The soft July data have once again generated expectations of monetary easing from China. Goldman however thinks further monetary easing would have incrementally less of an impact and would come at the cost of financial stability. This diminishing impact, they argue, would result as overcapacity/oversupply restricts long-term borrowing demand and due to interest rate deregulation, which tends to move the long-term risk-free interest rate to a higher equilibrium, as seen in recent data. As the tradable sector continues to recover on the back of an improved global outlook, Goldman believes that a combination of sectoral policies aimed at easing financial stress and structural adjustment would be a better policy option. They do not expect broad macro easing or an interest rate cut in what remains of this year.
Goldman's Li Cui Explains...
Better global growth has supported recovery, while domestic demand is still soft
Recent data show that the impact of earlier policy easing was short-lived, and domestic demand has remained soft. For July, in particular, most indicators related to domestic demand – including investment, financing and imports – decelerated notably from the previous month. Industrial production held up but this was most likely a reflection of stronger exports rather than domestic momentum. While one monthly data point does not signify a trend, the underlying picture is clear: Chinese exports have seen a visible recovery since last year, cushioning the impact of the domestic slowdown, in line with our expectation.
Given soft domestic momentum, market attention has again turned towards the potential for further monetary easing, including liquidity easing and a cut in interest rates. However, recent experience suggests that monetary easing is likely to have a limited impact on the growth recovery, as we have argued elsewhere. The credit rebound in May-June and the decline in July were entirely driven by short-term borrowing. Long-term borrowing corresponding to corporate capex and infrastructure construction has been muted, and stands at 15.5%yoy, compared with 17.3% at the end of 2013. Thus, long-term investment has continued to decelerate despite monetary easing. Along with the elevated long-term borrowing costs discussed below, this suggests that monetary easing has yet to produce a lasting impact on economic demand. The relief through higher short-term loans has mostly benefited enterprises with working capital needs, in particular companies in sectors with overcapacity.
Monetary easing is likely to have incrementally less of an impact on growth, but a higher cost in terms of financial stability
Monetary conditions have eased since Q1. The 7 day repo has declined by over 200 bps from its peak in late 2013, The domestic component of our FCI index also eased, although the majority of the FCI easing still came through the weaker exchange rate from last year.
There are reasons to question the impact of monetary easing (liquidity easing or interest rate cuts, as some observers have recently proposed), not least given their limited impact on growth so far.
First, long-term interest rates have shifted towards a new 'equilibrium' level. This is a powerful counterforce to near-term liquidity easing. Monetary policy affects the economy mostly through its effect on long-term borrowing costs. Despite the significant decline in front-end rates, the long-term risk-free rate has remained well above 4%, more than 100bp higher than in 2013, pointing to a rise in the term premium. (We calculate the term premium for 5-year government bond yields as the difference between the actual rate and the implied 5-year rate from the short-term rate forecast. See Exhibit 1, see Asia Economics Analyst: China: Higher term premium challenging monetary easing, May 16, 2014).
In turn, bank lending rates have held up as banks faced higher funding costs. Lending rates on general loans rose from 7.0% to 7.3% between December and June (the latest data available).
Higher long-term interest rates mostly reflect interest rate deregulation, in our view. As the government pursues incremental steps towards interest rate liberalisation and reduces financial repression, savers start to enjoy higher returns on their savings. This means increased funding costs for banks, and for the economy as a whole. Long-term interest rates thus show limited downward flexibility, despite the liquidity easing. This means that interest rate liberalisation tightens financial conditions, and hence a more supportive fiscal stance and exchange rate, as well as regulatory adjustments, are likely needed to compensate for the effect.
Exhibit 1: The increase in term premium* offsets the impact of liquidity easing on long-term borrowing costs
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* The term premium is estimated as the difference between actual 5-year government bond yields and the yield implied by the short-term rate outlook estimated on the basis of Consensus Economics forecasts. For a detailed discussion, see Asia Economics Analyst: China: Higher term premium challenging monetary easing.
Second, the cost of monetary easing for financial stability is higher. A steeper yield curve tends to encourage interbank risk-taking (although such activities have declined due to the recent regulations). A cut in the benchmark deposit rate, which is already below the market rate, risks deposit outflows to higher-yield products (as observed most recently at end-June). This could increase liquidity and disintermediation risks for the banking system, without clear evidence that such a rate cut would help to bring down borrowing costs in the economy.
Third, long-term investment demand is constrained for reasons unrelated to funding costs. Domestic cyclical sectors (heavy industrials and property sectors) are still weighed down by overcapacity/oversupply, and fiscal measures have been selective and measured in general. The fiscal stance turned more supportive from May to June after the unusually contractionary stance in the January-to-April period, but the overall fiscal deficit is largely on par with the budget – there has been limited incremental expansion overall.
Policy balancing act has stayed on track, in part thanks to the higher cost of funding that has cooled leverage growth
We wrote at the start of the year that the macro policy agenda is unusually complex this year, and that the government needs to maintain stable growth, control credit expansion and curb tail risks, while at the same time pursuing structural reforms. On the positive side, the government has a large set of policy tools that allow it to address various policy priorities at the same time.
So far, the score-card for this balancing act has generally been positive:
- Leverage growth has continued to come down, while economic growth has held up (Exhibit 2). Higher long-term rates help to contain leverage growth and reduce inefficient investment. Growth in the non-leveraged sector – in particular, exports – has helped to support the economic recovery.
- Financial stress has declined, even though interest rate deregulation has continued. Financial tail risks as perceived by the market have come down substantially, measured using our financial stress indicators, which are compiled on the basis of financial market prices and spreads. Such declines reflected the more dovish central bank signals and the new regulations aimed at limiting risk-taking in the interbank market (Exhibit 3).
Exhibit 2: Total Social Financing (TSF) decelerates, while growth has remained stable
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Exhibit 3: Market perception of tail risks** has declined sharply on the back of improved regulation
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** These indices are combined on the basis of financial market prices and spreads, adjusting for economic cyclical positions. In particular, the interest rate risk index is the weighted average of the deposit rate and the 7-day repo rate. The credit risk index is the average of the yield spread for longer-term financing costs (corporate bond, AA-rated) over the government bond yield, and the yield spread of the short-term financing cost (bank acceptance bill rate) over the government bond yield. The liquidity risk index is the average of the spread of the 3-month interbank rate over the overnight repo rate, and the spread between bank bond financing and the risk-free rate.
Selective policy support to continue; we do not expect broad macro easing or an interest rate cut
On net, a tradable sector recovery, continued prudential rules to curb excessive risk-taking and targeted/selective policies should help to keep the balancing act on track, allowing the government to continue to pursue the structural agenda.
While we expect the general policy stance to remain accommodative, we do not expect significant further monetary easing. Indeed, as cyclical conditions improve, interbank rates are likely to drift up again and financial conditions could become tighter in H2. We do not expect an interest rate cut for the reasons discussed above.
Meanwhile, targeted policies to assist SME/agricultural sector borrowing, as well as further easing in housing-purchase-related, restrictions will continue. The PBoC may elect to use the PSL – or Pledged Supplementary Lending (a newly created facility to provide long-term liquidity to selected banks) – for specific sector support. Bond issuance by local governments is also likely to pick up to offset the expected dwindling of local land sales.
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Of course, Goldman has been modestly bearish on China for months and this merely confirms that view but their perspective (at a time when the Fed is pulling back) is notable in that it leaves the ECB as the only treaty-busting player in the room that can surprise (since the BoJ is hampered by both proven ineffectiveness, soaring misery, and inflation pain).
