by Christopher Balding
The NanfangToday, 09:22
Here is video of the press conference of the PBOC announcing its rate cut and reserve cut with an explanation of their view of the Chinese economy.
The clear explanation for the IR and RRR cuts is that the Chinese economy is much weaker than what official data reports. In 2014, official real GDP growth was 7.3 percent and is on target to come in at 6.9-7.0 percent for 2015 according to official data. In less than 12 months the PBOC has cut interest rates six times from 6 percent to 4.35 percent. In any economy, an annual drop of 0.3 percent is little more than a rounding error or global economy fluctuation. To put this in a different perspective, China has cut interest rates almost 2 percent due to a drop in the GDP growth rate of about 0.3 percent during a period of admittedly slow global growth. Imagine if every country cut interest rates almost 2 percent for every drop in GDP growth of 0.3 percent. Most countries have bigger fluctuations than that every year. To believe the Chinese economy is even close to 7 percent, you must believe they are aggressively cutting rates to bring them back up to 7.5-8 percent. The Chinese economy is simply not close to 7 percent GDP growth.
There is also no such thing as “weak 6.9 percent” growth. By weak growth people must have some point of reference as to what makes 6.9 percent growth weak. It is not weak in absolute terms as it would still be one of the strongest rates of growth in the world if true. It is not weak in relative terms as last years growth was only 0.3 percent higher than this years expected growth. Even against the past few years, this would represent a slowing of the growth rate by less than 1 percent of GDP growth. Economic growth numbers measure a discrete value. By that I mean than 2 percent growth is 100 percent more than 1 percent and that 3 percent is three times 1 percent. This does not mean that 2 percent is some fuzzy amount more than 1 percent or that 3 percent is different from 1 percent as black is different from white. People that say Chinese GDP growth is a weak 6.9 percent are really revealing they don’t have the intellectual honesty or courage to say they don’t believe official data. There is no such thing as a weak 6.9 percent.
As much as the PBOC has been loosening via RRR and IR cuts, this money has largely left via capital outflows. There is definitely some correlation and some causation, but the relationship is undeniable. It should come as no surprise that capital outflows, while they had been picking up, really gained steam when the PBOC began cutting RRR and IR almost a year ago. This fits very closely with what we would expect theoretically. As interest rates decline, capital is going to leave the country. Unfortunately, the PBOC finds itself in a vicious cycle now. The more the PBOC cuts RRR and IR, the more capital is going to leave the country. Just to keep liquidity stable, it is going to have to cut more, and the cycle repeats. It should come as no surprise that as every half percentage point cut to the RRR releases an additional approximately $100 billion. Since the PBOC began cutting the RRR by 2.5 percent in total since January or 2 percent excluding the cut on Friday, FX reserves have dropped by approximately $300 billion or roughly 75 percent of the value of released cash. Add in small time lag and we are witnessing essentially 100 percent of RRR cuts leave China.
The regular interest rate cuts are driving China closer everyday to breaking the RMB/$ peg or imposing very strict capital controls. China simply cannot move interest rates down and not expect profound pressure on the peg. This leaves only two options: float the RMB or impose strict capital controls. So far China seems to have a fuzzy soft policy on both accounts. They appear to be quietly but gently tightening capital controls while using large amounts of capital to defend the RMB. Right now their basic strategy appears to play for time and hope the laws of economics and market pressures go away. I don’t think this is a solution to the exchange rate problem. I don’t think you can rule out that there is serious disagreement on these issues at the highest policy levels in Beijing that is causing some of the policy confusion that we see. It is distinctly possible political bureaucrats with less of an understanding of economics are hoping that policy making by fiat works in international finance as well domestic matters. The PBOC has smart guys who know where policy is being pushed by the continual lowering of interest rates but they are subservient to Beijing and will execute the political commands.
Lowering interest rates is absolutely the right policy and in fact, they probably should be lower. PPI is nearly negative 6 percent and CPI is under 2 percent at 1.6 percent. With interest rates above 4 percent and borrowers mostly paying above 6 percent, corporate real rates are at almost 12 percent. There is no reason interest rates should be so high except to maintain the peg. In other words, China is strangling its own economy to maintain exchange rate stability. With all that said, do not expect a change in interest rate or exchange rate policy any time soon.
I have heard recent jokes about the giant ball of money that rolls around China pushing up different asset prices. It’s a joke but there is definitely some truth to it. Let me explain. For many years, Chinese money growth has been well in excess of GDP growth. Due to capital controls, money creation remained in the country and drove up asset prices. Whether it was bank loans, factories, or homes, asset prices exploded. It comes as no surprise that money used to sterilize trade balances hits the banks and causes lending to increase well in excess of nominal GDP. On the real economy side, so much money leads to overbuilding and deflation as firms underbid each other to try and stay afloat. In the financial economy, asset prices inflate as money is essentially trapped and the ball of money simply moves between asset classes. Due to the capital controls and lack of investment options, there is essentially a giant ball of money that moves between major assets because it can’t go abroad easily and investment fads can easily fall out of favor.
Over the next few weeks I plan to write a number of posts about GDP figures by industry as I think there is a lot more complexity that needs to be explored. Right now I can’t because firm and industry data hasn’t been released for the third quarter, which should make you pause: national GDP has been released but firms aren’t even reporting third quarter data yet and industries haven’t even reported output data yet. However, at this point what is most interesting is how certain sectors of the economy either match or don’t match the reported data. Early data indicates that it isn’t what you think it is.
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