Implicit tightening of monetary policy is driving China's slowdown, says Moody's Analytics.
"China’s financial markets have been experiencing tighter liquidity as a result of deliberate government policy," says Alaistair Chan, Economist at Moody’s Analytics. "The PBoC has the ability to end the liquidity constraints but has chosen not to, partly out of concern that credit growth has been rising too fast. Policy has been implicitly tightened and this is driving an economic slowdown, which increases the risk of a policy mistake.'
Reduced liquidity can be seen in a number of areas, the most obvious being the Shanghai interbank lending market, notes Chan. The SHIBOR has fallen from its peak of 13.4% after a series of cash injections by the central bank, but remains historically high.
"The one-year generic bond yield has risen above the one-year official deposit rate. Normally this implies expectations of higher interest rates, but in this case bond yields have risen as banks sold them to meet short term obligations."
A selloff of more liquid one-year bonds has caused China’s yield curve to invert. Yields on one-year instruments are higher than on ten-year bonds, meaning that the yield spread has turned negative for the first time since the series began in 2006. An inverted yield curve can sometimes signal a recession as the market forecasts lower interest rates. In this case, given that the inversion was due to the one-year yield rising rather than the ten-year yield falling, it reflects liquidity shortages rather than the outlook for the real economy.
Uncertainty and tight liquidity may be paradoxically driving the yuan's recent strength, according to Chan. The yuan's steady appreciation against the dollar over the past few months (1.3% so far this year) was presumed to be due to high export demand. But a government crackdown on speculative capital revealed that export revenues may have been artificially inflated, possibly as part of a 'carry trade' of borrowing cheap dollars to lend in yuan.
This may explain why markets are forecasting yuan depreciation one year ahead. If and when the PBoC relents and eases liquidity constraints it will place downward pressure on the currency.
"Slowing growth, low inflation, a rising currency and rising bond yields all suggest that monetary policy is tightening. We believe that an implicit tightening of monetary policy is driving China's slowdown. The government has the ability to boost growth if it chooses. Lowering the reserve ratio, coupled with a renewed crackdown on WMPs, would ease liquidity constraints and also signal that the government is focused on shoring up growth and not reinflating the credit bubble."