Late last Friday, the Peoples Bank of China (PBOC) announced a second interest rate rise this year. It follows the first high-profile move on 27th April, when 1-year benchmark lending rates were also raised by 27bps. This policy move represents the latest attack in China’s ongoing war on fixed asset investment (FAI). We put the latest monetary policy tightening in its wider perspective, assess the potential for likely future moves and analyse the impact of such tightening on Chinese activity.
Chinese demand matters – especially to Asia
As we have suggested before, China is probably a much larger economy than the number four ranking suggested by its official GDP data. The World Bank’s PPP-adjusted figures rank China as number 2 in the world, or number three if the Euro Area is treated as a single block. More anecdotal rankings by volume suggest that China may even be larger than the Euro Area. The fact that one of the world’s largest economies is implementing a sustained programme of policy tightening has significant implications for global demand – especially as we await the full effects of US monetary policy. China’s policy, however, matters most immediately for the rest of Asia, which has the greatest exposure to China – exports to China from Asia (ex-Japan) account for over 40% of the total. Whilst the US accounts for part of the true end-demand for these exports, it is clear that China has become the key market for the Asian economies and that China’s policy will have a clear impact on Asian activity in general.
Why is China tightening?
During the spring of this year, senior Chinese officials began to express concern about the pace of economic activity and the likely need to cool it down. In particular, they noted that the rate of growth of FAI was excessive and therefore a target of policy, along with the rate of monetary growth. At the time, M2 was running at around 19%yoy, whilst lending was expanding by 14% – both measures above their targets of 16% and 13%, respec-tively. Moreover, FAI was starting to accelerate from its already high growth rate of around 27%yoy.The concern was not only the implications of a potentially overheating economy, but also the need to prevent further over-investment. At that point, the Chinese authorities indeed declared a war on investment (put more formally by the powerful State Council in June, when it spoke of the need to “decisively control fixed asset investment growth”). The weapons they have been using combine conventional monetary policy and more specifically-targeted actions intended to trim back local investment spending
Monetary measures are important but non-monetary measures are key
The latest interest rate rises are high profile and therefore tend to attract the most attention, but the PBOC has also implemented other measure – both monetary and non-monetary. As well as interest rate rises, the PBOC has implemented tightening this year through banks’ reserve requirement ratio (RRR). Following the rate rise in April, the PBOC announced a 0.5% rise in the RRR in June – effective July 5th. The rise was for all banks, and meant that for most banks the RRR would increase to 8%. This move was repeated again earlier this month with another 0.5% increase whose effective date was 15th August. Such moves confirm that the PBOC is shifting from a previously neutral policy towards a clear tight policy stance.
The rise in the RRR affects banks’ ability to lend by re-ducing the amount of free reserves against which they can lend – the measure puts a squeeze on the bank credit multiplier. The rise in the RRR will probably have little impact on the four big banks because they already had excess reserves, but it will likely be felt noticeably by the second-tier banks.
In addition to the above, China Bank Regulatory Com-mission (CBRC) has been issuing “window guidance” to banks, in the interest of limiting lending to various over-heated sectors. Such guidance is based on the recom-mendations from the National Development and Reform Commission (NDRC) – of which more below. Sectors which have been identified are those commonly associated with FAI such as cement, aluminium, steel and high-end real estate. Power and coal mining have also been identified. It is difficult to quantify this kind of tightening, but the effects of previous administrative guidance in 2003/04 did precede a clear deceleration in monetary growth.
Whilst the abovementioned monetary measures will serve to cool lending growth and investment activity in the months ahead, their impact has to be put into context. Bank credit accounts for around only 20% of total FAI. Consequently, monetary growth will slow but investment spending will be impacted to a much lesser extent. Certainly this was the case in previous tightening phases, when monetary growth slowed but the pace of FAI was more resilient. For this reason, policymakers have turned their attention to more direct administrative controls.
Policymakers are now addressing the root of the problem
In late April – before the first interest rate hike – the NDRC announced “structural adjustment” targets for various sectors associated with FAI and real estate. In its statement, the NDRC indicated that it would use a number of administrative measures, including tighter project approval criteria, project “clean-up” and more effective land supply control. Over the following weeks and months, the details surrounding these policies (which have been coordinated with other ministries as part of the general assault on FAI) have gradually been unveiled and we assess these measures below.
Tighter restriction on land supply: Towards the end of July, the Ministry of Land Resources (MLR) announced a package of measures to tighten up the land supply process. It is establishing nine regional land supervision offices, which will be staffed by central government officials whose job it will be to monitor local land transactions. What this really means is that the central government is sending in officials to stop illegal land transactions, which have helped to fuel excess FAI.
This key policy measure offers a very direct way of help-ing to restrict FAI and an overheating real estate market. Indeed, officials recognise that one of the key reasons they have been unable to cool FAI in recent years is that the land supply quotas they have set have been largely ignored by local governments. For example, MLR says that the share of illegal land transactions in local areas was 64% in the year to September 04 but has since ranged between 60% and 90%.
