China Watch

China's trade surplus surprisingly narrowed to a 6-month low of US$28.5B in September, from US$42B a month ago. The market had anticipated a milder drop to US$39.5B. Growth in exports improved to 8.1% y/y from 5.5% in August, while growth imports accelerated significantly to +18.7% from July's +13.3%. Notwithstanding a disappointing headline, the report continued to paint a healthy picture on China's economic outlook. A stronger-than-expected imports growth underpinned domestic economic strength. Exports growth, despite missing consensus, still picked up from the same period last year. More importantly, a narrowing trade surplus could tame the US' complaint of China's currency manipulation. This should help the government maintain a stable and modestly strong renminbi as CCP's 19th national congress approaches.

PBOC announced to adopt targeted RRR cut in 2018 in some banks to 'encourage inclusive financing, such as credit support for small and micro-sized enterprises (SMEs), startups and agricultural production, as well as small business owners, impoverished groups and students. All of the large and medium sized commercial banks, 90% of municipal commercial banks, and 95% of agriculture commercial banks are eligible for this measure. Banks with inclusive financing exposure higher than 1.5% of loans would be eligible for 50 bps RRR cut from benchmark ratios. Banks with exposure higher than 10% would qualify for additional 100 bps RRR cut. We believe the move is a fine-tuning of PBOC's other tightening measures, rather than a shift towards a loosening monetary stance. Indeed, by choosing a targeted RRR cut, instead of a broad-based cut or a rate reduction, the central bank is sending a signal that it has not changed the monetary policy stance which remains 'prudent and neutral”.

August data further evidenced that China's economic growth has peaked in the first quarter. Following the sharper-than-expected slowdown in growth in July, the latest set of macroeconomic data also surprised to the downside. The moderation was a result of the government's tighter monetary policy in an attempt to curb excessive investment in certain areas, such as real estate. Renminbi's appreciation against US dollar since the beginning of the year probably has weighed on exports. This leads the PBOC to loosen capital control which has been adopted over the past years to prevent renminbi from severe depreciation.

USDCNY continues to recover after the pair slumped to the lowest level since December 2015 last Friday. The rebound, long-awaited as the broad-based USD weakness has caused the pair to decline over the past 4 months, is facilitated by PBOC’s announcement to remove the requirement for banks to hold the equivalent of 20% of clients' FX forward positions as reserve for a year at 0% interest. For more than a decade, China has been implementing reforms in its currency, with the ultimate goal of achieving a floating exchange rate regime and convertibility for renminbi – a movement widely described as renminbi internationalization. However, this report seeks to explain that the government has only been moving back and forth, without making significant progress in transforming renminbi into a market-oriented exchange rate.

The two key phenomena, tightening in liquidity condition and renminbi strength, in the Chinese market have persisted. Last week, PBOC auctioned RMB 80B of 3-month Treasury deposits at 4.51%, the highest since December 2014. This came in after another auction of 3-month Treasury deposits on August 18, at 4.46%. Higher interest rates signaled that the government is trying to increase the borrowing cost, tightening money supply.

Chinese macroeconomic activities showed sharper than expected slowdown in July. Retails sales grew +10.4% y/y in July, down from +11% a month ago. The market had anticipated a milder moderation to +10.8%. Industrial production expanded +6.4% y/y in July, decelerating from +7.6% in the prior month. This came in weaker than consensus of +7.1%. Urban fixed asset investment expanded +8.3% in the first 7 months of the year, slowing from +8.6% in the first half of the year. The market had anticipated a steady growth of +8.6%. The slowdown in economic activities in China has been widely expected as the government pledged to deleverage in at attempted to defend and prevent systematic risks. However the abovementioned three major indicators came in even weaker than expectations. We expect Chinese economic growth to moderate in the second half of the year. Yet, the strength in the first half (GDP growth: +6.9%) signals that the government's full year target of 'around +6.5%' should be able to achieved.

China's trade and inflation data surprised to the downside in July, likely drive by the government's targeted tightening monetary policy. GDP growth is expected to slow in second half of the year. Yet, given the strong readings in the first half, with the economy expanding +6.9% in both the first and second quarters, GDP growth should be able to meet government's target of “around +6.5%”. We believe the government would continue its tightening monetary policy in order to prevent and resolve systematic risks, and to curb excessive strength in property prices. Meanwhile, as ultra accommodative monetary policies across major central banks are coming to an end, with the Fed and BOC raising interest rates, while ECB will begin discussing reduction of asset purchases, it would be detrimental to the renminbi if the central bank pledges to maintain monetary easing. This would exacerbate capital outflow from China.

