China: Risk of macro fallout will see policy err on side of caution

LAGOS (Capital Markets in Africa): Our house view is that recent bank failures are largely contained and in and of themselves do not represent a systemic threat. But market repricing and a shifting economic environment in the US/EU, alongside the PBOC’s surprise RRR cut, have led some to (once again) question China’s recovery and any associated contagion risk from tighter US and global financial conditions.

This is so despite the recent contrast between US and China risk premia in recent weeks. While US 10-year government bond yields have fallen around ~50bp over the past month, China’s 10-year has stayed remarkably stable. It is important to note that going into the recent US bank stresses, Chinese authorities had been on a path of paced regulatory reforms to lower overall financial contagion risk. These include a recent overhaul of the financial regulatory framework, increased regulatory scrutiny over a “disorderly expansion of capital”, and recent financial regulatory updates on risk classifications of financial assets and capital rules. Authorities are also laser-focused on stability this year. On the margin, the degree to which tighter lending and dollar funding conditions are met by a strong willingness by regulators to err on the side of caution and are addressed quickly, ought to stave off contagion risk.

The transmission mechanisms of tighter DM financial conditions
The main channels of a DM-led banking stress event on China’s macro environment are three-fold: 1) spill-overs of tighter financial conditions onto onshore risk premia, funding costs and confidence, 2) tighter bank lending leading to potential property sector stresses, and 3) weakened DM sentiment leading to contagion effects via trade links as imports pull back.

To explore the transmission mechanisms of the first channel, we look at the behaviour of a number of domestic funding and activity proxies to tightening financial conditions indices across DMs in past DM-originated / global crises. The four periods of stress that are DM-originated or global in nature, and with available historical data going back in time were: the global financial crisis 2008-2009, the European debt crisis in 2011-2013, US-China trade tensions in 2018-2019, and the global Covid pandemic from 2020.

Our statistical VAR analyses suggest that across these four historical stress events, tighter financial conditions in DMs affected onshore perceptions of systemic stress and economic policy uncertainty, but outside of the global financial crisis, did not have a statistically significant knock-on effect on domestic economic activity and consumer confidence.

We think this can be explained by the relatively quick and whole-of-government policy support that offset weaknesses and bolstered underlying confidence. Policymakers’ swift response in these crises were also arguably necessitated by the separate domestic shock events that accompanied these global / DM-rooted shocks (the Wenzhou private lending crisis in 2011-2013, and the deleveraging and anti-corruption campaign in 2018-2019 for instance). Applied to the current context, we think history suggests that: 1) the idiosyncratic nature of recent US bank stresses implies minimal spill-over risk for China in the absence of an accompanying domestic shock, 2) China’s policy response in any emerging crisis remains critical.

Second, China’s banking system is still relatively decoupled from DMs’, in part because of existing controls around capital flows but also due to the availability of liquid assets in the state-dominated commercial banking system. Cross-border bank exposures are also at manageable levels, with total cross-border lending trending around 5% of China-owned banks’ balance sheets. Accordingly, our proprietary Banking Sector Risk Indicator (BSRI) shows China’s banking system relatively well-placed in the recent global bank sell-off. Domestically, yields on 6-month Negotiable Certificates of Deposits (NCDs) between AAA, AA+, and AA rated banks have also compressed in recent weeks, indicating stabilising funding costs even for the lowest rated banks onshore.

System-wide data from the IMF suggests that both liquid assets as a share of total assets as well as short-term liabilities have risen in recent years and are ahead of most of the rest of EM Asia (though still below more advanced peers of Singapore and Korea). But aggregate banking sector data potentially masks tighter liquidity constraints at smaller banks – explaining why PBOC may have opted for an RRR cut more recently that would have effectively eased the funding costs for this segment of the banking system.

Then there’s the trade angle to consider in terms of the risks of a deeper US demand retrenchment, particularly if tighter lending conditions or uncertainty about the way current events may evolve dampen sentiment and drive down demand. Our US team estimates that the peak drag on US GDP occurs three quarters after the tightening in lending standards. But we note that in the event of a sharp retrenchment in US import demand, China is in fact one of the less exposed Asian economies in terms of trade linkages to the US.

Still, total merchandise exports to the US makes up a meaningful 16% of total Chinese exports (a small stepdown from the 19% share seen at the start of the US-China trade tensions in early 2018). Almost half of these exports are concentrated in machinery and electrical products – consumer durables including computers, office machinery, integrated circuits, and household appliances that carry higher demand elasticities. Data going back to 1990 suggests that prior retrenchment in overall US import demand growth have led to an almost one-for-one pullback in Chinese US-bound export growth.

Authorities will be quick to act, even if contagion remains a tail risk
In a political and macro environment where policymakers are laser-focused on stability, recent liquidity events (however contained) have raised the question of whether they could see policymakers embark on an easing cycle anew. This isn’t our base case for a few reasons, notwithstanding the domestic constraints of further aggressive easing. For one, there has not yet been any reported refinancing difficulties amongst corporates onshore, and credit demand has been on a gradual recovery. Second, China’s economic activity has been on an uptrend since the end of the country’s zero-Covid policy. Therefore, unless onshore funding market stress picks up and/or activity levels weaken more than expected, our baseline expectation holds that policymakers are likely to keep to a cautiously-accommodative policy path.

That said, Chinese policymakers will ensure systemic risk concerns remain in check, which could include erring on the side of caution should such concerns begin to surface. Recent history suggests that authorities have deployed a range of policy tools, including localising banking sector stresses with swift nationalisation (New China Life Insurance in 2008, Anbang Insurance in 2018) and equity injections (Baoshang Bank in 2019, Bank of Jinzhou in 2020).

Large, ‘whole-of-government’ easing cycles in the past have also accompanied global crises or crises that were reinforced by domestic shocks, even though we note that the size of stimulus has been smaller and deployed more gradually in more recent episodes. Monetary easing has typically been the first policy tool of choice, followed by heavy investment or infrastructure outlays. The latter has declined in size over the years, reflecting an incrementally smaller policy headroom as well as the structural costs of past stimulus. All of this suggests to us strong policy firepower and a willingness to ease, should external conditions deteriorate meaningfully from hereon.

Source: Oxford Economics