What’s a China “policy put”?
Unlike most developed markets, Chinese central bank (PBOC) operates more like a part of the government rather than an independent organization. Its official objectives include maintaining financial stability and performing functions prescribed by the State Council. Along with the major state-owned banks and policy banks, PBOC has funded government’s fiscal expansion in the past decade, attempting to smooth the economic cycles and to stabilize job market. While most of the traditional central banks in developed markets have similar goal at the end, inflation target has been their main priority. China however is a command economy with the state, rather than the market, being the most influential force driving growth and cycles. It’s easier and more promising for the government to coordinate the funding for its fiscal projects, instead of leaving this task to the invisible hands. As the banks’ credits were channeled to infrastructure and community projects undertaken by state-owned enterprises and local governments, China’s excess credit – as measured by the credit growth, or the growth of total social financing (TSF), in excess of nominal GDP growth – swung in the opposite direction of the fundamental economic trend (chart 1). Investors see this proactive government strategy as a “policy put”.
Lesson of previous policy put
The most obvious result of China’s policy put is the surge of leverage (chart 2). Between 2007 and 2018, TSF rose from about 120% of GDP to almost 215%, and debt to GDP rose from about 160% to over 260% (2017). In the first wave of stimulus in 2009, the government successfully cushioned the economic downturn. After the economy was stabilized and real GDP growth landed at 10% levels, the country only managed to slow down the leverage increase but didn’t reduce the leverage built up in previous years. Then the second wave of economic downturn arrived in 2012 as real GDP growth dropped to high 6% range till 2015. In this period, the leverage resumed and although this soft landing was successful in stabilizing growth, it eventually contributed to one-notch downgrade of its sovereign rating by both S&P and Moody’s in 2017. In this period, consumer prices remained very steady given that the government was actively controlling the prices of goods and services, but the wages rose steadily nevertheless. To the contrary of the consumer prices, asset prices have been volatile. China newly built commercial residential price index (new-built is the most active market in China) went through 3 major cycles ranging from about -5% to +10% during this period, despite of an extraordinary amount of austerity measures put in place for the property market. The wealth effect created by the excess credit growth boosted demand of foreign goods, foreign investments and outbound tourist spending. This partly contributed to gradual dissipation of current account surplus, decline of the foreign exchange reserves, and pressure on the exchange rate. On 11 Aug 2015, USDCNY depreciated by 3% to 6.39 in a single day, and the exchange rate further tested 7.0 in 4Q 2016. During the period, the government introduced various administrative measures on the currency exchange and capital control, which successfully stabilized the exchange rate.
The credit fueled fiscal stimulus orchestrated by the PBOC is a powerful counter-cyclical policy tool and it is very effective in creating jobs and stabilizing economic growth, but ultimately, we think the capacity for China to implement its policy put is constrained by the layman maintaining their confidence in the currency. Accordingly, it’s essential for the government to maintain a tight capital control. As the government institutionalizes tight capital control, surplus liquidity trapped in the country could be difficult to be contained and it could result in volatile asset prices.
Investment implication for 2019: Don’t fight PBOC
In 2019, China’s economy faces new challenges from many facets both internally and externally, and this underpins our view that we should see another policy put. In fact, we might have already seen a bit of it, given that for the first two months in 2019, net new credit deployed to long term corporate loans has already reached the level of 2H 2018 (chart 3). PBOC and the Chinese banks are ready to support the economy by extending credits to government projects and mending the credit transmission mechanism so that credits could be flowed to the required segments of the economy, in case of further risk escalation such as the trade negotiation with the US turning sour. The key investment implication of this policy put is that we should not be too bearish about China, including CNY, China government bonds and China credits. In particular, China government has a tight control on the exchange rate through administrative measures, and the CNY may or may not fluctuate along with the country’s fundamental.
We need to be watchful that some of the policy put may already be in the price, and there are a few moving parts globally, such as US-China trade negotiation and expectations of Fed’s policy stance. Among the major FICC asset classes in China, we see decent asymmetry in RMB-denominated bonds due to a dovish PBOC and potential appreciation if a deal is reached, which is the reason why we are moderately constructive towards such bonds on an unhedged basis. Outside China, we expect the policy put, if we see one, may benefit capex commodities (e.g. copper, iron ore and steel) and the countries exporting these commodities.