China's macroeconomic data for 2Q17 surprised to the upside. China's GDP expanded +6.9% y/y in 2Q17, same pace as the prior quarter but above consensus of +6.8%. Economic activities in June continued to improve. Industrial production growth accelerated to +7.6% y/y in June, beating consensus of and May's +6.5%. Retail sales expanded +11% y/y in June, up from +10.7% a month ago. The market had anticipated mild deceleration to +10.6%. Fixed asset investment in urban areas grew +8.6% y/y in the first half of the year, same pace as in the first five months of the year. The government acknowledged that the country's economy continued to improve. It appears that the country's growth is on track to meet the government target of “around +6.5%”.

The set of June data released so far has pointed to a steady growth trend in China, the world's second largest economy. Released earlier in the week, headline CPI stayed unchanged at +1.5% y/y in June, shy of consensus of +1.6%. Persistently soft food price (on deflation) continued to put downward pressure on the headline reading. For instance, pork plummeted -16.7 and egg price fell -9.3%.PPI, upstream price levels, steadied at +5.5% in June, in line with expectations. Subdued inflation offers the government room to maintain its targeted tightening measures, focusing on cracking down overheating asset prices. Yet, soft PPI suggested that growth in industrial profits would be limited.

China's headline CPI inflation accelerated to +1.5% y/y in May, from +1.2% a month ago. for the first 5 months of the year, CPI has stayed at average of +1.4%, amongst the lowest levels in history. Core inflation steadied at +2.1% in May. Non-food CPI moderated to +2.3% from 2.4% in April. Food inflation remained in contraction but the decline narrowed to -1.6% y/y in May from -3.5% in the prior month. We believe it was the low base that had helped improve the reading. PPI inflation continued to slow, falling to +5.5% y/y in May from +6.4% in April. Weakness in commodity prices is expected to weigh on PPI, sending it lower to around +5% in coming months.

China's manufacturing activities contracted for the first time in 11 months, as Caixin/Markit's PMI index suggested. The report shows that the manufacturing PMI dropped -0.7 points to 49.6 in May (a reading below 50 signals contraction), compared with consensus of a milder drop to 50.1. While the sub-indices of output and new business remained in the expansionary territory, but both fell to their lowest levels since June last year. Meanwhile, the sub- indices of input costs and output prices drifted to the contractionary territory for the first time since June 2016 and February 2016, respectively. Meanwhile, the sub-index of stocks of purchases showed renewed decline. The rebound in the sub-index of stocks of finished goods suggested that companies stopped restocking as inventory levels increased.

The Chinese government has accelerated its step to guide the renminbi higher and the immediate effect is a selloff of USDCNY to the lowest level since January, 2017. Last week, the China Foreign Exchange Trade System (CFETS) confirmed that China's central bank has added a counter cyclical adjustment factor (CCAF) to the calculation of the USDCNY daily fixing rate. The government indicated that the adjustment factor would help guide market expectations and let the fix reflect more accurately China's macroeconomic fundamentals. It is appropriate for the move to be introduced in this period of time when the US dollar is weak, as, in our view, the aim of which is to stabilize renminbi, i.e. to prevent it from weakening too much. Given the lack of the details of this adjustment factor, the movement of renminbi is getting more non-transparent, as well as government-driven, rather than market- driven.

China's headline CPI accelerated to +1.2% y/y in April, from +0.9% a month ago, as mainly driven by the recovery of food disinflation. Food price contracted -3.5% y/y, following a -4.4% drop in March. Nonfood inflation rose to 2.4% y/y in April from +2.3% a month ago. Core inflation (excluding food and energy) improved to +2.1% y/y from +2% in March. Such level should be in line with the government's target. PPI moderated to +6.4% in April from +7.6% in March. The deceleration came in more than expectations. A key contributor to the slowdown was commodity prices which slowed further in April as low base effects dissipated. Global prices also pulled back after the strong rally earlier in the year.

China's latest set of PMI data indicated slowdown in the country's activity growth. The official manufacturing index was reported to have dropped -0.6 point to 51.2 in April, whist the non-manufacturing PMI declined -1.1 points to 54 for the month. The slowdown was broadly based: the 'output' index slipped -0.4 point to 53.8 and the 'new orders' index dropped -1point to 52.3. The 'new export orders' index fell for the first time in 4 months, losing -0.3 point to 50.5, although the three-month moving average remained up. The 'input price' index sank -7.5 points to 51.8. The trend indicates that PPI inflation should have slowed more sharply in April. Recall that the March reading was +7.6% and the February reading was a record higher of +7.8%. The only sub-index that has shown improvement was the 'stock of finished goods' index, which gained +0.9 point to 48.2.

