According to Wei Yao of Societe Generale, in light of the lack of improvement in recent data as well as the harsh interbank liquidity squeeze, they believe it necessary to further revise down growth forecasts for China, from 7.6 percent to 7.4 percent for 2013 and from 7.2 percent to 6.9 percent for 2014.
Furthermore, the latest move towards further interest rate liberalization provides another clear signal that the new leadership is intent on fast-tracking financial market liberalization. Although such a reform should be beneficial for China’s long-term development, risk and pain could be set to increase in the near term.
China: Severe interbank liquidity squeeze
Societe Generale noted that the key factors leading to the 0.2ppt and 0.3ppt reductions in 2013/14 GDP growth forecasts are the severe interbank liquidity squeeze that occurred in June and the persistent financial regulatory tightening imposed by Beijing. On the surface, interbank repo rates have largely normalized to the levels seen before June, but the pressure is still on in other markets. Discount rates on bankers’ acceptance bills – a gauge of short-term liquidity conditions for corporates – are still about 160bp higher than May levels; and yields on low-grade corporate bonds remain on an upward trend.
The current development is reminiscent of H2 2011. Back then, the PBoC was tightening overall monetary conditions in order to tame rapid inflation. The interbank market tensed up first in mid-2011 and then normalized, but other fixed-income markets continued to see rates rising until the autumn (see chart above). At the same time, credit growth decelerated persistently. The liquidity tensions eventually culminated in burst bubbles in several regional underground banking systems, most notably in Wenzhou and Ordos. Economic growth suffered, partly due to tight liquidity conditions, and slowed by 1.4ppt from 9.5 percent yoy in Q2 2011 to 8.1 percent yoy in Q1 2012.
More risk events to follow, and a bond default most likely to be the next
Societe Generale long-held cautious view on China is based on two convictions. First, Chinese policymakers will not resort to the kind of credit-driven infrastructure stimulus seen in 2009/10 ever again for fear of exacerbating economic imbalances further. Second, they think that China’s growth efficiency has been deteriorating since 2010 and its debt problem has worsened. The former can only be fixed gradually by structural reform, while the latter means inevitable painful adjustments that could take place relatively quickly.
Hence, in their view, forecasting China’s near-term growth trajectory mostly hinges on the call as to when such adjustments will start and at what pace they will unwind. Given the control that Beijing still has over the economy and the financial system, the answer lies more with the degree of political will (and/or policy miscalculation) – at least at the beginning of the process.
Therefore, the central government’s handling of the interbank liquidity squeeze in June may bear great implications for China’s growth path going forward. For Societe Generale, the real significance is that the episode challenged the assumption of many market participants and observers that Beijing would never let anything bad happen. Now it is becoming clear that the new leadership not only has the stomach for persistent growth deceleration, but is also willing to go as far as stress-testing the financial system to contain a further build-up of risks.