China Macro Monitor November 2014 Rate Cuts Drive Next Leg of Equity Market Rally
This publication is a monthly report focusing on macro developments in China relevant to investors across asset classes and markets.
Summary
- Last week the People’s Bank of China (PBoC), the central bank, stepped up its fight against flagging growth and deflationary headwinds by cutting interest rates for the first time since 2012.
- The PBoC had been active this year in delivering very targeted policy easing and injecting liquidity into the banking system. However, last week’s move marks the first broad-based monetary easing action in over two years. We believe there will be more to come.
- We believe the PBoC will cut the reserve requirement ratio (RRR) as well as cut interest rates further as it aims to generate sustainable demand in the economy and ward off rising deflationary risks.
- The PBoC also increased the flexibility of banks to set deposit rates, highlighting its commitment to increasing financial market liberalisation.
- The Hong Kong-Shanghai Stock Connect opened for business earlier this month. The daily quota was hit on the first day of trading, illustrating the strength of pent up demand for domestic Chinese equities.
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PBOC CUTS POLICY RATES AND ADVANCES ON RATE LIBERALISATION
We have long argued that weak economic data and the threat of deflationary pressures will expedite policy stimulus from both the Chinese government and central bank. The PBoC has been very active in recent months in delivering targeted policy easing and injecting liquidity into the banking system. Last week’s moves however demonstrate that the central bank has stepped up its fight and marks the first time the PBoC has cut key policy rates since 2012. The PBoC cut the 1-year benchmark lending rate 40bps (to 5.6%) and cut the 1-year deposit rate by 25bps (to 2.75%).
At the same time the PBoC raised the deposit rate ceiling (the limit on deposit interest rates, expressed as a multiple of the benchmark deposit rate) to 1.2 from 1.1 times previously. Deposit caps have been a constraint on the formal banking system and have led to the growth the shadow-banking system which does not face the same draconian constraints. The moves to widen the ceiling illustrate that policy easing and liberalisation can go hand-in-hand. While the net effect on deposit rates for this first rate cut could become muted if all banks utilise the new ceiling1, the moves highlight policymakers’ commitment to supporting growth and liberalising financial markets.
We believe last week’s rate cuts will be the first in a series of cuts that will be necessary to stimulate the economy. A further 50bps could be cut in H1 2015.In addition we believe that China will cut the reserve requirement ratio (RRR) i.e. the amount of deposits and notes that banks must hold as reserves at the central bank. Cutting the RRR expands the capacity of banks to lend into the real economy. Although the PBoC cut the RRR for select banks earlier this year, we believe that a broad-based cut is now required
With shadow banks taking a back-seat, the onus is on the formal banking sector to provide financing into the economy. The banking sector therefore needs all the support it can get from the central bank.
The PBoC took further steps to liberalise interest rates by abolishing the benchmark guidance for 5-year savings rates and consolidated the benchmark guidance for loans of 1-5 years maturity. These moves allow regulated banks to attract more deposits that would have gone to shadow banks and therefore should aid their ability to lend
On 27th November, the PBoC refrained from selling repurchase agreements for the first time since July, loosening monetary policy further. It last suspended sales of repos, in the week of July 21 as initial public offerings boosted cash demand. This time the motivation seems more aligned with monetary stimuli. The sale of repos drain funds from the banking system. Indeed the PBoC could conduct reverse repos to increase liquidity in the banking system, a tool which we believe it will utilise in 2015.
The Renminbi depreciated modestly in November, helping to boost the competitiveness of Chinese exports. Exports were already been growing briskly during a period of Renminbi appreciation. The recent depreciation should act as a catalyst to extend that growth and is in line with the recent monetary easing efforts by the central bank.
HONG KONG-SHANGHAI STOCK CONNECT OPENS FOR BUSINESS
The Hong Kong-Shanghai Stock Connect programme, which allows foreigners access to the domestic equity market in China via Hong Kong, started on November 17th. This initiative marks the most substantial opening of the Chinese equity market in history. On the first day of trading, flows from Hong Kong to China hit the daily quota, in a sign of the strength of pent up demand for Chinese equity exposure. Coinciding with the opening of the Connect programme, capital gains tax on investments by foreigners has been waived for three years and the cap on HK dollar-yuan convertibility was lifted for Hong Kong residents in another significant sign of willingness to liberalise financial markets.
In June 2014, MSCI refrained from including China A-Shares into its MSCI Emerging markets Index due to concerns over difficulty in accessing the market. The Connect initiative should go a long way in alleviating these concerns. With approximately US$1.5tn benchmarked to MSCI China Emerging Markets Index, even a small allocation of 0.5% to the China A-Share market in the broader index could drive US$7.5bn into the market on the back of index replication by investors. With equity markets becoming more optimistic on index inclusion, China A-Shares have staged a rally.
As a point of reference, the MSCI United Arab Emirates Net TR USD index rose over 90% between the time MSCI announced UAE stocks would enter its Emerging Market Index and actual inclusion (see shaded area of chart). While the Chinese and UAE markets are vastly different in size and composition and therefore limits comparability, we believe the increasing probability of index inclusion will bode well for China A-Shares.
The Hong Kong-Shanghai Connect programme does not open the Shenzhen market up to foreigners and for that reason many investors prefer investment products benchmarked to broad indices with exposure to all A-Shares such as the MSCI China A-Share Index.
1 If banks fully utilize the new deposit ceiling, the new deposit rate will be 2.75%*1.2 = 3.3%, same as 3.00%*1.1 =3.3% under the old deposit rate and deposit ceiling.
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