Summary
Not only is the PBOC behind the curve, it also finds itself chasing a running target. The Fed’s policy pressure, money outflows, the dollar strength, the country’s high debt burden and deflationary tendency are all proving too much for policymakers, in our view. To avert a major crisis, there is growing pressure for a more drastic
approach, but by no means would it be guaranteed to work.
Fundamentals
On Saturday 27 June, the PBOC announced its 4th interest-rate cut since November 2014. Both lending
and deposit rates have been trimmed by 25bps to 4.85% and 2.00%, respectively. It has also reduced the reserve-ratio for city commercial and rural commercial banks by 50bps and for finance companies and non-bank financial
institutions by 300bps. Lu Lei, director of the PBOC’s research bureau, said this easing is aimed at lowering financing costs and stabilising investment expectations of both enterprises and households.
We had expected the PBOC to cutrates in mid-July when the government reveals the 2Q GDP results. But it seems policymakers could not afford to wait, especially when the stock market has plunged by more than 20% this month. There is a growing sense of panic in the market and a heightened sense of urgency in the government. As we have argued, the government has tried to drum up the stock market in order to maintain public confidence
and minimise social instability when economic fundamentals are not doing well. It has also tried to use it
to retain money when money is under pressure to leave the country. Even better, the stock market could
generate new cash for heavily indebted enterprises to pay for old debts. This strategy worked for a
while but has quickly come under challenge.
Fundamentally, we have our doubts about the effectiveness of monetary easing or stimulus measures. In our
view, monetary policy is not working, because: 1) money outflows have been accelerating, leading to a widening balance-of-payments deficit, 2) the PBOC keeps intervening in the forex market to stabilise the CNY, and 3) new credit creation keeps going to the stock market or to pay down debt rather than to support real activity.
Unless policymakers can break these constraints, like all other cuts in the past, we don’t think this cut will
make much difference. The only way to break one of these constraints is to allow the CNY to depreciate. This
would spare the need for the central bank to intervene in the forex market. Intervention to support its
own currency is effectively an act of tightening, thus defeating easing efforts.
Nevertheless, as we have long argued, allowing the CNY to slide is an act loaded with risk. The country is heavily exposed to dollar debt. It is the biggest dollar borrower outside the US. Currency depreciation could lead to a global
credit crisis. Perhaps this may be the ultimate policy choice – saving domestic borrowers by transferring
the pressure to foreign lenders.
The big picture we outlined in our recent report has notchanged. In this report, we argued that the stock-market
outperformance (until recently) was not justified by fundamental factors. We were concerned that there is a
heightened level of household leverage involved in this process rather than a more healthy development supported by long-term professional investors. China has been trying to muddle through a range of chronic issues.
This “muddling through” is at best a stable disequilibrium, in our view. We were worried that, if many
variables start moving, this could easily turn into an unstable disequilibrium. The USD trend may
well be one of those variables.