Furthermore, tighter monitoring measures will also be supported by an earlier announcement made by the MLR to include local land sales within the central budgeting process. Previously, such sales were outside the central budget and local governments had an incentive to maximise sales for local revenue. These sales facilitated excessive FAI growth.
Project clean-ups: Another part of the package of poli-cies to restrict FAI growth was the NRDC publication (jointly with four other ministries) of a circular on meas-ures to clean up recently started projects. Investment projects started in the first half of this year will be subject to a screening process designed to detect problem projects. Local governments will have to report all problem projects to the central government.
The projects will be judged according to five criteria: In-dustrial policy, approval rules, land policy, environmental impact and credit. The intention is to stop any project which fails to meet any of the above criteria. Along with the restrictions on land supply, the project clean-up measures clearly signal the central government’s intention to control and restrict the pace of FAI in the months ahead.
Macro measures to cool off real estate: Following talks between a number of ministries (including the PBOC, Ministry of Finance, Ministry of Construction and the Ministry of Land Resources) in late April, the State Council announced a package of measures to stabilise property prices. These included a decision to raise the minimum mortgage down payment for second home buyers (and first-time buyers for properties over 90 square meters) from 20% to 30%. Also, properties held for less than five years will attract a business tax of 5% – previously the minimum period was just two years. Local governments will be required to ensure that 70% of land supply and construction area for residential properties will be for low-middle end housing developments. Land supplied for construction projects will be confiscated by the government if the projects are not started within two years of their contracted commencement dates.
The aim of these measures is to reduce the speculative element behind the rise in property prices, especially at the high end of the market, whilst maintaining support for genuine secular expansion in the mid to low end. These centrally-coordinated macro measures are also being supplemented by more locally-oriented measures, like those seen in Shenzen in late April, where the local government also announced policies designed to control real estate prices.
Overall assessment of the policy measures so far
So the latest interest rate policy announcement has to be viewed in light of the less high profile measures that have been put into play. The interest rate adjustments are supplementary, rather than pivotal, to the other non-monetary administrative measures being enacted. In some respects, the rate rise is more symbolic given that lending finances a relatively small proportion of investment. But to the extent that the intention is to move towards a more market-oriented system of monetary control, the rate rise is an important part of the overall monetary mix. In the meantime, the earlier rise in the RRR and window guidance will also add to the tighter monetary conditions and begin to have an impact in the months to come. As far as FAI is concerned, however, the most important measure is the administrative packages that have been put in place to address excess investment at the local level. In this regard, the coming months could well bring with them evidence of a sharp deceleration in investment activity, as well as cooler lending growth.
Early indications that policy is starting to work
It is still too early to judge the full impact of the above-mentioned measures, since many have either only just been implemented or have yet to come into play. But from the latest data round, it possible to glean some signs that policy is starting to kick in. The latest urban FAI data showed a deceleration in the cumulative measure – from 31.3% in the January-June period to 30.5% in the January-July span. The implied July annual rate dropped more sharply, to 26% from 33% in June. These data only reflected the first round of interest rate rises and the first increase in the RRR. The August and September figures will begin to reflect more fully the monetary and administrative measures that have been announced more recently. Such cooling was also supported by evidence from industrial production, which also decelerated, from 19.5% in June to 16.7% in July
Policymakers likely to assess their efforts
Given the likely lagged reaction to measures imple-mented or about to come into effect, China’s policymak-ers may now well decide to sit back and assess the im-pact of their efforts. Judging from the impact of the previous policy tightening phase – which relied heavily on administrative measures – China’s overall activity rate could well see a distinct cooling in the months ahead. Consequently, we think that the pace of future policy announcements is likely to abate in the coming months as officials decide to take stock.
From a longer-term policy point of view, however, an-nouncements on conventional monetary policy measures are eventually likely to be forthcoming. Firstly, real interest rates are low compared with the secular trend in GDP growth. Given the intention to move to a market system of interest rates, further interest rate rises/RRR increases could arrive by the turn of the year. Furthermore, exchange rate policy is still a hot topic, especially given that on this latest occasion the PBOC decided to raise both lending and deposit rates. The deposit rate rises have been viewed as evidence that the authorities are less concerned about the implication of foreign inflows – thereby giving rise to speculation that the currency may be allowed to appreciate as part of overall monetary tightening.
Conclusions: soft landing… we hope
Although China’s interest rate rise was only a surprise in terms of near-term tightening and will have only limited margin impact on activity, the move should be seen in its wider context. China has been gradually tightening policy since the spring and the less high-profile measures are likely to be most effective. From here we anticipate a more noticeable deceleration in Chinese activity, which is likely to affect those countries most exposed to FAI in China.
The big machinery exporters, like Japan and Germany, will start to feel the squeeze, but Asia’s broad exposure means that it will probably see the most immediate effects. We remain of the view that China’s strong secular expansion will prevent a hard landing, but the coming months could well see an abrupt deceleration in overall activity
Nigel Richards is Chief Investment Officer, Asia, for AXA Investment Managers