PBoC Might Guide Interbank Rates Up, Still Not Tightening

The People’s Bank of China has scaled back its open-market operations pretty dramatically in April. After draining RMB602 billion of liquidity in March through bill and repo sales, the central bank has drained RMB124 billion through April 17. The bank only drained RMB14 billion last week, down from RMB218 billion three weeks ago. There are several factors behind the slowdown in liquidity reductions, but the upshot seems to be a slight hike to yields on the central bank bills in the coming weeks. This could come as early as tomorrow, when the PBoC will sell RMB40 billion worth of one-year bills.

The market is clearly expecting the central bank to hike rates. These expectations are being driven by strong economic growth and signals from policymakers that further monetary tightening is in the offing. GDP growth was around 13% on a q/q basis in Q1, or 11.9% y/y, despite the drag from net exports. Fixed-asset investment continued to grow at an inexplicable 26.4% y/y pace in Q1, despite a sharp slowing of central government projects to 9.1% y/y. Policymakers have hinted that the RMB/USD peg could come to an end soon, the PBoC resumed sales of its three-year sterilization bills and central bank advisors have been quoted in the media saying a hike to policy interest rates is justified.

Expectations that interest rates were about to be hiked contributed to a failed government debt auction on April 9, when the Ministry of Finance (MoF) was only able to sell RMB15.81 billion of a planned RMB20 billion auction of 273-day treasury bills. Even a 91-day bill auction failed to cover the target, and the average winning yield was up seven basis points from the last auction in December. The central bank probably scaled back its open market operations even more last week in order to ensure enough liquidity for future government debt auctions, but it too will have to start hiking yields if its liquidity reductions are to continue.

After previous failed MoF auctions in July 2009, the PBoC gently guided interbank rates upwards. The three-month reference yield move went from 0.965% to 1.328% by the end of August. Given that one-year bills are yielding negative real rates, the short end of the yield curve looks ready to move upwards.

When this happens, whether tomorrow or next month, expect headlines about China’s aggressive tightening measures. After all, the government’s real estate policy has shifted from extremely supportive in 2009 to its most restrictive ever this weekend. The central bank has hiked reserve requirements by 100 basis points. Stricter credit controls sparked a 73% reduction in new bank lending in March. Inflation slowed from 2.7% in February to 2.4% in March. This all looks like a Goldilocks scenario with the central bank cooking things up at just the right temperature.

We take a different view. RGE’s interprets the State Council’s statement preceding the Q1 data release last week as an indication of softer tightening preferences among the top CCP officials, who ultimately set monetary policy in China. Additionally, March’s unexpectedly low consumer price inflation data removed a bit of the pressure on the PBoC to tighten interbank liquidity, which may further delay the coming hand off from “generalist” Party leaders to the “technocrats” in the economic ministries that we detailed in a previous analysis. This will also take some pressure off the bank to hike interest rates this quarter, though RGE still expects a 27 basis-point hike by the end of June, when CPI inflation will exceed 4% y/y.

As usual in China, regulators are likely to rely more on targeted administrative tools in the coming months than on broad economy-wide measures like interest rate hikes. But economic growth and inflation look to continue outpacing monetary policy in China, and the central bank is falling further and further behind the curve.

RGE expects the CPI to exceed 3% for April, as most of the decline in March was due to softer food prices after the Chinese New Year holiday. Net exports should move back to surplus: the massive jump in auto imports is unlikely to be repeated given the building inventories at dealerships and the export-side of the processing trade will catch back up to imports after a slow return to work in March following the New Year holiday. Application of the administrative measures put in place to deflate the property bubble is likely to be spotty given the disconnect between local- and central- government preferences, not to mention the prevalence of mortgage-free purchases at the high-end of the market. Perhaps most importantly, the support to GDP growth from bank lending did not slow in Q1: new medium- and long-term loans increased 30% y/y. All of the slowdown in bank lending was due to a reduction in short-term loans and bills financing, which stronger corporate balance sheets can easily cover on their own. This will continue to support over-investment in Q2.

In short, China’s economy is overheating and the policy shift toward administrative tools only delays the reckoning. Minor hikes in interbank rates will not be enough, and the risk that China will have to impose stricter tightening measures in H2, just when the global economy starts to slow, is increasing. A moderately hard landing in 2011 (around 8%) is emerging as our base case scenario, which is detailed in the Q2 Economic Outlook to be published on the site tomorrow.


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