The PBoC’s fourth-quarter monetary policy report, released over the weekend, provides further evidence that monetary conditions have loosened, supporting an optimistic view of near-term economic prospects.
Bears claim that foreign exchange intervention has squeezed banking system liquidity, threatening a credit crunch. A previous post argued that the PBoC has more than offset the intervention drain by cutting banks’ reserve requirements. The latest report confirms this: banks’ excess reserves (i.e. the surplus over requirements) rose from 1.9% of their deposit base at end-September to 2.1% at end-December – see first chart.
The healthy liquidity position has contributed to banks’ passing cuts in official benchmark interest rates through to borrowers. The average rate on loans to non-financial enterprises fell by a further 37 basis points (bp) last quarter, to its lowest level in data in data extending back to 2009; the average mortgage rate declined by 32 bp, to its lowest since the first quarter of 2010 – first chart.
In other news, foreign reserves fell by a further $99.5 billion in January, following a $107.9 billion December decline. The monthly reserves change exhibits a positive correlation with the spread between the offshore (CNH) and onshore (CNY) renminbi exchange rates versus the US dollar. The spread narrowed sharply last week, suggesting a slowdown in the reserves outflow – second chart.
Economic news flow is currently light because of the Chinese New Year. Last week’s Markit / Caixin purchasing managers’ surveys were encouraging, with both manufacturing and services polls stronger in January – third chart.
The OECD’s Chinese leading indicator*, meanwhile, accelerated further in December, according to data released today – fourth chart.
*See previous post for details of this indicator.
Posts here from the summer suggested that US economic growth would fall short of consensus expectations because 1) real (i.e. inflation-adjusted) narrow money had slowed sharply, 2) corporate finances had deteriorated and 3) the inventory cycle was turning down. GDP is currently estimated to have risen by only 0.7% annualised in the fourth quarter, reflecting falls in business fixed investment, stockbuilding and net exports.
The above-mentioned three reasons for pessimism remain in place. The six-month change in real narrow money has recovered from close to zero in October but is still low by recent and international standards – see first chart*.
The “financing gap” of non-financial corporations (i.e. the difference between their capital spending and retained earnings) fell back between the second and third quarters, although a wider net borrowing measure including share purchases remained high – second chart**. The gap may have narrowed further in the final quarter as fixed investment and stockbuilding declined. This “good news”, however, is probably outweighed by a rise in bond market financing costs: the yield on the Merrill Lynch high yield index, excluding energy sector bonds, increased by 150 basis points between the third quarter and January.
Stockbuilding, meanwhile, remained significant – equivalent to 0.4% of GDP – last quarter. With final demand slowing, the inventories / sales ratio in the GDP accounts rose to its highest level since 2011 – third chart. The stocks cycle, therefore, may continue to exert a sizeable drag in the first half of 2016.
The labour market is unlikely to be immune to these trends. Productivity fell in the fourth quarter, boosting unit labour costs and increasing pressure on firms to cut jobs. Several indicators are flashing warnings: the American Staffing Association staffing index – which measures demand for temporary and contract workers – has fallen year-on-year for eight months, the four-week moving average of initial jobless claims is up 9% from its recent low, while the employment component of the ISM manufacturing survey dropped to its weakest level since 2009 last month.
The risk is that a softer labour market causes consumers to retrench, tipping the economy over into a recession. For this reason, a previous post suggested paying close attention to consumer expectations in the Conference Board and University of Michigan surveys – expectations usually fall sharply at the onset of recessions. The Conference Board measure rose in January, with Michigan expectations unchanged – fourth chart. Consumers may have adjusted, at least partially, to a weaker outlook, with the personal saving ratio rising to a three-year high in December.
In addition to a sharp drop in consumer expectations, the previous post suggested that a recession would be signalled by a fall in the ISM manufacturing new orders index below 42.5 and / or a rise in the net percentage of banks tightening credit standards on commercial and industrial (C&I) loans in the Fed’s senior loan officer (SLO) survey above 20%***. The ISM orders index edged up to 51.5 in January, although regional Fed surveys were more negative – fifth chart. The net tightening percentage in the SLO survey, meanwhile, increased to 6% – final chart.
