Slowdown in China Underway; Will It Mean A Reversal in Tightening?

Two notes from Andy Lees of UBS confirmed for me that a slowdown in China is underway and that developments in Europe are adding to the pressure.  In my view, this may mean a second-half reversal of the tightening we have seen in China to date on 2010.

In the first note, Andy says:

The 14 day SHIBOR (SHIF2W <INDEX>) rate continued to soar, up 18bpts on the day at 2.503% vs 1.64% at the end of April. Five year swaps are just 3.06%, so you can see how quick the curve is flattening.

Trying to find an explanation, we believe there is a real shortage of liquidity now in the market. The biggest banks, who would normally be the main lenders, are rushing to borrow money from the money markets. The reserve rate requirement is now 17%, just 0.5% short of its historical peak of June 2008, which combined with the enhanced sterilisation programme which has amounted to more than CNY1trn since the start of the year, together with the reduction of FX inflows and of course the reduced trade surplus, has resulted in a collapse in the excess reserve ratio to what we estimate is a very low 1.5%.


Curve flattening is generally a sign of a weakening economic environment. And the liquidity constraints Andy mentions suggests that the tightening by Chinese officials is having its intended effect in choking off the prodigious credit growth in China. In a separate note, he notes:

We are also seeing countries like China warn that their export growth to Europe will collapse from 25% to just 6% or 7%, which again would suggest that the European slowdown will not be as isolated as is imagined.

I think this insight is relevant across the globe.  For example, the Chinese have been buoying commodities markets and this has contributed directly to Australia’s resiliency in the face of the global economic downturn. The Reserve Bank of Australia has also been in tightening mode as the property sector there has overheated:

”Interest rate rises seem to have put on the brakes for consumption,” today’s report said. ”Australians seem to have cut back on buying goods and services to meet increased mortgage payments rather than delaying house purchases.”

Capital city home prices rose by a record 20 per cent in the year to the end of March, according to official data, with an unofficial gauge putting the adjusted median national house price at $542,827. Retail sales – contributing to the largest sector in the economy – rose a less-than-expected 0.3 per cent in March after a 1.2 per cent drop February.

Sydney Morning Herald, 27 May 2010

If China slows, this will have a knock-on effect in Australia.

I have also mentioned in the past that the Debt to GDP ratios in China are misleading. The municipalities and states have a panoply of private financing vehicles through which they have financed land speculation. When the property market softens, this will create a non-performing loan problem in China (see Chinese Banks: Aggressive tightening could spell trouble for non-performing loans). According to Chinese media reports, local government investment agencies are on the hook for CNY6trn (USD880bn) to state banks.  And clearly, if they cannot repay, the credit writedowns will impair capital.  Would these losses be socialized as they have been in the west? If not, China could face a hard landing. If so, the debt to GDP ratios would rise dramatically from the 20% you see in the chart below.

Global Debt to GDP
Courtesy: Casey Research

I will have more to say about the other Debt-to-GDP ratios on this chart at a later date.

  1. Scott says

    Mauldin has either a post or a guest post from about 2007 where the analogy was throwing bombs into the ocean until something blew up. I think it was GaveKal, but my memory is not great. He was speaking to the rate rising cycle by Bernanke and how they would persue it until something blows up. It was a timely piece that was forgotten because we are no longer worried about blowing up fish. We’re trying to triage the half alive fish.

    Whether or not we can apply that to China is beyond me other than the fact that I’ll say that policy is a blunt tool. Bernanke prefers regulation because monetary policy is a blunt tool, but really, what else is there. Regulation?

    If you believe that credit growth leads to a mismatch between liabilities and assets, then we could see some fireworks here.

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