It does appear that the Chinese government is now loosening monetary conditions in the country in a bid to combat a slowing economy and heightened trade tensions with the United States. This comes as a deviation from Beijing's financial de-leveraging / de-risking campaign, which has been ongoing since late 2016.
The Chinese economy has been showing signs of fatigue as the first half of 2018 has come to a close.
Investment in real-estate in China weakened for a third consecutive month to 9.7% growth in the year of 2018 through June. While this was above the 2017-through-June value of 8.5%, it marked a drop of 0.5 percentage points month-on-month, and the metric is now 0.7 percentage points lower from a peak of 10.4% growth in the first three months of the year, in annualized terms.
In another concerning sign, the new orders portion of the China non-manufacturing purchasing managers' index (PMI) recorded its second consecutive fall in June to a value of 50.6. The 50.0 mark separates expanding activity (above 50) from contracting activity (below 50). In this instance, new orders are still expanding, but just barely as the metric floats above the threshold.
The drop-off in June appears to have been rather pronounced, with the new orders index falling 0.4 points to 50.6. It could be argued that Chinese companies and individuals became concerned with the escalating trade rhetoric from the United States in May and June, and therefore fewer new orders were submitted. The PMI data for July will be watched keenly for signs of continued falls in this new orders index, as early July marked the first implementation of U.S. tariffs on $34 billion of Chinese goods, with immediate Chinese retaliation of the same magnitude.
The Chinese economy has been heavily reliant on credit to maintain high growth rates since the global financial crisis, and this has left it with a substantial debt load.
From the first quarter of 2015 to the first quarter of 2017, total private non-financial sector credit (all sectors) as a percentage of GDP jumped from roughly 190% of GDP to over 210% of GDP- quite an acceleration for the world's second-largest economy.
In late 2016, the Chinese government announced its intention to pursue a campaign of financial deleveraging and de-risking, an effort that authorities hoped would lower debt levels and close out opaque areas of financing, namely the shadow banking sector. As this campaign has plowed on, debt as a percent of GDP has fallen from a peak of 211.1% in the first quarter of 2017 to 189.8% in the first quarter of 2018.
That improvement, while still leaving the debt nearly double the annual output of the Chinese economy, is nothing to shake a stick at. This deleveraging campaign has put a dent in the credit-hungry habits of Chinese corporations and local governments (households maintain a debt-to-GDP ratio of less than 50%, per the BIS). This progress has come at the cost of economic growth, as the above data show. The side effect of a slowing economy was expected, as credit dried up and firms that truly relied on cheap credit to function began to struggle, but the slowing economy is now testing the resolve of the authorities. Beijing can either choose to continue tightening financial conditions and continue ahead with the deleveraging campaign, or the government may opt to pause the campaign and loosen monetary conditions to keep economic growth elevated, hoping that the stimulus does not destabilize the economy through asset price bubbles or other factors.
It now appears that Beijing has chosen to go with the latter option, as onshore financial conditions have undoubtedly eased during the first half of 2018. For evidence of this, we begin with interbank lending rates in China, benchmarked by the Shanghai Interbank Offered Rates or SHIBOR.
Traditionally, across global interbank lending markets, higher rates are a potential sign of stress, as banks may become less willing to lend to each other, thereby increasing the interest rates. Similarly, a flood of cheap credit may make banks rather lax about lending money, knowing their financial system is awash in liquidity (at least on the surface), and thus they reduce the interest rates at which they're willing to lend money.
The most-watched slice of the interbank rates is the overnight tenor, abbreviated above as O/N. This is the interest rate Chinese banks are charging each other to lend money simply for the overnight period. In the U.S., such overnight lending is primarily used for banks to maintain certain capital thresholds at the end of the day, for regulatory purposes. While I would assume the same can be said in China, I cannot say this for certain.
In any case, across tenors, interest rates have been falling. This trend has been most pronounced in the longer-term tenors, where rates are more stable. In particular, the interbank lending rates for periods exceeding 1 week (abbreviated as 1W above) really plunged around late-May or early-June, just eyeballing the graphs. I expect that these lower interbank interest rates surfacing around the time of escalating trade tensions with the United States is not a coincidence in the slightest, and instead is an effort by the Chinese government to cushion enterprises against any outsize effects from the U.S. tariffs.
