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China’s liquidity inflection point and the global tightening

|Includes: RRR-OLD

 

There’re two school of thinkings after China’s 50bps RRR hike.

 

First, it has caused many concerns that the tightening cycle has began, the liquidity punch bowl is about to be taken away and that is bad for the stock market China or overseas.

 

There’s another view that this RRR hike is nothing but good, it shows the economic growth has finally picked up, and now we’re actually fearing of overheating, look back in history, between 2006 and 2008 when the reserve requirement was nearly tripled from 6% to 17.5%, the whole Asia, not just China, enjoyed quite a good bull run.

So which is right?

 

See if you love history and tend to believe the history never lies, you’d definitely opt for the second scenario that the bull market is not over yet. I’m on the bullish side, but still there’re some aspects many analyst have ignored.

 

1)      Last time’s China’s tightening coincided with US easing.

 

The 2006-2008 tightening was China’s first large scale monetary policy endeavor after the 2005 RMB exchange rate reform, it was hiked many times fearing having overdone it. And the US house price started to tip over in 2006, that was before the balance sheet recession to show it its ugly head causing large scale deleveraging and during the Fed beginning to cut down rates. Hot money betting RMB appreciation are pouring into China, due to much better than expected export(mainly to US), earnings for Chinese companies met the high point in Q3 2007. That was the honey moon, and the only one.

 

See, this time, China’s move shows the inflection point for global liquidity. The 2009 equity bull market was essentially a commodity’s bull market, hence we saw the Aussie(commodity exporter) central bank first hiked the rate as a major economic power. And the commodity bull is mainly because of China buying, so as the ultimate user starting the tightening, it marks the turning point. This year, we’ll continue to see US trade deficit narrowing, and Fed will in no way expand its balance sheet the way it did in 2009, I expect the first Fed rate hike could be in mid this year, when the GDP growth starts to show steam. All the reasons why the dollar should further strengthen and global liquidity should be draining away from emerging markets.

 

2)      Carry trade unwinding, dollar and yield curve

 

Firstly, this directly relates to the dollar carry trade and its unwinding. Since everyone knows this, I’ll just say the developed world will all start the interest rate tightening cycle middle this year, except Japan, more reasons to long Japan.

 

Second, the US yield curve was too steep, the spread between 3m and 10yr T-bill rates is around 370bps, I concur it largely means the US economy is on a sound footing, but in reality, as the US banks collectively still have over 1 trillion liquidity in their system not directly lending to corporations, but heavy trading involves with borrow short and lend long bonds, and when the short term rate start hiking, it will result unwind and wouldn’t be equity market friendly.

 

3)      China’s real interest rate has already soared after the RRR hike.

 

Don’t say the 50bps was nothing, it meant something. Here in China, there’s source of lending from the banks, but for the small business, they have to frequently ask for help in underground banks, and those “shadow banks” hiked interest rate after the RRR hik. Current rate raised from 30% to 36% (annualized) in Shenzhen, that was 20% increase. This is important, because the whenever there’s a loan quota control, like this year PBOC get the target to be around 7.5 trillion RMB, banks fearing high bad debt ratio from SMEs will only give loans the SOEs, therefore only exacerbating matters.

 

The underground banks refer to all the banks that are not registered but still conduct lending/borrowing activities. I’m no expert on this, but I got a statistics saying the underground lending was estimated to be around 2.9 trillion RMB in 2005, that was 4 years ago, think today and their influence.

 

4)      This time the actual rate hike will be sooner than last time

 

China’s RRR is already at 16%, there’s probably just 2% room left, hoping for this kind of mild measure to go for much longer and keep the bubble going like last time is just naive.

 

PBOC will start hiking the interest rate without direct reference to the Fed, many analysts believe that early rate hike before the FED will only bring more hot money to China and hence higher inflation. I think this textbook thinking has failed to take into consideration that the “hot money” that betting for RMB appreciation come with funding cost. And as the global tightening is on its way, the cost is also rising. The interest rate differential won’t enlarge for an extended period of time.

 

I’ve witness the whole 2006-2008 boom bust as a money manager, there’re always similarities from the past, domestic or foreign, back then we were using bubble-ish examples in Japan, Taiwan etc in the 90s to get a hold of what was happening in China back then. But history never repeats itself 100%, it’s different every time.

 

Having said that, the 1.5 trillion RMB bank loans approved last year and haven’t been handed out by year end, plus the official 7.5 trillion loan guidance, China’s liquidity is indeed still good in 2010.

 

Well, I’d like to make myself clear, I still believe the China is in a Bull market with the SCHOMP index(China Shanghai Composite index) initially targets new high and on it's way to 4000. But many fund managers, including me are starting to consider a scenario that calls for a first major equity correction(for both China and US) in February/March due to real tightening concerns globally. Will the Valentine killing come this year?



Disclosure: None