China: Liquidity, Liquidity, Liquidity

Denise Yam | Hong Kong

Liquidity trends appear to have dominated the discussion of macro outlook for the Greater China economies of late. The relationship between liquidity and each economy has rather different characteristics, and we offer a descriptive account of each of them in this note.

China— managing excess liquidity. The Chinese government has been claiming success in macro tightening, reporting slower economic activity in response to administrative controls in the last few months. However, China has not yet resolved the fundamental problem of excess liquidity from the large trade surplus and capital inflows. The cost of capital remains too low, leaving the economy vulnerable to a revival in overheated and speculative investment. Recent PBoC rhetoric has shifted the policy focus to liquidity management, through lifting reserve requirements and/or issuing bonds. In 2006, the PBoC has hiked interest rates twice and raised reserve requirements on Renminbi deposits three times. Meanwhile, issues of central bank bonds have been kept up to absorb liquidity from the banking system. However, these measures have not been enough to offset the supply of liquidity from the balance of payments surplus.

Each percentage-point increase in the reserve requirement supposedly locks up Rmb320 billion of banking system liquidity. However, financial institutions' deposits with the PBoC totaled Rmb3.8 trillion at the end of September, already covering 11.6% of total deposits, exceeding the requirement. In other words, the "required" ratio of 9% has not been a binding constraint on liquidity. In fact, subsequent to the sharp increase in reserve deposits in 4Q03 following the first tightening move (August 2003), which brought loan growth down effectively over 4Q03-2Q04, the actual reserve ratio has again drifted downwards since early 2005, allowing or possibly contributing to the reacceleration in loan growth.

Because the reserve requirement has not been a binding one, the total achieved sterilization (increase in actual reserve deposits and central bank bonds outstanding) has fallen short of the intended sterilization (increase in required reserves and bonds) as well as the BoP surplus. The BoP surplus of US$207 billion in 2005 met with only a US$146 billion (71% of the surplus) increase in reserve deposits and bonds. In 2006, sterilization remains incomplete, at 76% in 1H06 (US$122.1 billion BoP surplus vs. US$92 billion achieved sterilization) and worsened to 59% in 3Q06 (US$46.8 billion increase in FX reserves vs. US$27.4 billion sterilization). The unsterilized surplus since 2005 therefore totaled US$110 billion.

Quantifying the impact of sterilization against the BoP surplus helps explain why the monetary tightening measures so far have not been sufficient to lift the cost of capital meaningfully, which we believe is vital in discouraging wasteful fixed investment. The bond issuance program has been far from aggressive in recent months, suggesting that the PBoC remains reluctant to lift interest rates significantly. We believe that this incomplete sterilization underpins the friendly liquidity environment in China, leaving lending, investment and overall economic activity vulnerable to a rebound. Although government policy continues to target slower growth, ample liquidity amid incomplete sterilization of the expanding BoP surplus should limit the harshness of the deceleration.

Hong Kong — enjoying liquidity inflows, but wary of volatility. Liquidity conditions and asset market performance have a strong influence on real economic activity in Hong Kong. The influence has further stepped up this year on the back of the increase in large-size listings of Chinese enterprises in the Hong Kong stock market. The HK$-denominated financial asset base has grown significantly, powering monetary expansion far ahead of economic growth. Capital inflows, absorbed by the banking system in the form of an expanding net foreign asset position (US$25 billion over the 12 months ending Oct-06), have resulted in a downtrend in the HK$ loan-to-deposit ratio, and lower HK$ interest rates (against their US$ counterparts) in recent months, further supporting asset market valuations and gains.

The expansion of Hong Kong’s financial asset base in the last few years has been driven by China’s increasing appetite for international capital. The performance of the asset markets is not so directly representative of Hong Kong’s domestic economic fundamentals, but ironically has become the driver of monetary conditions and economic sentiment. Stock market capitalization has surged to HK$12.1 trillion, more than 8 times GDP. In other words, each 1% rise or fall in the stock market represents an amount equivalent to 4% of broad money M3, or 8% of GDP.