*The chart includes a US January estimate based on money data for the first three weeks and an assumed 0.2% monthly fall in consumer prices.
**A post in December stated that the wider measure had declined sharply in the third quarter but this reflected an error in the official data, which has since been corrected.
***Average of large / medium and small firm net percentages.
Claims have been made that recent large-scale capital outflows have tightened Chinese monetary conditions. Proponents of this view presumably pay no attention to monetary data, or even interest rates. As previously discussed, growth of money holdings of households and non-financial enterprises, on both narrow and broad definitions, has risen significantly since mid-2015 – see first chart*. In interest rate markets, the three-month repo rate is little changed from its mid-2015 level, while the yield on 10-year government bonds has fallen by 75 basis points – second chart.
A balance of payments deficit on the current and non-bank capital accounts, other things being equal, results in a contraction of broad money. In China’s case, however, this negative effect has been swamped by stronger growth of bank lending to the private and government sectors. Interest rate cuts, meanwhile, have boosted the demand to hold narrow money, with part of the increase probably reflecting stronger spending intentions.
More informed proponents of the claim that monetary conditions have tightened cite a fall in banks’ reserve holdings at the People's Bank of China (PBoC) – down by 9.0% in the year to end-December. This decline, however, has little implication for wider monetary and economic conditions – in the same way that rapid rises in reserves in Japan and the Eurozone due to QE have limited relevance for economic prospects there.
Declining (or expanding) reserves matter only if bank lending is liquidity-constrained. It isn’t. The PBoC has offset the fall in total reserves by reducing reserve requirements. In the US, the St Louis Fed calculates a reserves series adjusted for changes in requirements. No such official measure is available in China but, if it were, it would be rising**. If not, money market rates would be under upward pressure.
Rather than total reserves, excess reserves – the amount surplus to requirements – is the relevant metric for assessing the availability of liquidity to expand balance sheets. The PBoC releases quarterly data on the excess reserve ratio, with the latest data point for end-September, when the ratio stood at 1.9% – third chart. An end-December number is due shortly.
The key issue is not whether monetary conditions have tightened – they haven’t – but rather whether faster money growth will accelerate capital outflows, forcing the authorities to abandon their commitment to exchange rate stability against the new basket. Important considerations for forming a view on this issue are 1) the extent, if any, of currency overvaluation and 2) US dollar prospects – further strength would encourage additional speculative outflows. The judgement here is that Chinese exporters remain competitive, reflected in a rising share of global markets, while continued US economic weakness will cap the dollar.
*The measures in the chart exclude money holdings of government organisations.
**The reserve requirement ratios of large and small banks fell by 12.5% and 13.9% respectively in the year to December.
The Bank of Japan’s surprise decision to introduce a negative interest rate on the top tier of banks’ reserve holdings recalls the famous Beyond the Fringe sketch in which Peter Cook’s squadron leader character calls for a futile gesture to raise the tone of the war. The move is very unlikely to have any positive impact on the economy and will probably also fail in its main aim of weakening the yen.
When the BoJ ramped up its bond-buying as part of its quantitative and qualitative easing (QQE) programme introduced in April 2013, posts here expressed scepticism about the effects on domestic monetary trends and the economy. Specifically, the first-round boost to the money supply from extra QE was expected to be offset by increased bond sales by banks and capital outflows, while any second-round stimulus to bank lending seemed likely to be small. So it has proved: annual M3 growth of 2.4% in December compares with 2.5% when QQE was launched.
Today’s move will push short-term market rates further into negative territory but is even less likely to shift the monetary or economic dials. QE, at least, has a positive first-round monetary impact, even if the final pass-through is minimal. The hope / fantasy seems to be that negative rates will prompt banks to ease lending terms, calling forth stronger credit demand. More likely, banks and borrowers will interpret the move as a negative signal for economic prospects and evidence of BoJ desperation, causing them to be more rather than less risk-averse.
