Why we are getting more cautious on China
The reason that China will always find itself in a position where its hand is forced on rates is because they continue to try and manage the currency and avoid significant depreciation while having a leaky capital account, which still enables individuals and corporates to get their money out of the country. The more the US raises interest rates, the more pressure is placed on the attraction of offshore locations for capital, making it harder to keep the currency stable. China has gone down two routes to ensure the currency doesn’t devalue which is to raise interest rates and to further clamp down on the current account. A huge 7.1% economic growth rate in the first quarter certainly goes a long way to keep capital onshore as well, but when the environment does sour it will place more pressure on the PBOC to hike rates further to keep capital at home. Rising market interest rates have also helped to attract offshore funding for banks. Where else in the world can you get 4.3% for lending to a well rated bank for 3 months? This has all contributed to a result of zero capital outflows as per the official numbers in the last two months. A good story - for now
There is no doubt financial risks are rising in China. This is going to put further constraints on the ability of the leadership to reform the economy away from the ‘old economy’ of heavy industry towards consumption, as the noose of past debts tightens on the economy, siphoning more resources away just to service past debts. The issues with liquidity I have highlighted will place further strain on an already creaking system, struggling with a massive volume of debt.
Being bearish on the China story is getting old and multitudes of investors have been run over waiting for the big crash to happen: however, there is one difference this time around, and this is the reason we are becoming more cautious. For the first time in modern Chinese economic history, interest rate policy is been implemented like it is a real emerging market country, and this is deeply concerning. Throughout the last decade-and-a-half China has been classed as an emerging market, but it was seemingly big enough and dominant enough on the world stage that interest rate policy acted like a developed market. In this sense it was set for domestic growth and inflation reasons, not for external reasons. It seems now that the PBOC is hiking interest rates to manage the currency and capital outflows, rather than domestic inflation or financial system stability. All you have to do is ask Brazil or Thailand or Russia why having to do this can make life very difficult for the domestic economy.
Extract from Income and Fixed Interest monthly: (VIEW LINK)
Appointed Head of Income & Fixed Interest in June 2010, Vimal is responsible for setting strategy, processes and risk management. He oversees $16.4 billion invested across Income, Composite, Pure Alpha, Global and Australian Government strategies.