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Navigating a safe course for China through 2018

Kerry Craig  |  14 Feb 2018Text size  Decrease  Increase  |  
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A smooth January gave way to a rough start in February, a reminder that rewards come with risks. The threat of a potentially faster pace of rate hikes from the US Federal Reserve (the Fed) was enough to trigger a swift change in sentiment.

Central banks have been the driving force behind markets for the last nine years, but the move from super loose and accommodative policies has begun, not only in big developed nations but also in big emerging economies like China. This matters for markets because while China can be a source of endless worry, it can also be a foundation for the region.

Concerns have grown in some quarters that China could be set for another period of bumpy growth in 2018 after a tighter policy bias from the People’s Bank of China (PBOC) in recent months. Following on the heels of the Fed’s quarter percentage-point rise in rates in December, the PBOC increased (by a smaller amount) the rates it charges to lend money to banks. The PBOC said that these measures were needed to address financial stability and control leverage and credit growth in the economy. Regulators had already started to clamp down on the shadow banking sector--including steps to end the practice of selling guaranteed wealth management products.

The outlook for China is never far from the minds of Australian investors and policy makers, given it’s our number one export market, most valuable tourism market, and a major source of foreign direct investment . But an expected slowdown in the Chinese economy has the ability to impact commodity prices and thus a flow on effect to Australia.

So far the resilience in demand for steel, and therefore iron ore, from China has been a double-edged sword. It adds to Australia’s trade and increases national income, but also keeps the currency high. Any slowdown in China could scupper the good news.

But do investors really have anything to worry about?

Hard landing?

Many fear that the authorities are woefully behind in regulating China’s economy and that recent moves could trigger a hard landing rather than promote financial stability. However, like an experienced captain steering a huge container ship skillfully through the dead of night, we expect the PBOC to chart a safe course for China’s economy in 2018. But to gain greater confidence in the actions of China’s central bank, investors need a better framework through which to understand policy action.

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Different methods, same goals

Investors are used to talking about central bank policy in terms of changes to official cash rates or, now-a-days, the amount of bonds they buy each month. While these are two of the most common dials on the monetary policy dashboard, they are by no means all of them.

The PBOC is a very different beast to the Reserve Bank of Australia or the Fed. Instead of targeting an appropriate level of inflation in the economy--as a proxy for how much demand and economic activity there is--the PBOC targets the total amount of money that’s available. In managing the quantity of money, the PBOC faces a delicate balancing act of trying to provide enough liquidity to promote economic growth while not providing so much that it creates asset bubbles and spurs financial instability.

The PBOC has an outright target of achieving financial stability, something that has been a more cursory objective of the RBA in recent years. In this respect, the PBOC may be ahead of other major central banks in explicitly acknowledging this element as part of its mandate.

An evolving strategy

To manage amount of cash in the economy, the PBOC targets what is known as the M2 money supply. Built into that target are economic goals--how fast real GDP should rise and tolerance for inflation--and financial goals such as furthering development of the financial system. To influence these factors, the PBOC maintains around a dozen reference rates and interacts with market through a variety of ways to get each in the right spot.

In this regard, the PBOC’s toolbox resembles less a hammer of one cash rate and more a set of delicate screwdrivers used to fine tune the financial system. Additionally, the PBOC has much greater regulatory authority than many other central banks, it is not necessary to hike rates on a particular product to discourage its use when the PBOC can just outlaw it.

Testing the ice

Even with greater power and flexibility, finding the right balance has still been tricky. Some policy moves led policy makers to inadvertently encourage the proliferation of less sustainable financial products creating the 2015-17 credit binge. But, as leverage has continued to build, the central bank has introduced specific measures aimed at controlling credit growth without sparking a hard landing. 

All of these actions can be viewed as the central bank testing the ice on a frozen pond in winter--taking normal-sized steps near the shore, such as macro-prudential measures, but moving more gingerly when in the middle of the icy pond (for example, specific product rules and targeted rate cuts for certain institutions).

As such, the PBOC will likely chart a safe course for China’s economy in 2018--reducing systemic risks but maintaining enough liquidity to support growth. This should reduce the prospects of another China-induced period of market volatility.

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Kerry Craig is a global market strategist with J.P. Morgan Asset Management. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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