We have seen robust pickup in consumption and investment on the back of asset appreciation and low interest rates in the last couple of years. Consumption has been lifted by the positive wealth effect, while employment, wages and household income have only been catching up in the last two quarters. Consumer businesses have also turned more positive on expansion plans amid stronger consumption. However, it worries us that, as a small, open economy with a fixed exchange rate, Hong Kong’s strong leverage on liquidity conditions and asset market performance results in volatile business cycles driven by non-domestic factors.

The imminent crossing of the RMB/US$ and HK$/US$ exchange rates upon further RMB appreciation has lifted expectation that the HK$ will follow. We sympathize with the psychological impact of the RMB breakthrough on the HK$, but believe it will prove to be temporary. We believe that the expanding HK$ financial asset base is the dominant factor behind the current low interest rate environment, meaning that low interest rates could be sustained even beyond the speculation for HK$ appreciation subsides. While we are reluctant to make purely speculative forecasts on further deviation of HK$ interest rates from their US$ counterparts (hence sustained strength in asset prices), it is quite possible that anomalous monetary conditions sustain for even longer.

Taiwan— reliant on foreign liquidity. Amid sluggish domestic demand and continuous outward investments by local enterprises and individuals, asset markets in Taiwan have been supported by loose monetary conditions, made possible by the accommodative stance of the central bank, the current account surplus, and sustained foreign interest in Taiwan’s financial assets. Balance of payments trends clearly demonstrate Taiwan’s increasing dependence on external demand and foreign portfolio investment. The persistently large current account surplus, likely to reach 6% of GDP in 2006, reflects the output gap amid structural weakness in domestic consumption and investment. In the financial account, Taiwan has been a net exporter of direct investment capital, totaling US$10.7 billion since 2004 and US$20.7 billion since 2001. Portfolio flows, on the other hand, are characterized by local investors investing increasingly abroad but partially cushioned by foreign investments in Taiwan equities. Foreign portfolio inflows totaled as much as US$13 billion in 4Q05, buoyed partly by the MSCI re-weighting, but these have been offset by accelerated outbound investments by locals since 2004, leaving the overall financial account barely in balance since 2004. The overall balance of payments surplus since 2001 has contributed a great deal to the easy monetary conditions in Taiwan and the recovery in asset prices. Ample liquidity in the banking system has kept interest rates low. Rates are low even at the long end, with the 10-year government bond yield hovering around 2% at present, keeping financial assets afloat even amid a weak domestic economy.

Nevertheless, easy monetary conditions and low rates should not be assumed indefinitely. Foreign capital inflow is a crucial factor in the current delicate monetary balance. Monetary conditions, and, hence, asset prices, are extremely vulnerable to an abrupt turnaround in foreign portfolio flows. The size of and swings in short-term capital flows have increased significantly in the past decade amid increasing global financial integration. Quarter-on-quarter swings in short-term capital flows could be as great as 20% of GDP and could be extremely destabilizing for financial markets. Needless to say, measures to slow the pace of capital exporting by local investors or even encourage repatriation of earlier outflows would be ideal, although the unfavorable political climate and business uncertainty prior to the drawing up of a concrete roadmap governing cross-strait exchanges are to be blamed for the persistence of the outflows at present. Fortunately, in Taiwan’s favor is the buffer of excess liquidity stored in NCDs (outstanding NT$3.74 trillion, or US$113 billion), which the central bank can release to the money market to maintain accommodative conditions and low interest rates in the face of unfavorable capital flows. Moreover, the US$260 billion-strong foreign exchange reserves provide an additional shock absorber.

The 2007 outlook for all the three Greater China economies is very much dependent on global liquidity trends. The correction in commodity prices and apparent taming in inflation expectations have caused markets to expect a more dovish monetary policy stance from the major central banks. Specifically, our US economists now believe that the Fed is done with tightening, and easing could kick in as soon as 2H07. Nevertheless, it would still be irresponsible to deny the growing risk of a contraction in global liquidity that could have a greater impact than in the past. Upside surprises to inflation continue to haunt the industrialized world, heightening risks of further tightening. In the much-feared scenario of global stagflation, investment fund flows to emerging markets will unlikely avoid an adverse turnaround, drying up funds for China’s investment, and forcing asset prices to correct in Hong Kong and Taiwan.