Market Views: Fixed Income
China: Pressures are escalating
Government stimulus has done little to restore investor confidence and capital flight has accelerated. There remain serious contradictions in policy that need to be addressed.
The negative tone which prevailed in emerging markets (EM) at the end of last year continues to dominate.
The traditional year-end rally failed to materialise in 2015 and the new year is also starting with renewed pressures on a number of EM assets.
This lack of respite shows that the long-term EM bear market is still in place.
The lack of respite is particularly evident in China, where the government’s stabilisation measures implemented in the aftermath of the summer 2015 stock market crash have done little to restore investors’ confidence.
The renminbi remains under severe pressures and capital flight has accelerated, as evidenced by the continued rapid contraction in FX reserves.
Judging by the current level of FX reserves as % of money supply (M2), the resources available to the central bank to defend the renminbi are diminishing quickly (see charts below).
This rapid contraction in FX reserves has not yet led to a visible domestic liquidity crunch.
Any upward pressures on onshore rates in the next few weeks should be viewed as a sign of renewed liquidity tightening, which in turn would increase the risk of a disorderly financial crisis.
These signs of a liquidity squeeze have already appeared in the offshore market, where the overnight CNH deposit rate briefly spiked to 65% this week (before settling down to more reasonable levels at this time of writing).
We have highlighted previously that China’s economic woes have become widely publicised.
Some positive policy inflexions also occurred in recent months, especially with regards to reducing inventories and excess supply in some sectors of the economy.
However, there are serious contradictions in the policy prescription that authorities appear to have adopted.
This has created a perception of policy flip flop and has exacerbated fears that authorities are losing control.
The most serious policy contradiction is related to the fact that authorities are easing monetary policy with one hand (cuts in reserve requirement, policy rates and a debt exchange) but are forced to tighten with the other hand. This forced quantitative tightening can be seen in the contraction in the balance sheet of China’s central bank (see charts below).
The contraction in the PBOC’s balance sheet is the direct result of the decline in its foreign assets (i.e. FX interventions to support the currency).
As a result, narrow money supply measures are also contracting.
In order to arrest this de-facto quantitative tightening, there will ultimately be a need to stop FX interventions.
In other words, pursuing the dual objective of monetary reflation and FX targeting is unsustainable.
Based on historical precedents in other countries, this policy contradiction has often been resolved by a change in FX regime (which involved a maxi devaluation). China will ultimately be forced to make this choice.
The problem is that given the policy ammunitions that Chinese authorities can still use to defend their current stance (moral suasion, repression, capital controls, further drawdown in FX reserves, current account surpluses), this required change in FX regime may still take time to be completed.
The unfolding crisis still appears to be more of a “slow motion crash” rather than the “sudden stop” experienced in other previous EM currency crises.
However, we have to be prepared for this disorderly outcome given the recent signs of failure in the various measures already implemented to contain capital flight.
A broadly cautious investment stance, with a particular focus on liquid EM assets (i.e. which can be sold easily and quickly), remains warranted. For this reason, we continue to avoid the credit space.
The required adjustment that Chinese authorities are continuing to “artificially” supress has already been reflected to a large degree in EM currencies and in selected local bond markets, which have collapsed substantially.
There are compelling pockets of value in these sectors but the upside potential is likely to remain difficult to unlock until China’s monetary and foreign exchanges policies become more coherent and more credible.