You know the weakness in commodity prices I’ve been talking about recently? It’s all to do with China.
While that’s hardly a newsflash, Chinese authorities confirmed yesterday that they are slightly worried about the current slowdown by tapping the growth accelerator again. From Reuters:
‘BEIJING (Reuters) — China will adopt a more vigorous fiscal policy to help tackle external uncertainties without resorting to strong policy stimulus, state radio said on Monday, citing the cabinet.
‘Slowing economic growth has sparked a heated debate among government researchers on whether fiscal policy should play a bigger role in softening the impact of a trade war with the United States.
‘The fiscal policy will focus on cutting taxes for companies while the pace of local governments’ special bond issuance will be quickened, it quoted the cabinet as saying.
‘The government will deliver a tax cut of 65 billion yuan ($9.6 billion) by expanding a preferential policy for small tech firms to all firms, on top of an initial goal of cutting taxes and fees by 1.1 trillion yuan this year, the cabinet said.’
Now, a US$9.6 billion fiscal boost, expanding to US$160 billion (1.1 trillion yuan) isn’t anything to get too carried away with in an economy the size of China’s. But it also comes with a commitment for increased monetary stimulus.
Authorities have tightened liquidity this year in an attempt to rid the market of speculative excess. But this drove up corporate borrowing costs and deflated the stock market.
Check out the chart of the Shanghai Composite Index below. It’s given up two years’ worth of gains in six months.
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The index is now rallying though, no doubt helped by news of Beijing’s relaxation of liquidity constraints.
How Much is China Prepared to Ease?
Just how much China is prepared to ease again is the question. Too much liquidity creates speculation, which in turns leads to capital flight, as the punters try to get the easy money out of the Middle Kingdom.
Trying to work out China’s capacity for ‘sensible’ stimulus (if there is such a thing) is a fools’ errand. Who knows? But I do know there is the potential for them to do a lot…sensible or otherwise.
It comes back to what we discussed yesterday.
That is, in the years since China joined the World Trade Organisation (and therefore the international trading system) in December 2001, it has amassed huge foreign exchange reserves by ‘saving’ its trade surpluses with the rest of the world.
As I mentioned yesterday, a trade surplus country in theory should have an appreciating currency. This is to ensure the surplus does not become chronic and create imbalances in the global trade system. Free and floating exchange rates are all about creating balance, not imbalance.
At least that’s how it works in theory. In practice, not so much.
China wanted to become ‘rich’ by producing more than it consumed. To do this, it needed to keep its currency competitive. So when the surplus dollars or euros flowed in, in exchange for goods, it printed yuan to offset this inflow.
The central bank kept the foreign exchange as reserves, and these reserves became an asset on the balance sheet. The freshly printed yuan went into the domestic banking system in the form of reserves. They were the liability to offset the foreign exchange asset.
So as not to create an inflationary storm by printing yuan, the central bank devised all sorts of tools to soak up the excess liquidity. One of those tools is to increase the ‘reserve requirement ratio’. It restricts how much domestic banks can lend.
China’s reserve requirement ratio peaked at 21% in 2011. But it is now down to around 15.5%. The People’s Bank of China has cut the ratio three times this year, with the latest occurring in late June.
Cuts to the reserve requirement ratio increase the capacity of the banks to lend. It’s a form of monetary stimulus.
The other issue to consider here is that China stopped accumulating US dollar reserves in 2014. As you can see in the chart below, treasury holdings peaked in 2014 and declined for a few years thereafter. They have increased over the past 12 months but remain well below peak levels. This is despite China generating ongoing trade surpluses with the US.
What’s going on?
Source: Council of Foreign Relations
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According to the Council of Foreign Relations:
‘In the past, China routinely bought dollars (and therefore Treasuries) to keep its currency down, but in recent years it has been more concerned with halting capital flight and keeping its currency up. Movements in China’s Treasury holdings, then, reflect China’s shifting exchange-rate policy, and not shifts in sentiment about U.S. policy.’
China wants a weak currency, but not too weak. It wants a strong economy, but not too strong. In short, the Communists are chasing Goldilocks. They’ve managed to keep the national porridge bowl just right for a while now. Can they keep it up?
Editor, Crisis & Opportunity