Lending rates across all tenors, including overnight, have recently been falling yet again, with interest rates at the two-week period and beyond reaching >five month lows. This is another symptom of further monetary easing engineered by the Chinese government, which is now seeking to toe the line between supporting economic growth and deterring a resurgence of risk appetite as credit is re-introduced to the system. With trade tensions remaining elevated and the U.S. threatening tariffs on practically all of its imports from China, Beijing will likely continue keeping the deleveraging campaign in a holding pattern, instead preferring to support the economy via stimulus measures (both monetary and fiscal).
Chinese local-currency sovereign bond yields have also recorded significant drops across the entire yield curve year-to-date, again a symptom of financial conditions easing instead of tightening. In an environment of tightening financial conditions, yields on bonds increase as credit in the financial system dries up, making money less readily available and thus placing a premium on attaining such money. This had been a feature of the Chinese financial system from late 2016 to early 2018, when the 10-year sovereign bond yield peaked at just over 4.00%, but since then yields on these bonds have fallen.
The yield curve can be used to determine the cause of these falling interest rates. Recall that interest rates in the longer-term end of the yield curve are primarily influenced by expectations for future economic growth, inflation and similar large-scale economic factors. In contrast, interest rates at the short-term end of the yield curve are more influenced by shorter-term economic and financial events; it is for this reason that the Italian 2-year sovereign bond yield exploded higher by a greater number of basis points than the 10-year yield did when political instability (a short-term factor, not a long-term factor like the business cycle) hit in May.
Year-to-date, the one-year Chinese local-currency sovereign bond yield has seen the steepest drop in basis points across the yield curve, falling 84 bps to stand at 2.98% as of the above image. In contrast, far tamer falls have been observed in the multi-year tenors, where the YTD basis points move has been confined to roughly 40.
Using the 'separation' of the yield curve explained in the second paragraph above, it is safe to determine that the significant fall in short-term yields relative to long-term yields stems from Chinese expectations and/or consequences of the government loosening financial conditions yet again to support the economy. It's the same situation as when short-term U.S. Treasury note yields rise in response to a Federal Reserve interest rate increase, but the 10-year and 30-year yields may barely budge; monetary policy primarily plays out in short-term interest rates.
Elsewhere in financial markets, the Chinese yuan (renminbi/Rmb) has rapidly depreciated against the U.S. dollar since mid-June, with the exchange rate jumping from Rmb 6.40 per US$ to Rmb 6.80. Much talk of the yuan has stemmed from U.S. President Donald Trump's accusation of currency manipulation by Beijing; whether or not that is the case is not to be decided in this post. Rather, the weakening of the yuan since April is another sign of easing financial conditions in China.
The gradual strengthening of the yuan throughout (at least) the second half of 2017 in the above image is not a fluke, but can be attributed to the tightening financial conditions observed in China throughout 2017 (for evidence, see the reduction of credit in the second half of 2017 from earlier in this post). In economic theory, the reduction of easily-available money in the Chinese financial system makes the remaining currency more valuable to hold, consequentially making that currency (the yuan) appreciate. This played out according to that script in 2017 as cheap credit dried up.
Now, as Beijing appears to relax financial conditions, the yuan has depreciated once again. It is necessary to consider that the depreciation in the yuan here may also be due to a variety of factors, such as trade tensions with the United States, a resurgent U.S. dollar amid U.S. economic outperformance relative to the world (especially the E.U.), overarching concerns about the slowing domestic economy, and even policy interest rate differentials with the U.S. No matter the amalgamation of factors that have contributed to the yuan's weakness in the second quarter of 2018, the easing of Chinese financial conditions has likely played a part.
Lastly, the renewed easing of Chinese financial conditions recently (as per the new leg down in most SHIBOR interest rates) has likely played a non-trivial role in the rebound of Chinese equities. The Shanghai Composite closed out June by entering a technical bear market, defined as a 20% drop from a recent peak. The above chart shows this sudden drop in mid-June, before the bleeding finally stopped in early July.
Since that nadir, the Shanghai Composite has drifted upwards, gaining as much as 200 index points as of this typing. Again, a number of factors may have contributed to this rebound, but this time it's a little less opaque than analysis of the yuan's moves. On one hand, Chinese stocks rebounded despite no material improvements in U.S. / China trade tensions. It is plausible to consider that the higher stock prices reflect optimism from investors that domestic companies will be able to take advantage of the depreciated yuan and see a boost in exports, but this assumption is destabilized when considering the still-murky final impacts of the still-unfolding U.S. / China trade tensions.
