Interbank lending rates
The below graph reflects the effects of the China Central Bank’s monetary tightening policies on interbank lending rates. The interbank seven-day lending rate spiked in June. Rates on government bonds have also risen, with the three-month yield on Chinese bills rising from 2.65% to 3.50%, and the ten-year bond yield rising from approximately 3.50% to 4.00%.
Jitters in China’s banking system
The real shock was the spike in interbank rates, as depicted above. The Central Bank of China seems to have surprised the markets with a warning shot across the bow of the banking system, catching many banks by surprise and sending a warning signal that aggressive lending in the “shadow banking system” and too much leverage needed to be reined in.
China couldn’t have picked a better time to give up communism and adopt capitalism. By pegging its currency to a chronically weak U.S. dollar, China has been able to maintain a low domestic price level and low cost of production despite gradual yuan appreciation. The euro bought $0.85 U.S. dollars in 2002, and bought $1.60 in 2008—practically doubling against the U.S. dollar. It also appreciated against the Chinese yuan by around 10% from 2003 to mid-2008. Not pegging to the euro was probably a great idea. Chinese exports have prospered over the past decade, as China’s currency has remained pegged to a fairly weak dollar, especially vis-à-vis the euro. However, going forward, this may be changing.
The delicate dance of central banks is about to get more complicated, and after a fairly harmonious synchronization of monetary policy between the United States and China central banks, monetary policy between the United States and China could get out of step. China has begun tightening. The U.S. Fed has signaled that it may also “taper” its policy of monetary easing. Should the U.S. Fed taper too hard, too fast, and cool the budding U.S. recovery too quickly, the U.S. Fed might accidentally step on the foot of the China Central Bank (PBOC) by amplifying the effects of China’s current policy of monetary tightening. Plus, Japan has begun loosening monetary policy, which is weakening the yen and providing greater export competition in Asia. If China were to experience a hard landing next year, and if Larry Summers were the new Federal Chairman, at least the world would have someone to blame.
The changes in monetary policy in both the United States and China, in conjunction, could reinforce one another and introduce significant turbulence into the monetary soft landing that the China Central Bank (PBOC) is trying to engineer. The Chinese economy could get a lot cooler a lot faster than expected. Investors may fear an inadvertent excess of monetary tightening in a soft global economy, which might exacerbate the recent stresses in the Chinese banking system, and create a Japan 1990 redux—replete with a collapse of banking stocks, the broader economy, and equity markets. This concern is putting pressure on Chinese stocks, as reflected in China’s iShares FTSE China 25 Index Fund (FXI). Of the top ten holdings of FXI, three are banks, accounting for roughly 22% of total holdings.
Will Fed tapering exacerbate China tightening?
Since the crisis of 2008, the U.S. Federal Reserve (Fed) has engaged in several rounds of “quantitative easing,” which means lower interest rates in the United States, a relatively less attractive or weaker dollar, and by association, a weaker Chinese yuan. However, looking forward, we see that the Fed may begin to scale back its easing measures next year and withdraw some liquidity from the U.S. financial system.
Currently, China has already begun its tightening in order to reign in the growth of credit. The above graph reflects the first shock of monetary tightening that occurred in June. China Central Bank Governor Zhou is facing a similar challenge that Japanese Central Bank Chief Mieno faced in 1990, and that Alan Greenspan of the U.S. Fed faced in 2006. Commentators have raised the concern that China could see a significant drop in equities prices, as happened in Japan in 1990, followed by a “lost decade” (or two and change) of economic growth. You hardly need to be reminded of what happened to U.S. equities prices in October 2008. With some luck, China may manage to tighten monetary policy without substantial disruptions to the banking system and equities markets like Japan in 1990 or the United States in 2008. With more luck, Chinese markets will also not overreact if the U.S. Fed begins to taper its quantitative easing policy.
Given the uncertainties in the global economy surrounding monetary policy, the US S&P 500 as reflected in the State Street Global Advisors S&P 500 SPDR (SPY) or the Blackrock iShares S&P 500 Index (IVV), as well as the Japan Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs could continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and potentially Korea’s iShares MSCI South Korea Capped Index Fund (EWY) ETFs. While both U.S. and Japan equities markets have been well supported, continued weakness in China and Korea merit close attention.
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