China's macro medicine

Are China's recent monetary policy changes a painkiller or a steroid?

19 Sep 2018

by Hayden Briscoe, Head of Fixed Income, Asia Pacific

On the back of launching the first Chinese bond fund in the world denominated in CNY, we've leveraged this first mover advantage launching the first Japan-domiciled China bond fund and there's another one in the pipeline. With the global bond index inclusion of onshore China fixed income coming in April 2019, institutional investors are already moving their strategic allocations to China. All this is happening with China macro and trade issues dominating the headlines and, with these in mind, plus an eye on why tactically it makes sense to invest in China fixed income in the coming months, here's our take on the macro outlook for China.

What happened in June?

Policy measures take time to impact the real economy and the mini-cyclical slowdown we predicted last year not only came into view in June 2018, but caused a meltdown in China's onshore bond markets.

Deleveraging had a huge part to play and the program, essentially a raft of regulations and credit controls that began in late-2016, has throttled credit growth (see Exhibit 1) and pushed China into slowdown territory in June.

Exhibit 1: Bloomberg China Credit Impulse, July 2005-July 2018

Source: Bloomberg, September 3, 2018

Already tight liquidity, made worse by a corporate money scramble to meet mid-year tax bills, plus cash hoarding by banks before mid-year stress tests, brought China's onshore bond market to a standstill.

Wintime, a China-based coal miner, launched a new issue priced at 6-7% but the auction failed. There was no clearing price discovery for distressed issuers and bonds were not being marked to market. Wintime defaulted on its commercial paper on July 5th and entered debt restructuring with its creditors after its new issue failed. The company still has RMB 7 billion of outstanding bonds on the open market.

Wintime's case also showed the discomfort for China's corporate sector, itself the cause of a marked pick-up in defaults and bankruptcies this year.

Defaults, though small (0.8%) as a share of total lending, and wider bond market trends flashed red in June, and so did the outlook for the economy, with growth in money supply and investment reaching historic lows, equity markets sagging and China-US trade concerns increasing.

Exhibit 2: Onshore Bond Defaults, FY 2015 – YTD 2018 (RMB Billions)

Source: Bloomberg, August 8, 2018

Exhibit 3: Fixed Asset Investment and M2 Money Supply Growth (YoY-3M M.A.), March 2009-July 2018

Source: Bloomberg, September 3, 2018

The PBoC's prescription

To stabilize the situation, China's monetary policy medics at the People's Bank of China (PBoC) went to work and delivered a policy prescription.

Three courses of new policies were most notable:

  • Money market injections: The PBoC aggressively injected RMB 502 billion on July 23 via its Medium Term Lending Facility (MLF). MLF was introduced in 2013 to direct money to underserved or stressed sectors of the economy.
  • Directed bond buying: The PBoC fast-tracked local government bond issuance and directed banks to bid the issues at generous yield pickup of 40 basis points over rates on government bonds. The PBoC provided window guidance to banks to provide MLF funds to buy corporate bonds with lower credit ratings (AA+ or below). Prior to this, the corporate bond market was in a meltdown, liquidity had dried up for good and bad borrowers.
  • Bond market rescued: PBOC action rescued the corporate bond market, but don’t be fooled by the rollover of maturing bonds, especially for the local government financing vehicles (LGFV). They have been given respite for only 12 months, the length of the MLF lending.

Exhibit 4: MLF Financing (RMB Billions), January 2016-July 2018

Source: Bloomberg, August 8, 2018

Three other policy tweaks included:

  • Relaxation of asset management (AM) rules: The PBoC eased up on AM regulations previously announced in April. Now banks could put non-standard debt assets back onto their balance sheets and have more time to meet new regulations.
  • Looser MPA capital requirements: The PBoC reduced minimum capital requirements for its MPA tests, thus easing capital stress in the commercial banking sector and boosting money market liquidity.
  • Simplified bond issuance rules: the Shanghai Stock Exchange simplified approval procedures for corporate bonds on June 30 to make it easier for companies to issue on onshore markets.

These coordinated policies eased the pain of tight market liquidity in the market, and yields of AAA- and AA-rated corporate paper came off from their peaks in mid-July.

Exhibit 5: Corporate AAA and AA Yields, January 26th, 2015-August 29th, 2018

Source: Wind, August 30, 2018

What it means for China

The range and nature of measures used tell us three things.

Firstly, the PBoC was compelled to act because a major economic slowdown shifted from a prospect to a reality in June.

Secondly, China used a nuanced, targeted approach, differing markedly from the heavy-handed, quota-driven monetary policies of the past.

Thirdly, China's bond market is now more important than ever. The shift to diversified financing channels from a bank-dominated financial system is happening and, like in the US, China's bond market now gives visibility into the economic outlook.

What it doesn't mean

Despite the hopes of the sell-side and commentators applying China's past behavior to the current situation, it doesn't mean that China has dramatically loosened policy and decided to flood the economy with credit - and current real estate policy gives a guide to official thinking.

