China: What A Swell Party This Was as Punchbowl LeavesVW Staff
The cheap liquidity is now drawing to an end in China. With China withdrawing liquidity and less generous liquidity provision from the US going forward the region is facing the consequences of having drunk too readily from an abundance of virtually free credit. The potential withdrawal of liquidity in China then highlights the countries vulnerable to an effective hangover. See Kyle Bass: China Could See ‘Full-Scale Recession’ Next Year
Via Tim Riddell, Head of Global Markets Research, Asia, ANZ from a new report titled What A Swell Party This Is Was, we focus on China below.
Read more: China Liquidity Crunch
- The medium term outlook for Emerging Asia remains constructive with data over the past month confirming the likely durability of the US and Japanese recoveries. Still, the Asian production and export numbers have remained relatively muted to this improving outlook.
- Downside surprises in inflation had given policy makers scope for further precautionary monetary policy easing; however abrupt currency depreciation is now expected to mitigate any beneficial cyclical commodity price disinflation. In the real sector, pockets of food and energy price inflation remain problematic. In the financial sector, asset price deflation is now expected to be the overriding price dynamic.
- Regional trade dynamics remain mixed given the increased unevenness in the global growth backdrop, however we remain impressed by the continued strong gains in Japanese IP and manufacturing sentiment. Ultimately this will prove to be a ‘pull factor’ for ASEAN supply chains.
China Policy and Structural
- Financial stability demands policy stability. Rate cut windows are closed and regional central bankers prepared to insulate economies from capital flows via a macro-prudential tilt to policy will be rewarded with lower-volatility, higher quality funding.
Our China Core View: Who Has Partied Too Hard?
China Regional Overview
The first half of June was characterised by an environment where policy makers had the flexibility to respond to an uncertain global backdrop by further cutting policy rates. We expected that window for possible policy action to remain open through the third quarter when the disinflationary impact of commodity price falls would start to fade and output was likely to be supported by firmer growth in both the US and Japan. The ‘sudden stop’ episode of capital flows that occurred over the two weeks to 25 June has slammed that rate cut window closed. It would be a bold policy maker indeed, in fact we would consider it a deliberate invite to volatile currency depreciation, who cut rates in the near term.
Read More: China Money Market
In this current lull in capital outflows, typically after sudden-stops there is a more considered reappraisal before risk capital starts to make a tentative return, it is useful to clearly identify where future frailties are likely to lay. We did this in our recent feature note, Saffron Alert on India, where we identified a deterioration in the near term quality of current account deficit funding as the most likely outcome of India’s problems. It is also equally important to identify where future areas of resilience may lay, as we did in our recent update on the Philippines, Steady as She Goes!, which we see as being able to weather the capital outflow and financial volatility storm relatively well.
The sudden stop is that moment when funding, particularly of current account deficit economies dries up and investors heads for the exit. A sudden-stop event is typically considered to have occurred when the change in flows is two-standard deviations outside of normal. Based on our examination of weekly flows over the past 52 weeks, for the majority of economies we cover the outflows late June were three standard deviations larger than normal following a two standard-deviation outflow in mid-June. A large and abrupt sudden-stop indeed!
The sharp repricing of mature economy bond yields hardly seems a sufficient explanation. Earlier episodes of bond repricing have not necessarily led to a reversal in capital flows to emerging markets but something different is occurring now.
An additional explanatory factor is that growth drivers are rotating away from the emerging world and back towards the developed world. This in itself underpins a less supportive environment for capital flows, particularly as it entails a process of monetary policy normalisation in the US. And this leads to the final explanatory factor, which is perhaps the most powerful in the current situation, and that is liquidity, or more importantly, the expectation of ongoing liquidity. Where earlier than expected Fed tapering has been a game changer is that it has fundamentally changed the assumption of ongoing generous liquidity as a support to capital flows.
There needs to be a relative repricing of asset markets in this environment if emerging markets are going to continue to attract liquidity. The automatic stabiliser in currency outflow periods is that currency depreciation, via cheapening the relative price of domestic assets lends itself to this outcome helping economies and markets find a new equilibrium after sudden stop periods. As of the first week of July, it appears that we are in one of these lulls after a sudden stop period.
The risk is that during this lull, markets become unilaterally negative on the region. Certainly the conversation in the emerging market space focuses on who has been swimming