The rebound in the Shanghai Composite came despite the release of rather pessimistic Chinese economic data in mid-July; a brief dip was seen, but the index has more than erased those losses. For these reasons, I'm led to believe that Chinese stocks have benefitted in a non-trivial way from the government easing financial conditions within the last several weeks.
--
As the Chinese government continues its balancing act of supporting the economy but discouraging irrational investment activities, further gradual easing of domestic financial conditions are expected. The U.S. Federal Reserve is expected to continue increasing interest rates this year and next - in addition to continuing its balance sheet normalization program -, while the European Central Bank will end its asset purchase program at the end of this year. Both actions will see global liquidity continue to dry up, tightening global financial conditions in general.
With Beijing showing its desire to support economic growth at the expense of delaying further progress in the financial deleveraging / de-risking campaign, further easing of domestic financial conditions looks probable. Chinese stocks and bonds look set to benefit further, absent an unexpected deviation from the path.
Andrew
The Chinese economy has been showing signs of fatigue as the first half of 2018 has come to a close.
 |
| Source: China National Bureau of Statistics |
 |
| Source: China National Bureau of Statistics |
The drop-off in June appears to have been rather pronounced, with the new orders index falling 0.4 points to 50.6. It could be argued that Chinese companies and individuals became concerned with the escalating trade rhetoric from the United States in May and June, and therefore fewer new orders were submitted. The PMI data for July will be watched keenly for signs of continued falls in this new orders index, as early July marked the first implementation of U.S. tariffs on $34 billion of Chinese goods, with immediate Chinese retaliation of the same magnitude.
The Chinese economy has been heavily reliant on credit to maintain high growth rates since the global financial crisis, and this has left it with a substantial debt load.
 |
| Data from BIS |
In late 2016, the Chinese government announced its intention to pursue a campaign of financial deleveraging and de-risking, an effort that authorities hoped would lower debt levels and close out opaque areas of financing, namely the shadow banking sector. As this campaign has plowed on, debt as a percent of GDP has fallen from a peak of 211.1% in the first quarter of 2017 to 189.8% in the first quarter of 2018.
That improvement, while still leaving the debt nearly double the annual output of the Chinese economy, is nothing to shake a stick at. This deleveraging campaign has put a dent in the credit-hungry habits of Chinese corporations and local governments (households maintain a debt-to-GDP ratio of less than 50%, per the BIS). This progress has come at the cost of economic growth, as the above data show. The side effect of a slowing economy was expected, as credit dried up and firms that truly relied on cheap credit to function began to struggle, but the slowing economy is now testing the resolve of the authorities. Beijing can either choose to continue tightening financial conditions and continue ahead with the deleveraging campaign, or the government may opt to pause the campaign and loosen monetary conditions to keep economic growth elevated, hoping that the stimulus does not destabilize the economy through asset price bubbles or other factors.
It now appears that Beijing has chosen to go with the latter option, as onshore financial conditions have undoubtedly eased during the first half of 2018. For evidence of this, we begin with interbank lending rates in China, benchmarked by the Shanghai Interbank Offered Rates or SHIBOR.
 |
| Source: Shibor.org |
The most-watched slice of the interbank rates is the overnight tenor, abbreviated above as O/N. This is the interest rate Chinese banks are charging each other to lend money simply for the overnight period. In the U.S., such overnight lending is primarily used for banks to maintain certain capital thresholds at the end of the day, for regulatory purposes. While I would assume the same can be said in China, I cannot say this for certain.
In any case, across tenors, interest rates have been falling. This trend has been most pronounced in the longer-term tenors, where rates are more stable. In particular, the interbank lending rates for periods exceeding 1 week (abbreviated as 1W above) really plunged around late-May or early-June, just eyeballing the graphs. I expect that these lower interbank interest rates surfacing around the time of escalating trade tensions with the United States is not a coincidence in the slightest, and instead is an effort by the Chinese government to cushion enterprises against any outsize effects from the U.S. tariffs.
