China: Stimulus calibration underway
- Short-term rates recently reached near 6-year high amid PBOC liquidity withdrawals
- A sizeable cash injection before next month’s LNY holiday is unlikely
- Liquidity calibration could be accompanied by more credit calibration measures
- Implications for investors: Credit spreads of firms pursuing deleveraging should narrow, …
- … while highly leveraged firms could face pressures
The People’s Bank of China offered RMB100bn of reverse repos on Thursday, resulting in a net withdrawal of RMB150bn from the market. That added to its RMB178bn drainage from the past two sessions and came after the central bank mopped up medium-term liquidity earlier this month. The tension was further aggravated by reports that banks onshore had become reluctant to lend to each other, causing interbank interest rates to spike. The volume-weighted average rate of overnight repo climbed to 3.04% yesterday, the highest since April 2015. 7-day repo fixing rate has risen 59bps month to date, defying a seasonal pattern of decrease.
It signals a probable end to the PBOC’s accommodative stance over the past two months. While the fund injection since November has stabilized the onshore credit markets, excess liquidity risks further stoking leverage in the financial system. In particular, the daily turnover in overnight repos touched a seven-month high in early January as financial institutions rapidly increased their borrowing in order to engage in the bond carry trade. As a result of the cash withdrawal this week, the spread between China's 10-year government bond yield and the overnight rate has narrowed sharply to 14bps versus 269bps in late December.
The latest development reinforces our view that PBOC will normalize monetary policy this year. And recent data seem to endorse such a move, with industrial profit growth accelerating to 20.1% YoY in December. Export boom also continued last month, pushing the trade surplus to a record high. Market is scaling back bets for a sizeable liquidity injection before next month’s LNY holiday, with one-year interest rate swaps rising for the fifth session to 2.64%. Indeed, the recent resurgence of COVID-19 cases in some provinces may discourage Chinese residents from traveling over the holiday period, potentially reducing the demand for cash.
Quantitative to qualitative calibration
Quantitative calibration by the PBOC is easily observed, as market rates will quickly adjust to reflect the amount of liquidity in the banking system. But there is a second dimension to which may not be so easily apparent. We think the Chinese authorities have already layered on qualitative calibration via a slew of credit measures earlier, and they will likely expand these measures going forward. Liquidity is simply too blunt a tool for leaning against risks of asset and property bubbles. Targeted measures can ideally reduce such risks, without also exerting a drag on other sectors that may still be struggling from COVID19.
For instance, China’s “three red lines” policy was first reported in Q4 2020, which restricts the amount of debt growth for real estate developers based on three debt metrics. The limits for annual debt growth are set between zero for developers that have breached all three red lines, to 15% for developers which have remained within all three red lines.
Early in January, regulators also announced regulatory caps on banks’ lending exposure to the property sector. The six state-owned commercial banks and China Development Bank must limit property lending to 40% of their total, with mortgage lending not exceeding 32.5%. Though a transition period of 2 to 4 years is allowed, new loans to property developers and homebuyers should grow at a slower rate this year.
One may question why China is moving so quickly to calibrate both liquidity and credit conditions, even as the global economy continues to struggle. The pertinent point is that financing channels have functioned extremely well for China during the COVID19 crisis, helped by banks stepping up loan support to the economy, on top of state-mandated loan forbearance. In fact, we estimate that the amount of new credit last year is similar in magnitude to the blockbuster credit surge post the 08/09 Global Financial Crisis, when measured as a proportion of GDP (see Macro Strategy – Managing China’s credit boom).
In the depths of a recession, China’s move to expand fiscal spending funded via loans to Local Government Financing Vehicles (LGFVs) and to stimulate credit growth is a good one. But with 2021 growth looking more secured, having such outsized credit growth for a second year could risk overheating asset markets, and that would be far from desirable from policymakers’ point of view.
Markets should favor deleveraging firms
Given the macroprudential rationale for liquidity and credit tightening, we expect credit markets to differentiate firms more carefully by their degrees of leverage, particularly for those in the real estate sector.
Firms that can show meaningful progress towards deleveraging via asset sales or equity capital raising should be well rewarded and enjoy significantly lower spreads. Conversely, firms that are too slow in reacting to a less accommodative policy environment could face risks in rolling over their bonds. Credit investors are likely to be more wary of stern control measures in the pipeline targeting the most leveraged firms.
Long CGB on yield spikes
Accordingly, we expect the CGB and CNY swap curves to stay relatively flat. We prefer to go long on CGB when there is a liquidity-induced spike. While capital gains may be elusive in the absence another shock, the yield cushion should be sufficient to offset downside price risks with yields largely normalized.
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