If admitting you have a problem is the first step toward recovery, then China is making progress. The question is progress to what, because the generic answer, "another debt-fueled boom" is no longer applicable. Recall that as we noted here initially in the summer of 2013 [23], the very reason why China finds itself in a reformist quandary is that the traditional method of Chinese "growth" - issuing a little under $4 trillion in aggregate system debt per year - no longer works as the bad debt portion of the Ponzi scheme is rising at a faster pace than the total notional of debt itself.
Which means the PBOC, which cut rates for the first time in two years on Friday, will have its work cut out for it. And in the worst tradition of "developed world" banks, Beijing will now have no choice but to double down on the very same bad policies that got it into its current unstable equilibrium, and proceeds with a full-blown policy flip-flop, leading to a full easing cycle that reignites the bad-debt surge once more.
And sure enough, today Reuters reports [24]citing "unnamed sources involved in policy-making" (supposedly different sources than the unnamed sources Reuters uses to float trial balloons used by the ECB and the BOJ), that "China's leadership and central bank are ready to cut interest rates again and also loosen lending restrictions" due to concerns deflation "could trigger a surge in debt defaults, business failures and job losses, said sources involved in policy-making." In other words, China has once again looked into the abyss once... and decided to dig a little more.
The story is well-known: "Economic growth has slowed to 7.3 percent in the third quarter and policymakers feared it was on the verge of dipping below 7 percent - a rate not seen since the global financial crisis. Producer prices, charged at the factory gate, have been falling for almost three years, piling pressure on manufacturers, and consumer inflation is also weak."
Of course, in modern economics, deflation simply means deleveraging, which as we showed last weekend [25], is precisely what is happening to China's shadow banking sector every month in the prior quarter.
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And so, since deleveraging in China, which at least on goalseeked paper is growing a little over 7%, the Polibturo has no choice but to join all the other central banks in going all in on stimulative monetary policy.
Back to Reuters [24]:
"Top leaders have changed their views," said a senior economist at a government think-tank involved in internal policy discussions.
The economist, who declined to be named, said the People's Bank of China had shifted its focus toward broad-based stimulus and were open to more rate cuts as well as a cut to the banking industry's reserve requirement ratio (RRR), which effectively restricts the amount of capital available to fund loans.
"Further interest rate cuts should be in the pipeline as we have entered into a rate-cut cycle and RRR cuts are also likely," the think-tank's economist said.
Friday's move, which cut one-year benchmark lending rates by 40 basis points to 5.6 percent, also arose from concerns that local governments are struggling to manage high debt burdens amidst reforms to their funding arrangements, the sources said.
The good news for China, if only in the short term, China's housing bubble is about to be rekindled. "Top leaders had been resisting a rate cut, fearing it could fuel debt and property bubbles and dent their reformist credentials, but were eventually swayed by signs of deteriorating growth as the property sector cooled. Until then, they had persisted with targeted policy steps, such as cuts in reserve ratios for selected banks and liquidity injections into the banking system. But these failed to bring down borrowing costs for the corporate sector."
it also means the natural conduit of Chinese excess liquidity, the luxury segment of the US housing market, which as we have been tracking for the past 6 months is best exhibited by the Y/Y tumble in San Francisco [27]home prices...
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... is about to supercharged once again, as Chinese "investors" rush to the US to park the latest batch of hot Chinese money.
Alas, it means China's brief experiment with reflation by way of the stock market is now over, as the central-planners give up in their attempt to recreate US wealth allocation, and revert to the traditional Chinese housing bubble paradigm.
As to what it will mean for the economy, the jury is clearly out: the problem is that not pursuing bubble policies will eventually lead to mass social upheavals, something Beijing can not afford: "Employment still holds up, but corporate profits have been squeezed as producer price deflation bites, and it's unreasonable for banks to have hefty profits."
China's leaders also worried that a sharp economic slowdown could hurt employment and undermine public support for reforms. "Employment still holds up now, but it will definitely be affected if growth slows further," said Yin Zhongli, senior economist at the Chinese Academy of Social Sciences, a top government think-tank.
The central bank does not have the final word on adjusting interest rates or the value of the yuan. The basic course of monetary and currency policy is set by the State Council, China's cabinet, or by the Communist Party's ruling Politburo.