Lending rates across all tenors, including overnight, have recently been falling yet again, with interest rates at the two-week period and beyond reaching >five month lows. This is another symptom of further monetary easing engineered by the Chinese government, which is now seeking to toe the line between supporting economic growth and deterring a resurgence of risk appetite as credit is re-introduced to the system. With trade tensions remaining elevated and the U.S. threatening tariffs on practically all of its imports from China, Beijing will likely continue keeping the deleveraging campaign in a holding pattern, instead preferring to support the economy via stimulus measures (both monetary and fiscal).
 |
| Source: AsianBondsOnline |
The yield curve can be used to determine the cause of these falling interest rates. Recall that interest rates in the longer-term end of the yield curve are primarily influenced by expectations for future economic growth, inflation and similar large-scale economic factors. In contrast, interest rates at the short-term end of the yield curve are more influenced by shorter-term economic and financial events; it is for this reason that the Italian 2-year sovereign bond yield exploded higher by a greater number of basis points than the 10-year yield did when political instability (a short-term factor, not a long-term factor like the business cycle) hit in May.
Year-to-date, the one-year Chinese local-currency sovereign bond yield has seen the steepest drop in basis points across the yield curve, falling 84 bps to stand at 2.98% as of the above image. In contrast, far tamer falls have been observed in the multi-year tenors, where the YTD basis points move has been confined to roughly 40.
Using the 'separation' of the yield curve explained in the second paragraph above, it is safe to determine that the significant fall in short-term yields relative to long-term yields stems from Chinese expectations and/or consequences of the government loosening financial conditions yet again to support the economy. It's the same situation as when short-term U.S. Treasury note yields rise in response to a Federal Reserve interest rate increase, but the 10-year and 30-year yields may barely budge; monetary policy primarily plays out in short-term interest rates.
 |
| Source: MarketWatch |
The gradual strengthening of the yuan throughout (at least) the second half of 2017 in the above image is not a fluke, but can be attributed to the tightening financial conditions observed in China throughout 2017 (for evidence, see the reduction of credit in the second half of 2017 from earlier in this post). In economic theory, the reduction of easily-available money in the Chinese financial system makes the remaining currency more valuable to hold, consequentially making that currency (the yuan) appreciate. This played out according to that script in 2017 as cheap credit dried up.
Now, as Beijing appears to relax financial conditions, the yuan has depreciated once again. It is necessary to consider that the depreciation in the yuan here may also be due to a variety of factors, such as trade tensions with the United States, a resurgent U.S. dollar amid U.S. economic outperformance relative to the world (especially the E.U.), overarching concerns about the slowing domestic economy, and even policy interest rate differentials with the U.S. No matter the amalgamation of factors that have contributed to the yuan's weakness in the second quarter of 2018, the easing of Chinese financial conditions has likely played a part.
 |
| Source: MarketWatch |
Since that nadir, the Shanghai Composite has drifted upwards, gaining as much as 200 index points as of this typing. Again, a number of factors may have contributed to this rebound, but this time it's a little less opaque than analysis of the yuan's moves. On one hand, Chinese stocks rebounded despite no material improvements in U.S. / China trade tensions. It is plausible to consider that the higher stock prices reflect optimism from investors that domestic companies will be able to take advantage of the depreciated yuan and see a boost in exports, but this assumption is destabilized when considering the still-murky final impacts of the still-unfolding U.S. / China trade tensions.
The rebound in the Shanghai Composite came despite the release of rather pessimistic Chinese economic data in mid-July; a brief dip was seen, but the index has more than erased those losses. For these reasons, I'm led to believe that Chinese stocks have benefitted in a non-trivial way from the government easing financial conditions within the last several weeks.
--
As the Chinese government continues its balancing act of supporting the economy but discouraging irrational investment activities, further gradual easing of domestic financial conditions are expected. The U.S. Federal Reserve is expected to continue increasing interest rates this year and next - in addition to continuing its balance sheet normalization program -, while the European Central Bank will end its asset purchase program at the end of this year. Both actions will see global liquidity continue to dry up, tightening global financial conditions in general.
With Beijing showing its desire to support economic growth at the expense of delaying further progress in the financial deleveraging / de-risking campaign, further easing of domestic financial conditions looks probable. Chinese stocks and bonds look set to benefit further, absent an unexpected deviation from the path.
Andrew
