a recent
survey of Chinese institutional and individual investors carried out by the
Securities Times and the financial news website Panorama (p5w.net). Comments by
President Hu Jintao at the end of last month emphasizing the importance of
"handling the pace and intensity of macro adjustment on a scientific basis" and
stressing the desirability of "maintaining stable and relatively fast growth
for as long as possible" were seen by about 70% of the survey group as a signal
that macro controls will be relaxed; 50% believed that due to the global
economic slowdown monetary policy will be less tight in 2008, while 20% even
expected CPI inflation to be lower this year than last.
Deciphering the curve
While the US yield curve has steepened since November - ie short rates have
fallen more than long ones - in China the entire curve has shifted downward.
From November 1 to February 15, overnight SHIBOR has fallen 72 basis points
while government bond yields are down by an average of 54 basis points for all
maturities. The steepening in the US is what is normally seen following
monetary easing - since the Fed targets short-term rates, the effect is most
pronounced at the short end. The decline in long-term rates tends to be
relatively smaller as monetary stimulus can potentially lead to an eventual
rise in inflation, which reduces the value of future interest payments in real
terms.
The downward shift in the Chinese yield curve, on the other hand, is hard to
interpret as a response to monetary tightening. The PBoC's deposit reserve rate
increases ought to have elevated the short end by reducing the supply of
short-term funds in the banking system while the higher one-year deposit rate
should at a minimum have pushed up the one-year yield. And if the new tight
policy is expected to continue for the foreseeable future, why have long-term
yields fallen?
What the Chinese bond markets seem to be telling us is that, as long as US
dollar rates stay low, tightening won't work while if the subprime crisis leads
to a severe global economic downturn tighter money won't even be desirable. The
monetary authorities really have only two options in their fight against
inflation - either allow much faster currency appreciation or do nothing and
hope that the slowing world economy will solve the problem for them. The
downward shift in the yield curve can thus be seen as a signal that the "tight"
approach announced at last December's economic work conference may soon have to
be replaced by the authorities' original "appropriately tight" monetary policy
stance.
Mark A DeWeaver, PhD, worked as a research analyst in Shenzhen from
1991-1995, first for W I Carr and later for Peregrine Brokerage. He manages
Quantrarian Asia Hedge, a fund that invests in Asian equities and related index
products (on the web at www.quantrarian.com), and can be reached at deweaver@quantrarian.com.
(Copyright 2008 Mark A DeWeaver. Used by permission.)
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