China Macro Insights: Why liquidity tightened?

Analyst: Xiyang Cai, CFA FRM ;  Date: Nov-26, 2016

Highlights

Economic indicators on growth and inflation in October are mixed but positive in general. Massive public investment in infrastructures and strong sales on property and automobiles in the first three quarters have stabilized China's economy. We forecast the growth momentum would highly likely prolong to 2017Q1, giving more freedom for policy makers focusing on risk prevention、deleveraging and asset bubble depressing. RMB depreciated 3.0% against USD since October as Donald Trump became US president-Elect and USD index strongly rebounded 5.5% from 95.6 to 102.

Growth prospects

With respect to Official data in October, we observed that manufacturing activity and Industrial production continued moderate expansion with growth rates of 6.0% YoY.

Fixed asset investment marginally edged up to 8.3% compared with 8.2% of September, main driver came from investment in property, which was rebounded 0.8pct to 6.6%, while investment in manufacture stabilized at 3.1% and infrastructure slightly contracted 0.33pct to 17.59%.

Consumption growth rate fell 0.7pct to 10% YoY in Oct due to base effect, and the accumulated figure only fell 0.1pct to 10.3%, we estimate the whole year consumption performance would run stable.

Exports contracted again, but at a slightly slower pace than in September. Even so, a weaker yuan and a more resilient U.S. household sector could boost growth momentum for exports. Early signs have been positive, with the purchasing managers' indexes including the export orders moving further into expansion territory, suggesting external demand for Chinese goods will continue to improve.

Headline inflation CPI slightly accelerated 0.2pct to 2.1% as CPI is set to gain pace in the coming quarters due to favorable base effect. Food-price tracker, the most significant component of the CPI, rose 3.8% compared with the same period of last year, up from 3.3% in September. Supply-side shocks can move food prices, but with demand weak there's little chance of a sustained resurgence of inflation. Producer price PPI continued to edge out of deflation to 1.2% as energy and raw material prices surging from a bottom. PPI rebound helps industrial corporates expand revenue and improve financial performances.

Property prices in major cities continuing to rise, but at a markedly slower pace as policy controls start to take effect. There are 79 cities in October compared with 81 in September continued housing price upward MoM among the 100 large and medium size cities.

Meanwhile, a wide range price upwards and production expansion have been observed, like power generation and usage, steel\copper\alumina production and sale, sales of machine for industrial and constructions, accelerated growth on transportation volume of cargos etc. We think with over 4 years drastic rebalance on the industrial sector, the supply and demand relation would probably stop deteriorating as PPI started to rebound, and investment and inventory growth rate started to bottom out, even though the sharp rebound is not likely to see, but the moderate growth momentum prolong to 2017Q1 is worthy to expect.

Shadows ahead

Main difficulty ahead lies in the structure of the economy’s dynamics: market oriented sustainable demand has been diminishing while fiscal stimulus facing budgetary constraints.

Behand the encouraging headline readings, the key figures to watch will be auto sales and property sales and construction. Auto sales are being boosted by tax incentives that may expire at year-end of 2016. Property is downward pressured as policy tightens and high base effect of 2016 will decelerate the growth rate of 2017.

Shadows for the coming year of 2017 would come from: 1）demand overdraw of the household sector as housing and automobile expenditures will decelerate in a trend due to gov't tightening policies start to bite；2）Gov't driven Investment in infrastructures will encounter budgetary constraints; 3）Sluggish export prospect due to Brexit on June and uncertainty of the highest 45% trade tariffs will be potentially imposed by US president-elect Trump.

Policy outlook

China's Central Bank (PBoC) hold monetary policy neutral in essence due to a bulk of reasons: 1) the economy stabilized in the short run, economy growth rate at 6.7% can be fulfilled and over 10 million new jobs has been created for 2016; 2) RMB depreciation expectation, capital flight and FX reserve diminishing as USD strengthening has been a great challenge; 3) marginal rising headline inflation in 2016Q4 to 2017Q1 due to supply-side shock and excess liquidity; 4) China's Central Political Bureau meeting asked for depressing asset bubble and deleveraging of financial market and State-Owned Enterprises (SOES).

Liquidity and bond market

Even though there is no action has been observed in raising or cutting benchmark interest rate or Required Reserve Rate (RRR), the Central Bank started tightening via open market operation as the weighted average price of incremental liquidity provided by PBoC has been lifted by approximately 20bps since august.

Since October, stabilized economy, general neutral but marginal tight monetary policy and strengthening Dollar as well as inflated G4 sovereign bonds yields, imposed pressures on the Chinese bond market. Yield of 10-year China Treasury bonds rebound from 2.73% to 2.91%, and closed at 2.84% at November 25.