Abstract: RMB’s recent depreciation is, to a certain extent, a result of the Fed’s tightening moves, but the fluctuations of the interest rate of Chinese government bonds is more associated with the country’s own economic downturn. An important reason behind is that Chinese monetary policy still enjoys a high level of independence, partly because of the country’s not-so-open financial market and the free-floating regime of the RMB exchange rate. The Chinese market is marginally reviving, but the actual effect of the policies remains an uncertainty that could disrupt the market going forward, and China must prepare for the worst scenario with a possible “perfect storm”.
I. CHINA REMAINS INDEPENDENT WITH ITS MOENTARY POLICY
First, I would like to share some of my observations on the interest rate of long-term government bonds, exchange rate of currencies and major equity markets across the world, before focusing on the performance of China’s financial market over the past months.
The dollar index measuring the greenback against a basket of currencies has soared recently, with the interest rate on 10-year Treasury bonds jumping above 3%. This has spilled over to other economies, with the interest rates on 10-year government bonds of Germany, France and Italy all rising significantly. Italy experienced the biggest surge, followed by France and Germany whose interest rate climbed up from the negative territory to nearly 1%. Japan at the moment does not have much inflation pressure, and there hasn’t been signal from the central bank of monetary tightening, but the interest rate of its 10-year government bond has risen by over 20 basis points, from zero or negative to 0.25-0.3%. At the same time, while the euro has depreciated against the USD, the Japanese yen has depreciated much more.
Among major markets, the economic cycle of Europe and Japan, especially Japan, is very diverged from that of the U.S. Meanwhile, the free-floating regime and drastic depreciation of the Japanese yen have cushioned the blows to Japan’s financial market, and the Bank of Japan’s promise on stabilizing the long-term interest rate of the government bond has failed to prevent an upsurge in the rate by 20-30 basis points.
In China’s case, Renminbi recently has depreciated against the USD. The exchange rate moved from 6.3 to almost 6.8 at its lowest point, which is pretty drastic in such a short period of time. But considering the divergence of the economic cycle and monetary policy between China and the U.S., this is not unexpected. However, it’s still noteworthy that while the long-term interest rate on government bonds in China has been stable, the short-term rate, including the R007 and the interest rate of 1-year government bonds, have declined remarkably.
On top of these developments, recent geopolitical risks have been driving capital out of the Chinese bond market, and that is an important factor to consider. For some time after the outbreak of the Ukraine crisis, the Chinese bond market has experienced a certain extent of net outflow of foreign capital. With other factors unchanged, this will undoubtedly lift the interest rate in China. In other words, had there not been the Ukraine crisis, the interest rate of Chinese bonds should have experienced an even more dramatic decline despite the Fed’s rate hikes and RMB’s depreciation.
In a global view, RMB’s recent depreciation is partly a result of the Fed’s rate hikes; but compared with Japan, Germany, France and Italy, the fluctuations of the interest rate of government bonds in China is more associated with changes in the country’s own economy.
An important explanation for that is that Chinese monetary policy still enjoys a high level of independence, partly because of the country’s not-so-open financial market and the free-floating of the RMB exchange rate. That’s why while the interest rate across major markets are rising, the interest rate of Chinese government bonds, especially the short-term one, has plunged instead of going up in tandem with the American interest rate.
This means that behind the recent RMB depreciation, in some senses, is the downturn of the Chinese economy.
II. AS COVID RESURGENCES PUSH UP THE SAVINGS RATE, CHINESE HOUSEHOLDS TURN MORE RISK-AVERSE WITH INVESTMENTS
Next, let’s look at the recent savings rate and savings flow in China amid Covid resurgences.
The two major outbreaks in 2020 and 2022 have both led to a leap in household savings rate, partly non-voluntary because people can’t spend, and partly precautionary because people become more aware of uncertainties.
Household savings rate in China once reached 5-6% in 2020. This year, it might well have approached 3%. But where are the excessive savings going?
Back in 2020, there was a 1-month short-lived panic at the onset of the pandemic, after which savings flowed to the stock and real estate markets, significantly pushing stocks back up from the short fall, and boosting house sales and prices.
While in 2022, amid this wave of Covid outbreak, savings seem to have been channeled to three places: 1) savings deposits, as manifested by the fast increase in M2; 2) the fixed-income and fixed-income+ market, which is why the credit spread has begun to narrow without fundamental changes in the economy, with credit bonds gaining momentum and the credit risk premium in markets at all levels declining; 3) debt repayment, as households use savings to pay back their debts in advance or at larger amounts in order to deleverage.
This is a stark contrast with 2020, showing shattered confidence of households in employment safety and future income.
III. BOOST LONG-TERM MARKET CONFIDENCE AND MAINTAIN STABLE POLICY EXPECTATION
Finally, I would like to talk about the Chinese equity market.
Among major equity market indexes, the Nasdaq index has plunged by over 30%; S&P, by over 20%; the ChiNext index and Shanghai & Shenzhen 300 index, by about the same. But two problems would stand out if we examine the Chinese stock market against its own history and the global financial market.
First, this is the first stock market plunge in China over the past two decades NOT preceded by any obvious monetary or liquidity tightening.
Second, the Chinese stock market tumbled more drastically than that in Japan or Europe, whose bond markets have also been pretty turbulent due to the blows from Fed tightening. But the volatility in the Chinese bond market is owed to more deep-seated reasons.
In fact, we’ve already known since February that, if we apply the discounted cash flow (DCF) model, the reason behind the Chinese stock market fall was not the interest rate or other factors on the denominator end in the fraction; nor was it because of market worries over short-term profitability fluctuations. Instead, the market mainly worries about the numerator end: in other words, market expectations of long-term cash flow growth and certainties have weakened.
One possible explanation is that some of the market segments have been overvalued after years of strong growth, overdrawing future potential for profitability growth, leading the stock prices to fall at a certain point by their own gravity without major influences from external factors.
Another possible reason is the adjustments in macroeconomic and regulatory policies which have added to uncertainties of some of the industries.
The two explanations don’t contradict, while the latter may be more important to the market.
IV. PREPARE FOR THE WORST AND BE ON GUARD AGAINST A “PERFECT STORM”
Based on the above analysis, I share two of my judgements and predictions.
First, during mid-March and late April, Chinese policymakers released a series of strong policy signals to cope with the economic and financial headwinds, followed by concrete policy adjustments. The market seems to be stabilizing from a transaction point view, which means that it may have absorbed all, if not too much, of the above negative factors, and at the same time it is tentatively evaluating and pricing the proactive policies.
In other words, the Chinese market, or at least the stock market, is marginally reviving and trying to absorb positive factors. However, the actual effect of the policies remains an uncertainty that could disrupt the market going forward, and China must be vigilant against new turbulences as a result of unexpected developments.
Second, we need to prepare for the worst: given the divergence between the economic cycles of China and developed economies, a strong dollar could add to depreciation pressure on RMB; and mounting downward pressure on the Chinese economy may lead to an unexpected eruption of risks that could trigger massive capital outflows. In the extreme scenario where the two happen at the same time, China could experience a sweeping plunge in its stock, debt and foreign exchange markets with mutual effects that may even spread to the credit and real estate market to form a “perfect storm.” This is not a likely scenario, but definitely an alarming one.
This article was published on CF40’s WeChat blog on May 30. It is translated by CF40 and has not been reviewed by the author himself. The views expressed herein are the author’s own and does not represent those of CF40 or other organizations.
