Hong Hao: Is a Fine-Tuning of China’s Easy Monetary Policy on the Horizon?
Hong Hao is managing director and head of research at BOCOM International, a subsidiary of the Bank of Communications. This article is an edited version of a China Market Strategy research note first released on the BOCOM International website on July 27.
China’s stock market hit another snag on Friday, with the Shanghai Composite plunging almost 4% and the ChiNext dropping over 6%. Concurrently, the realized volatility on the major indices surged to the level seen in late 2018 when trade disputes between China and the U.S. were escalating, and seen in February this year when Covid-19 was ravaging China. The correction we forecasted two weeks ago is still unfolding. It is a volatile market to trade.
Against this vexing turbulence, I was invited to an online forum organized by Renmin University, together with other great economists who are renowned in different disciplines of the market. I was asked whether eased monetary policy had introduced financial arbitrage into the market, and consequently liquidity was not helping the economy where it was most needed. A question such as this implies there are concerns about the potential prospect of monetary policy fine-tuning, especially given the recent market surge and the murmurs about a bubble similar to 2015. Meanwhile, a high-level meeting on China’s property market chaired by the vice-premier emphasized reining in property market speculation.
All policies have costs. The costs of an easy monetary policy for any market, be it China as an emerging market or the U.S. as a mature and developed market, are that it tends to induce market speculation. At a time when liquidity is abundant, as shown by the daily market turnover of well over 1 trillion yuan ($142 billion), and the future is uncertain as seen in the surging market volatility, people will not bother to focus on the fundamentals and will trade aggressively instead.
After all, the heightened uncertainty makes our future increasingly inscrutable and thus it’s futile to study the fundamentals. Given the liquidity and the uncertainty, people will trade and speculate out of avarice, rather than buy and hope. As such, we can think of market gains driven by intensifying speculation as a necessary cost of any monetary easing. The key policy decision is to see whether such costs outweigh the necessity of the eased policy
We would argue that policy should remain supportive. The second-quarter GDP structure was worse than expected, and the economic growth in the first half is still negative. The employment picture remains clouded, and service industries and SMEs are still struggling. Looking forward, the tension between China and the U.S. is escalating, and likely to remain so till the November election. In short, the economy will need all the help it could get from fiscal and monetary policies.
A drop in the market interest rate below the official deposit rate did create some temporary arbitrage opportunities to easily earn a positive spread in the second quarter this year, but that is the whole point of allowing the market to function so that the force of arbitraging could revert market prices back to normal. After all, the loopholes in China’s financial system that created persistent arbitrage opportunities when market interest rates were consistently below the benchmark deposit rate before the liquidity crisis in June 2013 have since been plugged.
Meanwhile, property tightening can be a prelude to subtle changes in policy. During the second quarter, property-buying fervor once again grabbed headlines. Many cities are once again witnessing long queues of buyers looking to win a lottery to buy property. And property sales volume is now mostly back to pre-Covid-19 levels in many cities. Cement production machines are humming. As a property bubble poses a bigger systemic risk to the Chinese economy than the stock market, especially when large-cap stocks are still at cheap valuations, it is not surprising that policymakers are paying close attention.
That said, we note that since 2014, property price inflation and stock returns have been inversely correlated. And although news headlines about property speculation are gripping, property price inflation is actually tame, especially given the low interest rate level. If the authorities are seeing the same picture, then the signal is to cool off the momentum in the property market, rather than a hawkish property tightening. If property price inflation remains mild, it is not a bad omen for stocks given the inverted correlation since 2014.
Further, market interest rates are still near historic lows, corresponding to lows in Chinese stocks in history. And the very long-term technical chart for China’s largest blue chips is showing a secular uptrend. Except for the ChiNext, the valuation of major Chinese indices is low, especially large-cap indices such as the SSE50, CSI 300 and the HSCEI.
In the near term, the issue will be how to balance the need to stabilize the economy versus quelling market speculation. The upcoming Beidaihe meeting will reveal more clues. The market understands these intricacies and is thus likely to continue struggling amid the sales of insider stakes in many listed companies in the coming weeks. While long-term valuations are supportive of the large caps, the instinct to trade out of human avarice will blind people from the longer-term picture of a future in five or more years. The volatility in the expensive ChiNext will continue to roil sentiment. And as such, the market will remain unsettled for now.
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