China – A Slowing Engine

Moderating, but not collapsing

In late 2011, we highlighted the likelihood of slowing industrial production, weakening exports, and a correction in property construction in China in 2012. Weak data for the first two months of the year shows that this slowdown is happening. Industrial production (IP) growth slowed to 11.4% y/y in January-February from 12.8% in December 2011, while electricity production growth slowed to 7.1% y/ y from 9.7% over the period (see Chart 1). IP growth also weakened on a m/m basis, from 0.94% in December to 0.38% in January and 0.70% in February. We expect China’s GDP growth to slow to 8.3% y/y in Q1-2012 from 8.9% in Q4-2011, before bottoming in Q2.

China’s export growth dipped to 6.8% y/y in January-February, and imports increased only 8.2%, as Chart 2 shows. Exports to Europe, China’s largest overseas market, were flat on the year in nominal terms (and down in real terms), while exports to the US did better. We see a clear risk of further export weakness in Q2, and estimate that net exports will subtract 1ppt from 2012 GDP growth.

Inflation pressures have receded, with food prices falling across the board after the Lunar New Year. The recent increase in fuel prices should not have much effect on the slowdown in inflation. We expect CPI inflation to slide to 3.5 % y/y in Q1-2012 from 4.6% in Q4-2011, opening the way for more policy loosening. We forecast average CPI inflation at 2.0% in 2012.

Real-estate investment remained strong in January-February, growing 23% y/y, according to official data. Growth of residential area under construction rebounded to 33% y/y in January-February after being flat in Q4(but we wonder if this is a statistical mirage). Investment activity is likely concentrated in late-stage projects. Developers are cautious about the market given weak sales and large inventories.

The volume of land sales dropped 0.5% y/y in January-February. There has been some positive news in Q1, though. Banks have been encouraged to lend to first-time home buyers and to developers of “ordinary” apartments. This has stimulated sales. We expect sales to continue to recover, helped by lower mortgage rates and slightly lower prices. Real-estate investment growth, however, looks likely to decline In Q2 and Q3, further dragging down steel and cement demand. As growth slows further in H1-2012, Beijing will likely continue to fine-tune real-estate policy to ensure a soft landing for the sector, but we do not expect a reversal of the central government’s overall policy this year.

Bank lending has gotten off to a weak start in 2012. We estimate that total Chinese yuan (CNY) loans will increase by around CNY 2.25trn in Q1, lower than the CNY 2.4trn required to meet the annual loan growth quota of CNY 8trn, considering the typical pattern of heavier lending in Q1.

Given that banks do not face a strict loan quota this year, the weakness in new lending likely reflects limited loan demand. The increase in bill financing (60% of new loans in January-February, compared with 51.2% in 2011) indicates falling demand for long-term financing, a reflection of deteriorating investment appetite. New deposits in the first two months of the year totalled CNY 800bn, compared with CNY 1.29trn in the same period last year.

In another sign of loosening, several big banks were allowed to increase their loan-to-deposit ratio targets beyond the levels previously allowed. We estimate that if the big three banks are allowed to raise their loan-to-deposit ratios by 100bps, they will be able to lend an extra CNY 300-350bn. We expect the authorities to lift these ceilings further if necessary in order to keep credit growth at least at its current level from Q2 to Q4-2012.

The People’s Bank of China (PBoC) cut banks’ required reserve ratio (RRR) by 50bps on 24 February, unlocking some CNY 370bn of funds. Liquidity conditions have improved significantly in recent weeks, with the 7-day repo rate dropping to 2.89% on 15 March from a peak of 7-8% before the Lunar New Year. We expect the rate to remain around 3% in the near term. The draft discount rate has continued to fall, to around 5% from 8-9% in early January 2012. Lower interbank rates should improve banks’ lending ability and reduce corporates’ funding costs.

Exogenous money supply, another liquidity driver, is also likely to be contained by underperforming export growth, falling FDI, and mild CNY appreciation expectations. The PBoC’s purchases of USD shrank to CNY 25.1bn in February from CNY 140.9bn in January, although they likely picked up in March.

We now look for four more 50bps RRR cuts this year (we had previously expected one cut in March, but the above-mentioned decline in rates removed the urgency). We now expect no change to benchmark interest rates this year – loosening will be done without rate cuts. The market will likely call for more policy loosening in Q2, as macro data is likely to remain weak.

Local government debt is not an imminent risk this year. The banking regulator has asked banks to roll over local government debts and classify them into different categories. However, setting aside government resources to cover these debts could undermine the size of the fiscal stimulus local governments can provide to stimulate economic growth.

RRR cut to prompt wider 2/5Y IRS spread

Going forward, gradually improving liquidity and expectations of more RRR cuts should widen the CNY 2/5Y IRS spread further towards 40-50bps. As such, we maintain our CNY 2/5Y steepener (current: 34bps, entry: 20bps, target: 40bps, stop-loss: 10bps). The negative carry and roll-down for this trade is around 2bps per month. We see this as manageable, as we expect to close this trade within the next three months or so.

Less CNY appreciation, but more volatility

Q1-2012 has seen more two-way variability in the PBoC’s USD-CNY fixes, with no clear CNY appreciation trend. The macroeconomic case for new CNY gains has weakened given the narrowing of China’s external surpluses, subdued inflationary pressures and clouds over China’s export prospects. It also seems likely that the CNY valuation issue has slipped down the international policy agenda given China’s status as a potential provider of new financing for the IMF and/or Europe.

Chinese officials have signalled that they see the CNY’s current valuation as approaching equilibrium and plan to give market forces a bigger role. A widening of the USD-CNY daily trading band (from +/-0.5% to +/-1%) is likely in H1-2012. We see exporters selling USD spot into CNY weakness, which makes sense to us. While we do not expect this to lead to extended CNY weakness (as the demand-supply balance for CNY on the mainland is still broadly CNY-supportive), the absence of CNY spot gains and a bigger role for interest rate differentials in driving forward pricing will likely put USDCNY non-deliverable forwards (NDFs) onto an irregular upward path. Relative value investors should buy USD in the 6M and 12M NDFs on dips.

In H2-2012, an improvement in the global economic outlook and new risk-seeking flows will likely prompt new gains for Asia ex-Japan (AXJ) currencies versus the US dollar. We think the Chinese authorities will tolerate modest CNY gains until year-end (our end-2012 forecast of 6.21 represents a 1.4% appreciation from end-2011). As this lags other AXJ currencies, we maintain a medium-term Underweight recommendation on the CNY for real money investors.

(Authors: Economists from Standard Chartered Bank)