Michael Hintze: Quantitative Easing China-Style by CQS Insights
Introduction
In this edition of CQS Insights, Bunt Ghosh discusses why Yuan devaluation is unlikely, the arrival of Quantitative Easing with Chinese Characteristics and what this means for China’s fixed income and equity markets.
Like many market participants we at CQS are keen China watchers. In many of my CQS Insights pieces I have highlighted the opportunities and challenges China presents, both from within and outside the country. There are two themes that I find particularly fascinating. First, from my many visits to China I am always impressed by how astute the Chinese leadership is. They are smart, understand the challenges and have thus far been able to navigate China’s economic development effectively. Second is China’s political cycle. As opposed to the short-term electoral cycle prevalent in the West, China’s electoral cycle allows for Five Year consumption plans that enable long-term macroeconomic planning to be implemented. A fundamental tenet of 2011’s Five Year plan was a drive to shift economic growth from being infrastructure-led to consumer-led. Part of this shift is reform of financial markets structures. Financial market structures, regulation and a legal infrastructure are being put in place to support this goal. These reforms are pushing China towards a more open economy with a goal of having a fully convertible currency.
The internationalization of the Yuan and capital account liberalization is a central plank of China’s economic planning. Remember for a currency to be a global reserve currency it needs to be investible. An important milestone in that process is the International Monetary Fund (IMF) meeting in October of this year when the IMF will consider whether the SDR basket needs to widen. The Chinese authorities expect the Renminbi to be included in the new weighting structure and are very cognizant that a significant devaluation may jeopardize that objective.
As Bunt Ghosh points out in his piece:
“The importance of this policy goal has to be considered in the context of China’s long-term strategic plan for greater involvement in leadership of the global economy.”
The establishment of the Asian Infrastructure Investment Bank is a case in point. Other examples of financial markets reform include the establishment of Shanghai/Hong Kong Connect last November (the combination has created a top three global exchange); the forthcoming Shenzen Hong Kong Stock connect, arguably as significant as Shanghai/Hong Kong for its own flows. Another example is the recent announcement in Hong Kong that the long awaited mutual fund recognition will take place allowing cross border fund sales between Hong Kong and the mainland. Financial reform is taking place.
In the attached piece Bunt Ghosh argues that currency devaluation would make all these critical reforms far more difficult to execute. Furthermore and additionally supporting the thesis that Yuan devaluation is unlikely, is that markets do not appear to appreciate how tight a monetary policy the People’s Bank of China (PBoC) has been running since the 2010. He argues that what we are now seeing is Quantitative Easing (QE) with Chinese characteristics – QE Chinese-style - which should continue to benefit China’s fixed income and equity markets.
Sir Michael Hintze, AM
CQS Founder, CEO and SIO
Michael Hintze: Quantitative Easing China-Style
Summary
- We believe the Yuan will not be devalued
- Markets do not appear to appreciate how tight a monetary policy the PBoC has been running over the last 5 years and why there will be further rate cuts
- What we are now seeing is Quantitative Easing (QE) on Chinese terms
- China’s fixed income and equity markets are likely to continue to benefit from lower rates
On the last day of the year in 1993 the PBOC devalued the Yuan by just under 50% from 5.76/$ to 8.62/$. The risk that they will do so again has risen substantially over the last year as the Chinese economy has slowed and many investors perceive the recent cuts in interest rates and FX band widening as a precursor to the event. We believe that this expectation is wrong as the core thesis behind a potential devaluation is the attribution of the entire slowdown in China’s growth being due to structural issues; namely an overleveraged property sector and a slower than expected rebalancing of the economy away from investment to consumer-led growth. We believe this to be an incomplete analysis.
Growth and its rebalancing
Figure 2 below shows the breakdown of Chinese GDP by expenditure. What is immediately visible is that the dramatic investment-driven stimulus to growth that started in 2000, peaked in 2011, and is handing the baton over to consumption.
The problem is that while consumption has been growing, the overall rate of growth has not allowed the economy to maintain its prior growth rate. Some of this underperformance can be attributed to the structural headwinds that face the Chinese economy, however, what the market appears to have missed is the level of monetary tightness that the economy has been laboring under for the last five years.
Monetary Conditions
Monetary conditions were notably loose at the peak of the crisis in 2008/09 and then began a long period of substantial tightening. As can be seen in Figure 3 (above), 2014 saw a small easing of monetary conditions as the currency band widened, but that did not persist as sharp devaluations in the Yen and the Euro dragged the Yuan’s Real Effective Exchange Rate (REER) higher and declining infl ation saw real rates rise sharply. The current policy stance of cutting rates and the RRR1 is aimed at reversing this tightening. This policy stance is aimed at unwinding the tightening due to Quantitative Easing (QE) policies elsewhere and falling inflation. Unfortunately the scale of the tightening means that three interest rate cuts and a cut in the RRR have not as yet been sufficient. Further rate cuts remain likely during the course of the next few months.
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