It's Time To Start Worrying About China Again
One year ago, S&P futures would tumble the second a flashing red headline noted that things involving China, the Yuan, or the PBOC were not playing out as expected. One year later, the market has forgotten it ever cared about the world’s biggest debt bubble.
However, the time may have come to once again start worrying about China.
With China coming back from its week-long holidays last Friday, a very important event took place under the radar, and was largely missed by the broader investing public masked by the relentless noise out of Washington and the January payrolls report: China has resumed tightening. For those who missed it, here is a recap of what we said first thing on Friday:
“this morning China announced an unexpected tightening of policy when it raised rates on 7, 14 and 28-day reverse repos by 10bps to 2.35%, 2.50% and 2.65% respectively. That’s the first increase in the 28-day contracts since 2015 and since 2013 for the other two tenors. Keep in mind that this is the first working day following the New Year holiday in China, so it seems to be a decent statement of intent by the PBoC.
Additionally, the SLF rate was increased to 3.1 percent from 2.75 percent. The implicit tightening sent Chinese stocks lower, with the Shanghai Composite closing down 0.6%, and accelerating the selloff in Chinese 10Y government futures.
While China’s first effective tightening in two years largely slipped between the market’s cracks, the press is starting to pay attention (“China’s central bank raised key interest rates in the money marketFriday, reinforcing a shift toward tightening monetary policy aimed atdeflating asset bubbles and reducing long-term financial risk.” MarketWatch, Feb 3; “China’s surprise increase in interest rates on medium-term loansweighed on bond prices. …Some traders were clearly rattled by China’s first-ever increase in interest rates for its medium-term lending facility (MLF) loans, which was seen as signaling that short-term funding costswill move higher eventually as authorities try to cool an explosive increase in debt.” Reuters, Jan 25).
To be sure, Friday’s explicit tightening followed several similar implicit actions by the government, which has been flashing warnings it would tighten and/or engage in deleveraging to slow down China’s stupendous ascent toward 300% debt/GDP, including a sharp slowdown in government spending which has collapsed from 20% one year ago to only 8% Y/Y at the end of 2016, the first slowdown in home price acceleration in 19 consecutive months following Beijing eagerness to pop China’s housing bubble, the recent hike in auto sales taxes from 5% to 7.5%, and so on.
China’s sudden tightening move, which according to many will end the single biggest catalyst for the global reflation/growth story of 2016, namely China’s dramatic debt-fueled growth impulse which in turn then spilled over to the rest of the world, has already been dubbed as “The Most Important Unnoticed Global Event” by the likes of Cornerstone.
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And since China’s push to tighten financial is really that important, here again courtesy of Goldman, is a full recap of what happened, why it matters, and a breakdown of all the key Chinese acronyms to keep an eye on in the coming days as the PBOC is very likely to continue expanding its tightening bias into other monetary conduits.
PBOC raised interest rates on key monetary operations, further reinforcing tightening bias
On Friday, PBOC increased interest rates on OMOs (open market operations) by 10bp and on SLF (standing lending facility) by 10-35bp–shortly following the rise in interest rates on MLF (medium-term lending facility) less than two weeks ago. We believe that the PBOC will retain its tightening bias in the near term as the underlying financial-leverage and macroeconomic arguments for tightened monetary policy have largely remained.
Daily OMOs have been a key PBOC tool to manage interbank liquidity conditions.
The central bank on Friday increased the interest rates on reverse repo OMOs (liquidity injections) of 7/14/28-day tenors by 10bp (to 2.35%/2.50%/2.65%). The last time the PBOC raised OMO rates was more than two years ago in 2014.
The PBOC also increased SLF rates on overnight/7-day/1-month tenors by 35bp/10bp/10bp (to 3.10%/3.35%/3.7%).
SLF is collateralized lending by the PBOC to financial institutions which request funding (see Appendix table for key PBOC toolkit). SLF usage has been relatively small (e.g., in January, the turnover and outstanding balance of SLF were well below RMB 100bn, while those of OMOs were about 20 times larger at roughly RMB 2tn). But given that SLF is likely tapped only when the interbank funding conditions are particularly tight, the SLF rate increase should still matter for the marginal funding cost in the system. The asymmetrically large increase in the overnight SLF rate will likely be an encouragement for financial institutions to lengthen the maturity of their interbank funding (we estimate that small commercial banks’ interbank repo borrowing has an average maturity of only about 2 days).
Media reports also suggest that the PBOC has increased SLF rates further by 100bp for those banks that fail Macro-prudential Assessment (MPA) requirements. This has not been confirmed by the PBOC, however. As background, the PBOC set up MPA at the beginning of 2016 through which the central bank may fine-tune each individual bank’s required reserve ratio (RRR) on a quarterly basis depending on its performance based on several prudential metrics (see here for further official details of MPA).
The underlying financial-leverage and macroeconomic arguments for tightened monetary policy have largely remained. We continue to expect that the PBOC’s tightening bias will remain unless either i) there is a clearer deleveraging in the interbank funding market, and/or ii) economic activity slows materially.
Appendix table: OMOs and SLF play different roles in PBOC’s policy toolkit