Confused By What's Going On In China? Goldman Answers All Your Questions

One day after China's rate policy unexpectedly decoupled with the Fed, and in light of recent developments in China's loan market discussed last night, Goldman's MK Tang writes that the firm has "received a number of inquiries on yesterday’s China money and credit data, as well as recent PBOC rate actions." To answer all lingering questions, Tang has published the following handy Q&A "to link these issues together by answering some of the key questions."

China: Q&A on money and rates

Q1. Didn't the PBOC suggest that its interest rate policy was partly tied to the Fed policy?

Yes, but it does not have to be. The PBOC did not raise rates on open market operations (OMOs) today (and also kept 7-day repo rate fixing broadly stable at 3.44%), despite the Fed hike overnight. This is in contrast to March 16, when the PBOC raised OMO rates by 10bp immediately following the increase in Fed funds rate.

Although the PBOC cited the Fed hike as a reason for its move on that occasion, domestic conditions (e.g., growth, inflation, financial leverage) seem to have been more important factors for its actual stance on interbank liquidity. Given the recent growth moderation from the very strong pace at the start of the year, announcements of tighter prudential policies from other agencies, and advancement in financial deleveraging (more on this below), the PBOC has in recent weeks signaled a less hawkish policy stance. In any event, we already expected an incrementally easier PBOC stance given the credit headwinds in the pipeline (see here) (Exhibit 1).

Another reason why the PBOC may feel less pressure to hike is that the pace of FX outflow has slowed partly on tighter capital control. This increases the scope for China’s interest rate policy to be independent (as a reminder: according to the “impossible trinity” thesis, a less open capital account allows a country to maintain an independent monetary policy even without a flexible exchange rate regime). We also note that the abrupt RMB appreciation two weeks ago as well as the USD soft patch could also help reinforce RMB sentiment and mitigate potential outflow pressure driven by higher USD rates, in lieu of a corresponding rise in domestic rates.

Exhibit 1: Interbank interest rates have trended down in the last several weeks

Source: CEIC

Q2. What is "financial leverage"? How is this different from shadow banking?

While there is no universally adopted definition on these concepts, it is useful to distinguish two types of leverage in China.

1. One is credit extended to the real economy (i.e., non-financial corporates and households). This includes i) transparent forms of financing (e.g., bank loans, corporate bonds), ii) traditional shadow banking credit (e.g., trust loans, entrusted loans, undiscounted bank acceptance bills), and iii) newer form of shadow credit (e.g., credit extended by funds and brokers’ special purpose vehicles but booked as equity investment). The first two components are included in the official credit data (TSF), while the third one may not be. In light of this, last year we introduced our "money-implied" credit measure which should also capture this last credit component. In recent months, policy tightening has prompted a much more rapid slowdown in this shadowiest credit component than those reflected in TSF, as we recently discussed (Exhibit 2).

2. The other type of leverage is related to financial institutions borrowing money to invest in financial assets such as bonds, and this is often referred to as “financial leverage”. This is different from the first form of leverage in that the borrowing does not directly go toward supporting the real economy (see our note here for more discussion). This is not reflected in either TSF or our own money-implied credit measure (both of which are intended to include credit extended to the real economy only). There is no comprehensive data on this sort of leverage, though one proxy could be the amount of interbank repo borrowing by fund institutions (Exhibit 3).

Exhibit 2: The part of credit to the real economy not captured in official data seems to have slowed particularly rapidly in recent quarters

Source: Goldman Sachs Global Investment Research

Exhibit 3: Fund institutions have borrowed heavily in the interbank repo market , suggesting high financial leverage

Source: CCDC

Q3. Why was M2 growth so weak in May? Is it because of financial deleveraging?

Yes, but not entirely. At 9.6%yoy, M2 growth in May was even slightly weaker than the previous lows in early 2015. And indeed, M2 data had also surprised on the downside in the previous two months. In a statement yesterday, the PBOC suggested that the M2 weakness was to a large extent due to a moderation in financial leverage (the second type of leverage discussed in question 2 above). In particular, M2 held by NBFIs (non-bank financial institutions) grew at a very slow 0.7%yoy, vs. 10.5%yoy growth in M2 held by the real economy.

The PBOC statement is in line with our assessment that the worst of financial leverage growth is probably behind us. Judging from the recent rate spreads in the interbank market (R007 minus DR007; i.e., general average repo rate less repo rate applied to banks only) and bond market (bond yields minus swap rates), liquidity pressures faced by NBFIs and the scale of bond positioning seem to have been meaningfully reduced in the past several weeks (Exhibits 4 and 5).

Exhibit 4: Premium paid by NBFIs to borrow in interbank has narrowed and become less sensitive to underlying liquidity conditions

Source: WIND
Exhibit 5: Bond valuation (relative to swap) has also become less over-valued

Source: CEIC
That said, financial deleveraging does not seem to have been the only major reason for the slow M2 growth. A slowdown in liquidity accrued to the real economy (i.e., the first type of leverage discussed in question 2) also seems a likely key contributor (Exhibit 6). In particular, our proxy for M2 held by the real economy has been trending downward since late 2016 and probably fell much further in May, given information from the PBOC statement (our proxy is the sum of cash in circulation, and household and non-financial corporate deposits). The weakness in M2 held by the real economy is a particularly strong signal for slower credit extended to the real economy, because some other key forms of the real economy's financial savings (e.g., wealth management products, insurance products) are apparently also under pressure, given various regulatory tightening measures. Conceptually, a lower level of the real economy’s total financial savings (deposits plus non-deposit financial savings) is a likely reflection of less credit extended by the financial system to the real economy. This suggests that the trend of overall credit (including also credit not captured in TSF) extended to the real economy might have been softer than suggested by official credit data (we do not have sufficient data to update our money-implied credit measure beyond Q1 yet). If so, this would be a continuation of the pattern from Q1 and in line with our view for continued drag on credit given the past rise in market rates.

Exhibit 6: M2 held by the real economy has been decelerating since late 2016, and probably slowed further in May

Source: PBOC, Goldman Sachs Global Investment Research

Q4. What is the outlook for interbank rates?

We continue to expect interbank liquidity to be kept at a fairly stable level as in recent weeks, given slower growth momentum, material progress in financial deleveraging and a tightened capital control that can limit outflow pressures from higher US rates. Moreover, on a forward-looking basis, we expect the past increase in market rates to continue feeding through to actual lending rates (Exhibit 7), which could slow credit further. This argues for slightly easier interbank rates (as what we have already seen in the last few weeks) to pay for insurance against the credit headwinds in the coming months.

On the other hand, given the cyclical strength in export demand, less leakage via FX outflow as well as an apparently stronger politically-driven willingness of local governments to support demand, economic activity could continue to perform fine despite the ongoing credit slowdown. For commodity demand in particular, our commodity team colleagues have suggested that bank loans (which have remained solid) may matter more than other forms of credit (which has slowed more rapidly). Overall, in our view, significant pre-emptive accommodation seems unlikely—we may not have any major monetary easing unless weakness in growth materializes.

Exhibit 7: Market interest rates tend to lead bank lending rates by roughly 6 months

Source: PBOC, CEIC, Goldman Sachs Global Investment Research