25 April 2017
China’s economic data for March and the first quarter were surprisingly good, and perhaps no aspect was more surprising than the continued strength in the housing sector. Despite policymakers naming deleveraging and eliminating housing bubbles as this year’s top economic priorities, the current policy mix of administrative measures and targeted rate hikes have had an underwhelming impact, at least so far. Money supply and credit growth have notched down slightly, but the measures have done little to cool China’s red-hot property market (see Chart 9). While the property sector has been largely unaffected by recent policy moves, rate hikes have increased corporate borrowing costs and should eventually begin to impact mortgage lending. Further tightening may be needed if house prices continue to climb but, as we note below, the People's Bank of China (PBOC) may not have much room if it hopes to maintain growth at target.
China’s monetary policy has been shifting since the end of 2016. The PBOC has been relying on market-based tools to reduce financial sector leverage – it hiked lending facility rates; withdrew liquidity through open market operations; and introduced stricter macro-prudential rules to target off-balance sheet credit growth. These moves have been effective. For example, the SHIBOR rate has climbed; the 7-day repo rate, which is perhaps the best indicator of overall liquidity, has trended upwards; the interbank spreads are up 180bps from last year’s low; and defacto deposit rates have edged up. Tightening interbank liquidity is primarily targeting financial sector leverage; namely, smaller, speculative banks borrowing excessively in wholesale funding markets to increase assets and chase yield. By raising interbank rates, the PBOC hopes to squeeze the liabilities of smaller banks and reduce financing to non-bank financial institutions.
While it is unlikely to lead to a liquidity event, especially in such a politically important year, the probable result will be slower credit growth, both to non-bank financial institutions but also the real economy. Small and medium-sized banks rely on wholesale funding to fund roughly 25% of liabilities mainly through issuing certificates of deposit (CDs) in the interbank market. As liquidity tightens and interbank CD rates rise, banks will have little choice but to reduce credit growth. As a result, corporate borrowing costs have increased and corporate bond issuance has fallen sharply and supply growth has dropped to a historical low. Bank lending was down due to lower corporate borrowing, and total credit growth dropped from 15.8% to 15.1%. If history is a guide, higher interbank rates should pass through to higher mortgage rates (see Chart 10). However, if mortgage and house price growth fail to slow, further tightening may be needed. This puts the PBOC in a dilemma. Empirical analysis suggests that China requires approximately 14% year-on-year credit growth to maintain GDP growth at or near the 6.5% y/y target. With current total credit growth trending downwards, the PBOC may have little room for further hikes. Strong Q1 growth offers some room for growth to slow, but the PBOC is largely in unchartered waters. With increased system-wide reliance on wholesale funding and fewer government controls over lending and deposit rates, execution risks are high and rising.
Alex Wolf, Senior EM Economist