Governor Kuroda’s principal goal, of course, was to restore the yen to a weakening trend – days after recommending that the Chinese authorities tighten capital controls to maintain RMB stability! The problem for him and ECB President Draghi is that markets now perceive them to be running out of ammunition; their easing initiatives, therefore, mainly serve to underline the fragility of the global economy, leading to a larger downward revision in US than domestic interest rate expectations*. With US monetary trends suggesting continued economic weakness, BoJ / ECB depreciation efforts may struggle to gain traction.
*Two-year government yields have fallen by 25, 13 and 7 basis points respectively in the US, Germany and Japan since the start of 2016, according to Bloomberg.
Posts here in 2013 suggested that the trend in UK core and headline consumer price inflation would change from down to up in early 2014 in lagged response to faster monetary growth and labour market tightening. The core rate did pick up into mid-2014 but then reversed course sharply, falling to a new low in the first half of 2015. Headline inflation bottomed at -0.1%. What went wrong?
The forecast was invalidated by two major developments: the effective exchange rate surged by 15% between 2013 (calendar year average) and August 2015, putting strong downward pressure on manufactured import prices; and plunges in crude oil and natural gas prices from June and November 2014 respectively cut household energy bills and reduced costs for suppliers of core goods and services.
A case, nonetheless, can be made that domestically-generated inflation has followed the expected path. The annual rate of change of unit labour costs, in particular, rose from -2.0% in the second quarter of 2014 to 2.0% in the third quarter of 2015 – see first chart. It may have remained at around this level in the fourth quarter, with recent slower pay growth offset by weaker productivity performance.
The disinflationary impact of the strengthening exchange rate, meanwhile, has probably peaked. The average level of the effective rate in January is still slightly higher than in January 2015 but it has fallen by 5% since August.
Core consumer price inflation, therefore, has started to recover. The annual change in the CPI excluding energy, food, alcohol and tobacco rose from a low of 0.8% in June 2015 to 1.4% in December. A narrower core measure also excluding education (to avoid a distortion from the large rise in undergraduate tuition fees from 2012) has increased more sharply, from 0.5% to 1.3% – second chart.
The argument that core inflation would rise was based on historical lagged relationships with monetary growth and measures of labour market slack. The labour market has tightened significantly further since the first half of 2014. The unemployment rate has fallen from 6.5% then to 5.1% in the three months to November, with the November single-month estimate at 4.9%. The stock of unfilled vacancies has risen by 18% since the first half of 2014, while the recruitment difficulties index in the December Bank of England’s agents’ survey reached its highest level in data extending back to 2005.
Broad money trends have also strengthened. The preferred broad measure here under normal circumstances is non-financial M4, comprising money holdings of households and private non-financial corporations. Annual growth of this measure, however, is currently understated because of households switching funds from bank deposits into the Osborne election bonds made available to pensioners by National Savings for a brief period in early 2015 – such bonds would be included in M4 if issued by a bank instead of the government. A wider aggregate including all National Savings products grew by an annual 6.6% in November, the fastest since May 2008 – third chart.
Strengthening credit growth suggests continued solid broad money expansion. The M4Lex lending measure (i.e. bank lending to the private sector excluding “intermediate other financial corporations”) rose by an annual 3.5% in November, the fastest since April 2009. The stock of arranged but undrawn sterling credit facilities, meanwhile, has surged, a development that normally signals stronger lending expansion – fourth chart.
The tentative view here, therefore, is that the recent increase in core inflation, unlike the 2014 firming, will be sustained (with due allowance for monthly volatility). Domestic arguments for a rise are stronger now than in early 2014, while the exchange rate drag is likely to lessen, with possible downward pressure on sterling from Brexit uncertainty.
If correct, Bank of England Governor Mark Carney was unwise to validate expectations of a further extended interest rate hold in a speech this week. This signal threatens to accelerate the pick-up in credit growth and sustain broad money expansion at a level likely to be too high to be consistent with 2% inflation over the medium term.