Chinese yields cast doubt on 'V' bottom

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.