More Easing Ahead

More Easing Ahead. Following the weakening of a number of key economic indicators in August, we believe that China’s government will step up its stimulus policies in the coming weeks and months.

The People’s Bank of China last week pumped 500bn yuan of liquidity into banks and cut the 14-day repo rate following the release of poor August economic data.

While structural reforms will continue and balanced growth remains a key priority, we believe targeted stimulus will be accelerated to ensure growth meets the government’s 7-8% target.

A gradual ratcheting up of targeted monetary and fiscal stimulus, together with expected increased inflows into domestic A-shares as the Shanghai-Hong Kong Stock Connect program goes into effect in mid-October should support the continued strong performance of A shares as we move into Q4 2014 and beyond.

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He who treads softly goes far

 

Disappointing data reported over the past month is likely to serve as a catalyst for further policy stimulus in the next few months in our view. While toeing the official line that reform takes precedence over everything else, Premier Li Keqiang has also reminded local governments of their “inescapable responsibility” to meet growth targets. Keen not to be perceived as going back to the ‘old China’ ways of pursuing growth for growth’s sake, the stimulus is likely to remain more subtle than the CNY 4trn ‘bazooka’ used in 2008. At the same time, the government has the capacity and policy conviction to see that the growth target of 7-8% is met.

While there have been no broad-brush cuts in reserve requirement ratios or lending rates since 2012, the government and the central bank have been actively easing policy since April (see table below).

A large part of the stimulus since April has been delivered by the central bank, the People’s Bank of China (PBoC). The PBoC has the capacity to act quickly – as we saw last week – and can separate itself from some of the Central Government’s reform initiatives.

The table below is far from exhaustive, with local governments in particular having undertaken a number of stimulus activities of their own. However, with the probe into corruption, local governments have been unusually reticent, shying away from highlighting their activities. Nevertheless, policy adjustments to house purchase restrictions for example are likely to go a long way to helping the slowing housing sector see new sources of demand.

 

The case for more easing

The absence of inflation constraints

 

The PBoC has substantial capacity to stimulate the economy without raising inflation anywhere near its target of 3.5%. In August inflation slipped to 2.0% from 2.3% in July. Indeed if it is serious about the target, it will need to stimulate demand as it is unlikely that a significant supply-side shock is going to raise inflation to 3.5% in the near-term.

Compensating for shadow-bank deleveraging

 

While most shadow-banking activities sit within the oversight of the China Banking Regulatory Commission, a small portion does not. Fears of excessive credit growth in the shadow-banking sector has led to pull-back in trust loans (lending by non-bank, deposit taking institutions). Additionally loans that have been taken off balance-sheet by banks (by “undiscounting” bankers’ acceptances) are increasingly being kept on balance sheet. With the onus of credit intermediation falling back on formal banks and with loans remaining on their balance sheet, the PBoC needs to help State banks free-up lending capacity so that credit can be directed to the real economy.

 

Shadow banks lend and pay depositors on commercial terms, in contrast to many state banks. They arguably direct credit to growing sectors of the economy more efficiently than state banks. If this period of shadow bank deleveraging/banking renaissance continues, loan growth may have to increase more substantially to get credit into the right parts of the economy. The PBoC’s encouragement would therefore be necessary to facilitate this process.

 

Export growth alone is not enough

 

Export growth has been surprising strong, while import growth has been relatively muted. While that will help boost GDP figures for the quarter, it is not guaranteed to continue indefinitely.

Indeed with the renminbi appreciating against the dollar, which in turn is appreciating against most other currencies, Chinese exports are getting more expensive for recipient countries

Also lower import growth in China, could hurt demand for Chinese exports from its partner countries, creating a negative feed-back loop.

With China seeking to rebalance its economy away from being an exporter of goods lower down the value chain, the need to stimulate internal demand is clear.

 

Property markets need micro-targeted policy assistance

 

As discussed in the August China Macro Monitor, while developers have displayed some cautious optimism by increasing building activity, demand is currently weak as many potential buyers are taking a ‘wait-and-see’ approach. So while captive demand exists with urbanisation continuing unabated, a lack of confidence could contribute to a downward spiral in demand. A decisive policy shock could break this mind-set and avoid the build-up of excess housing. Given that housing supply-demand balances vary widely across provinces and cities, the policy moves will likely have to be carefully targeted with local governments taking the lead in implementation.

China A-Shares continues to rise

 

Over the past month, the China A-share index has continued to increase, although the soft economic data has capped its gains.

The successful completion of a practice session last weekend will likely see the Shanghai-Hong Kong Stock Connect go live in mid-October as planned. We believe that the Connect initiative will allow better arbitrage between the Hong Kong and Shanghai exchanges, narrowing the current premium Hong Kong stocks have over those trading on the mainland (see Shanghai-Hong Kong Stock Connect: A Boost For China A Shares). A-share discounts to H-shares have been steadily narrowing over the past two months, but still stand at 4%.

The application of quotas favours flows to the mainland over outflows to H-Shares in Hong Kong and will increase the number of investors in the China A-share market.

The Connect does not however link up the Shenzhen exchange to Hong Kong and therefore broad China A indices (which track stocks on both the Shanghai and Shenzhen exchanges) offer investors a compelling alternative to buying stocks directly

Investors have additionally benefited from yuan appreciation, with the China A Share index priced in US dollars.

While most economic data last month was disappointing, the flash release of HSBC/Markit’s purchasing manager indices for September came in as a positive surprise, indicating a potential increase in industrial activity is on its way. Domestic equity markets reacted positively to the news.

We anticipate as government and central bank easing gradually ratchet up in the coming weeks and months, and foreign investors increasingly focus on the extremely beaten down valuation of the A-shares market relative to major developed equity benchmarks and their own history, that A-Shares will continue to outperform.

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