Long used as a tool to prop up the economy during tough times, China's real estate market had a key source of policy support withdrawn in June.

In June, China Development Bank (CDB), China's largest policy bank, announced a rollback in the estimated RMB 1.26 trillion it provides for shantytown development, a national project dating from 2008 that builds new projects to replace old housing and finances residents' purchases

That's significant because shantytown development has boosted the real estate sector, accounting for 19% of national sales in 2017. Now that loans to developers have been curbed or access curtailed, a key support for the sector, and the economy, has been withdrawn.

A painkiller, not a steroid

With this in mind, we see the PBoC's policy prescription in June 2018 as a painkiller rather than a steroid.

That is different from the steroid-like, large-scale policy stimulus enacted in 2008 and 2015 that boosted the economy in the short-term but saddled the financial sector with unsustainable debts in the longer-term.

The reality of continued sales restrictions on the real estate market, plus the shantytown policy change from CDB, means support for the economy remains limited and resolve remains in China's core leadership to continue deleveraging the financial system.

Liquidity remains tight

And current money market conditions tell us two things:

  • Firstly, liquidity has eased slightly, but only slightly. Bond yields have fallen but still remain high by historical standards. Many regulations on bond financing introduced during the deleveraging drive still hold and aren't about to be taken away.
  • Secondly, China's monetary authorities aren't interested in making life much easier. Look at key rates like seven-day repos, interbank deposits, and 3-month Shibor – they have all been increasing since mid-August and we have seen little in the way of open market operations to put downward pressure on rates.

Slower growth ahead

Put together, this means that the real impact to the economy from the PBoC's policy support in June and July will likely be neutralized, adding further weight to our expectation of slower growth in prospect for China in late-2018 and into 2019.

Crucially, despite intervention to ease liquidity, controls on China's shadow banking channels - a source of China's debt build-up and an indirect way of putting credit into the economy - remain robust, and flows remain well in negative territory so far this year.

Exhibit 6: Shadow banking channels: Entrusted loans, trust loans and undiscounted bankers' acceptances (RMB trillions), Jan 2017-Jul 2018

Source: People's Bank of China, August 15, 2018

With all factors considered, we continue to expect slower growth for China in H2 2018 and into 2019, with the IMF most recently forecasting 6.6% growth for 2018 (2017:6.9%) and 6.4% growth in 2019.

Opportunities onshore

But for investors contemplating how to allocate to China in the current environment, onshore fixed income continues to look attractive.

Current conditions are unprecedented, particularly for those set up to deal on China's interbank market. That is because hedging costs on foreign currency have turned negative.

Onshore banks' demand for USD shifted up dramatically amid weakness in the CNY. For investors going direct into China's onshore markets, these conditions offer a pick-up with negative hedging costs.

Exhibit 7: RMB onshore forward hedging costs (Bps), September 8th, 2017- August 31st, 2018

Source: Bloomberg, September 2, 2018

On top of this, the State Council, China's most powerful policymaking body, announced on August 30th that it would introduce a three-year exemption on withholding tax and VAT on bond interest earned by foreign institutional investors on onshore fixed income.

For investors concerned about recent volatility, we feel the recent RMB devaluation has run its course and when we look at the RMB on a trade-weighted basis, against the CFETS basket, the RMB remains at, or around, levels seen in the past 2-3 years.

Exhibit 8: CFETS RMB Index, Nov 30, 2015-Aug 31, 2018

Source: Bloomberg, September 2nd, 2018

Looking at specific categories, yields in the 3.6% to 4% range for 10-year government debt continue to look attractive compared to prevailing yields on other developed markets.

Exhibit 9: Government Bond Yields Compared, October 23rd, 2013-August 23rd, 2018

Source: Bloomberg, August 31st 2018

From a technical perspective, the onshore market breakdown in June had reverberations into China hard currency securities and impacted the larger names in the real estate market most of all. Now that onshore bond markets have eased off, the technical pressure on these names has now subsided.

As such we see excellent value opportunities in high-yield, particularly in the hard currency space. Looking at the market currently, yield-to-worst levels are approaching 9.5% and credit spreads of close to 700 bps compare favorably to spreads of around 360 bps in the US high-yield space.

And from a long-term performance point of view, we'd remind investors that the high-yield space has delivered annualized returns of 11.3% over a 10-year period, compared with 6% for the China equity market, whilst also having less volatility.

Exhibit 10: China High Yield (HY) Spread vs. US High Yield (HY) Spread (bps): 30th June 2013- 30th June 2018

Source: Bloomberg, J.P. Morgan. China High Yield as represented by JACI China HY. JACI is the J.P. Morgan Asia Credit Index. US HY represented by Bloomberg Barclays US Corporate High Yield. Spread as represented by the option-adjusted spread (OAS). As of 10 July 2018

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