China: Shifting From Reactive To Proactive

by: Bernard Keightley

Assessing the Chinese reaction function is the key to navigating the Sino-US trade war.

Recent policy actions out of Beijing signal a shift toward a more proactive stance.

I assess seven potential policy paths China could take from here and their implications.

Since Chinese President Xi and the National People’s Congress removed presidential term limits, the prospect of Xi’s leadership (and that of his successors) potentially lasting decades has become reality.

Although seen as controversial move abroad, the move should allow even more longer-term strategic thinking to prevail. China prides itself on its ability to ride out short-term turbulence in favor of lasting gains; something which is becoming evidently much more difficult for Xi’s counterparts in the West.

The Chinese leadership appears, perhaps naively, to have believed it could sit out the Trump administration’s sabre rattling over trade, in the hope they would eventually be dealing with a much-depleted presidency or even an entirely new administration in the not too distant future. Unfortunately for the Chinese, sympathy for Trump’s stance and indeed fresh anti-Chinese rhetoric is also well embedded inside the Democratic Party.

Sino-American relations have been strained by a slew of negative press particularly related to the long arm of the Chinese state and its over-manipulation of its economy but also on events such as the mistreatment of its Rohingya Muslim minority. Instead of a softening in opinion of late, it appears to be hardening.

And the Chinese are responding -- the slew of recent policy actions indicate Beijing is adopting a more proactive stance in its efforts to stem the fallout from the US-China trade war. Note the mid-2018 shift in the table below:

Source: Zerohedge

With the current Chinese leadership likely to remain a key long-term constant in the trade war, determining the Chinese reaction function may just be the single most important driver of global markets for decades to come. In this article, I assess seven likely paths Beijing will follow from here and the potential market impact resulting from each move.

The Next Move?

China’s leaders must now come to terms with the threat of becoming embroiled in a long-term struggle with the US over trade disputes and other issues. A lack of dialogue between the two superpowers could pivot the global economy into the next phase of the confrontation, with the potential for US tariffs to be increased even further, threatening China’s domestic economy and growth rate.

However, China seems to be making headway in rectifying its misreading of the situation, adopting a more proactive policy stance whilst seeking a resolution that will be more to its advantage. It has been absorbing punches for too long in the hope that the US would relent with its assault on trade.

But the PBOC has finally started to ease monetary policy conditions for consumers and businesses. Public-private partnerships approvals have risen whilst local government bond issuance has increased in order to help finance the projects.

In order to maintain growth following the latest round of US tariffs the PBOC produced a coordinated response in the form of liquidity stimulus and fiscal measures. To underline its easing bias, the PBOC provided another 100-basis point cut to its reserve requirement ratio, injecting further liquidity into the system via Chinese banks.

Source: Pictet

These actions are a statement of intent in tackling the growth deceleration that we have seen over the first half of the year.

So, is this just a series of calming measures or a bold plan to reaccelerate growth?

Potential Policy Paths and Implications

While it is not clear what form the next response will take, a significant policy action is almost certainly forthcoming. In recent months there have been regular announcements from the central government, PBOC, and various regulatory agencies but it is too difficult to pinpoint anything definitive as to what an eventual forceful response might resemble.

What we, as market participants, can do is consider a list of possible policy outcomes as well as the likely impact on asset prices given each response.

1) "Plunge protection" for Hong Kong and mainland listed shares: This could take place via either unilateral intervention or U.S. asset sales. In sufficiently large size, this could add spring to the step of Chinese equities while weakening U.S. equities but the spillover to other assets is likely to be limited.

2) A managed currency depreciation via the PBOC’s daily fixing activities: Such a move is unlikely to have the same magnitude of reaction as the devaluation in August of 2015, however the directional effect on assets would be similar; a stronger US dollar, weaker equities, underperformance among Emerging Market assets and lower rates in developed markets.

3) A managed currency depreciation through monetary easing via interest rate cuts and perhaps even a quantitative easing (QE) program: Unlike a managed currency depreciation through the daily fixing, a monetary policy style depreciation is unlikely to impact markets as much. The most likely outcome would be strong performance from Chinese equities, supporting other risk assets in the process. The U.S. dollar would most likely strengthen after such a move.

4) Fiscal stimulus targeted at investment expenditure: Something akin to the large credit stimulus that China undertook in 2016/17 could, I think, lead to higher commodity prices (via elevated Chinese infrastructure demand) as well as rising Emerging Market assets and high beta equities. The U.S. dollar would most likely weaken and U.S. assets underperform.

5) No policy response: Use the market drawdown to bring private assets onto the state balance sheet and settle political scores. In the unlikely event that China maintains the status quo and makes no further response, the current mood of a weaker yuan, underperforming Chinese/EM assets, and global equity market turbulence would continue.

6) Sell US and other developed market assets in order to trigger a hike in yields and a selloff in US equities: Given that the equity markets are President Trump’s favorite barometer of trade war success, one must wonder why China refrains from using its substantial holdings of US Treasuries to inflict damage on US asset markets to dent President Trump’s resolve. While selling substantial portions of its reserve holdings would likely result in a steeper yield curve, lower U.S. equities and a weaker U.S. dollar, Beijing is perhaps keeping this one in reserve.

7) Military confrontation in the Strait of Taiwan: Whilst the chances of a tariff war spilling over into geopolitical conflict are small, Trump’s presidency has been anything but predictable and further US military pressure to assert rite of passage in the Strait could pose a potential flash point. If such an event were to occur, expect an immediate flight to safety globally, with the US dollar, US Treasuries and gold likely to be the only beneficiaries.

As discussed here, there are many options open to the Chinese, and each will impact markets in the region and globally to a varying degree. Whatever steps Beijing takes, the US/China relationship will remain a key determining factor for markets over the medium to long term.

In the meantime, investors should continue to closely monitor any signs of policy movement, consistently updating their investment frameworks to take advantage of any opportunities presented whilst remaining extremely vigilant to spillover threats and market risk.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.