By: Our Correspondent

To judge from the performance of the Shanghai stock market, which as of
the June 12 close is up 50 percent year-to-date, you might think that a
'V'-shaped bottom for the Chinese economy was all but a foregone
conclusion. But China's interbank bond yields have been telling a
somewhat less optimistic story.

While the yield curve, measured
by the difference between one and 10-year yields) has steepened from
1.61 percentage points at the end of last year to a near-record 2.15 pp
as of June 12, there was a noticeable shift from "bear steepening" to
"bull steepening" two weeks prior to the National People's Congress
(NPC) meeting in early March.

In January and the first half of
February, 10-year yields were rising faster than one-year yields, but
since then one-year yields have been falling while the tens have been
moving sideways. (As bond yields move in the opposite direction to
prices, bear steepening occurs when long yields rise during a bear
market in long maturities; bull steepening when short yields fall
during a bull market in short maturities.)

If sentiment in the
bond market had continued to improve following the NPC meeting, as it
did in the stock market, long yields should have kept rising as
reflationary expectations would naturally lead long-term investors to
demand higher returns. Instead, it seems that bond market participants
found the details of the economic stimulus package that came out in the
weeks leading up to the NPC to be a bit underwhelming. A similar loss
of confidence in the stimulus can be seen in Mysteel's composite steel
price index (available at www.mysteel.net/myspic), which was up 60 percent from its November low in early February but is down 9 percent since then.

A grain of salt

The
banks also appear to be unconvinced that a sustainable recovery is at
hand. Bank lending has set new records—the 5.2 trillion yuan in new
loans for the first four months of this year already exceeds the
central bank's 5 trillion yuan minimum full-year target— but the
composition of this loan growth indicates extreme caution on the part
of the bankers. Large state-owned enterprises (SOEs) and
government-backed infrastructure projects got the lion's share of the
new loans while the non-state small and medium sized enterprises that
provide most of China's employment continue to be starved for cash.

The
bankers' reluctance to finance anything without at least an implicit
government guarantee makes it pretty clear that they don't expect the
stimulus spending to "jump start" the rest of the economy. It also
calls into question the sustainability of this year's high loan-growth
rates. There are, after all, only a relatively small number of "safe"
borrowers and presumably most of their financing needs for the year
have by now already been taken care of.

Jiao Jin-pu, an official
with the People's Bank of China Graduate School, recently told
reporters that surveys indicate only a third of the new funds lent out
this year have been drawn down. This suggests that this year's fixed
asset investment statistics should be taken with a grain of salt. The
fact that most of the lending for fixed asset investment apparently has
yet to be spent supports the view of Chinese Academy of Social Sciences
researcher Yuan Gang-ming, who believes that in many cases the receipt
of project financing has been counted as FAI, regardless of whether or
not any work has actually been started.

Another sign of the
banks' lack of confidence is the fact that one third of this year's new
lending has taken the form of bill discounting, a form of credit
extension to enterprise borrowers based on their contracts with
customers. Such loans are considered safe because they are for
relatively short periods and can easily be sold (i.e., rediscounted)
prior to maturity but in China they often don't correspond to any real
commercial activity. This year it is rumored that a lot of this
financing has been used for stock market speculation.

Thus even
with a large scale infrastructure-spending program underway, this
year's new lending appears to have far exceeded the requirements of the
"real" economy.

Feigned compliance

The fall in one-year
yields since mid-February is a natural consequence of the growth in
unutilized loan balances and bill discounting, as both push down
short-term rates by contributing to liquidity in the financial system.
The bull steepening of the last three months thus has a lot to do with
"feigned compliance" on the part of local governments, SOE's, and banks
in their response to the central government's 8 percent growth target.

When
local government and SOE borrowers take out loans and immediately
record the entire amount as investment, they and the banks can claim to
be doing their part to stimulate the economy even when the funds are
basically idle. And by expanding bill discounting, the banks can make
the same claim regardless of whether or not the new lending has any
effect on the "real" economy.

There is thus considerable doubt
that this year's stock market rally is really telling us anything about
the effectiveness of the government's stimulus program. The move up in
the first six weeks of the year, coinciding as it did with rising long
yields and bear steepening in the bond market, might be seen as a
reflection of genuine optimism about the economic outlook. But since
then, falling short yields and bull steepening suggest that the
subsequent price action has been driven primarily by excess liquidity,
the very presence of which is indicative of a high level of skepticism
about the prospects for a 'V'-shaped recovery.

Mark A
DeWeaver, PhD, worked as a research analyst in Shenzhen from 1991-1995,
first for W I Carr and later for Peregrine Brokerage. He manages
Quantrarian Asia Hedge, a fund that invests in Asian equities and
related index products (on the web at www.quantrarian.com), and can be
reached at deweaver@quantrarian.com.