One other thing that China will also have to address now is the collapse in the Yen: as discussed here months ago, Asia is on the verge of a full-blown currency war involving a retaliation by both South Korea and China to Japan's monetarist lunacy. And since China just admitted it has a problem, why not go full-bore and devalute the Renminbi as Albert Edwards is convinced it will have to soon?
Of course, the rational readers out there will point out: what madness is this, for China trying to fix a problem by using the same policies that led to the problem in the first place? Well, that's true, however it hasn't stopped the Fed, the ECB or the BOJ yet. So China is merely joining the party.
Curiously, and paradoxically, one place that will suffer first as a result of the rate cut are China's banks. According to another Reuters update [29], "China's latest interest rate cut is set to dent the profitability of domestic lenders, especially mid-sized banks, which are already suffering from higher bad loans and a slowdown in profit growth."
The narrowing of interest rate margins will eat into lenders' profitability, with Cinda Securities' chief strategist, Jiahe Chen, predicting it will cut profits by up to 5 percent.
Interest margins generated from lending have already been shrinking for second-tier lenders, which have been squeezed by competition from online financiers and a rise in funding costs stemming from an industry tussle for deposits.
Fitch Ratings downgraded its credit rating of China Guangfa Bank, a medium-sized lender, two days before the rate-cut announcement, and said the level of off-balance-sheet lending among second-tier banks was a concern.
The squeeze on profits will make it tougher for lenders to raise capital to meet new international rules designed to protect depositors from banking collapses. Retained profits are one way in which banks can build up regulatory capital.
"In the past when Chinese banks disburse loans, they mainly relied on profits from their own capital to replenish their capital," Jiang Jianqing, chairman of China's biggest commercial bank, the Industrial and Commercial Bank of China Co Ltd 601398.SS 1398.HK, told a conference in Beijing on Saturday.
Another unidentified source is hardly as enthusiastic about the prospects for Chinese growth:
While the measures may ease the financing costs of these firms' existing loans, it is unlikely to encourage banks to write new loans to lower-rung borrowers, bankers said.
Smaller companies are considered high risk and banks do not want to increase their exposure to weaker borrowers, they said.
"At the moment banks have a lot of problems with them, they have higher rates of default ... we're suspicious of their creditworthiness, so we're very careful about lending to them," said a senior loan officer at a top-10 bank.
He declined to be identified because he was not authorised to speak to the media.
In a note released earlier today Barclays reaches the same conclusion:
Further interest rate liberalization squeezing NIMs: The more important action, in our view, was the PBOC further lifting the deposit rate ceiling from 1.1x to 1.2x the benchmark rates (BMRs). The PBOC also simplified the BMR categories by removing the BMR for 5-year deposits and reducing the benchmark lending rate categories to three from five. We expect that the banks may adopt differentiated deposit strategies with the larger banks likely to not fully float up to the new 1.2x deposit ceiling while the mid- and small-size banks are likely to immediately raise deposit rates to the new ceiling. Bank loans will likely also move to the new BMRs at repricing dates or at maturity when renewed.
Negative impacts likely on 2015 NIMs and profits: We analyze the impacts of the BMR cuts and the lifting of the deposit rate ceiling under two scenarios: 1) if banks all move to the new ceiling, we estimate that their 2015 NIMs and net profits would fall by 19bps and 12% on average but 2) if banks keep their deposit rates at 1.1x, the rate cuts would only reduce NIMs and net profits by 13bps and 9%. For individual banks, we expect BOCOM and CITIC Bank to be most negatively affected and BOC to be least negatively affected.
Market reaction: We expect the overall market to react positively to the PBOC’s actions, but China bank shares are likely underperform given the now lower NIM and profit growth outlooks. In fact, rate cuts and deposit rate ceiling increases in 2012 and 2008-09 mostly led to banks’ share prices declining on the day after the announcements. In the recent 2012 cycle, large banks’ shares underperformed the HSCEI in the next four months while those of mid-size banks underperformed for seven months before catching-up.
In short: the Chinese remedy will only make the underlying condition worse. But this is to be expected from an economy which, as Morgan Stanley observed [30], has already crossed into the "Minsky Moment" singularity.
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Just don't tell that to the algos, for whom the only thing more bullish than good news, is bad news.