China's economic activities surprised to the upside in 1Q17. GDP expanded +6.9% y/y, beating consensus of, and 4Q16's, +6.8%. Growth was led by a +7.7% expansion in the tertiary sector, followed by a +6.4% growth in the secondary industry. Economic activities also strengthened across the board in March. Retail sales expanded +10.9%, accelerating from +9.5% in the combined January to February period. Industrial production (IP) growth improved to +7.6%, the fastest pace since end-2014, from +6.3% in the January-February period. The market had anticipated a mild drop to +6.2%. Fixed asset investment (FAI) increased 9.2% y/y to March, up from +8.9% in the January-February period. Looking into the details, investment gained +19.8% in the primary sector, +4.2% in the secondary sector and +12.2% y/y in the tertiary sector. Moreover, private investment expanded +7.7% y/y in March, up from +6.7% in the prior month, while the growth in public investment slowed to +13.6%, from +14.4% in February. For the first quarter of the year, retail sales grew +10%, IP rose +6.8% with manufacturing output up +7.4% while fixed asset investment expanded +9.2%, of which real estate investment and tech investment up +9.1% and +22.6%, respectively.

The latest inflation report continues to portray a subdued CPI, high PPI environment in China. Headline CPI improved to +0.9% y/y in March from +0.8% a month ago. The market has anticipated stronger pickup to +1%. Core inflation (excluding food and energy) rose +2% y/y, up from +1.8% in February. The decline in food prices deepened to -4.4% y/y from -4.3% in February. Nonfood inflation improved modestly to +2.3% y/y, up from +2.2% in February. PPI eased to +7.6% in March, from +7.8% in the prior month, compared with consensus of +7.5%. Both seasonal factors and moderation in the commodity price rally were key reasons for the slowdown. Lunar New Year in the first week of February pushed prices higher and absence of such factor was reflected in the March reading. Meanwhile, mining input prices gained +3.7% y/y in March, compared with a +36.1% y/y rally in the prior month. Oil and gas price, gaining +68.5% y/y in the month, was the biggest driver of PPI inflation last month. We expect PPI to stay high in coming months but growth would be more gradual due to strong base effect. Meanwhile, the rally in commodity prices over the past months is seen passing through to downstream CPI.

While lacking surprises, the US-China meeting held last week managed to avoid a trade war between the world's two biggest economies. Donald Trump and Xi Jinping agreed on a 100-day plan on trade that aims at boosting US exports. Meanwhile, the North Korea issue has remained a deadlock. Trump's announcement to launch airstrike in Syria during the meeting, followed by the deployment of a US navy strike group near the Korean peninsula, is a call for China to take necessary measures to address North Korea's nuclear program. Intensified geopolitical tensions have continued to pressured Korean financial market with Korean won extending weakness for a 5th straight day against US dollar while the country's benchmark equity index, KOSPI, recording the biggest one-day selloff in 6 weeks.

China's financial system continues to display fragility and liquidity squeeze. China's 7-day repo rate jumped to 5.5% (close), the highest level since late 2014, on Tuesday, followed by PBOC's injection of RMB 80-90B to the market on Wednesday as some small banks failed to repay debts in the interbank market. Less than a week ago, PBOC raised a range of short-term and medium-term interest rates to reduce financial risks, thought to be a response to Fed funds rate hike. Interbank rates should remain volatile over the coming week, ahead of PBOC's quarterly macro-prudential assessment in late March. Although recent data suggested that the problem of capital outflow eased in February, ongoing interest rate normalization in the US would prolong China's capital outflow problem, sustaining the challenges facing China in the implementation of its monetary policy.

Recent Chinese economic indicators have been positive. The country surprisingly recorded trade deficit, of RMB 60B, in February. The market had anticipated a decline of surplus to RMB 173B from RMB 355B in January. Imports soared +44.7% y/y while exports gained +4.2% y/y, compared with growths of +15.9% and +25.2%, respectively, in January. The sharp rise uin imports might indicate improvement in domestic demand. China's FX reserve added +US$ 6.9B to US$ 3.01 trillion in February, marking the first increase in 8 months. The market had anticipated further decline for the month. After adjusting for currency valuation effects, the reserves probably increased US$ 19-25B in the month. While this might be the first sign of the effect of China's capital control measures, we expect the government remain cautious as outflow should remain a problem for the rest of year. Note that a reason for the uptick in February was the improved performance of renminbi at the beginning of the year. Further information, including PBOC's FX position and SAFE flow data, is needed to grasp a clearer outlook of the capital flow situation. We remains bearish over renminbi as the Fed's monetary policy normalization program should continue to support USDCNY.

In PBOC's latest set money report, China's new renminbi loans rose to RMB 2.03 trillion in January. However, it came in below consensus of RMB 2.44 trillion and RMB 2.5 trillion the same period last year. Although it is usual for new loans to be high earlier in a year as banks front-load their loans for profit maximization, the January figure missed expectations as lending to non-bank financial institutions fell for the month. Outstanding renminbi loans growth decelerated to +12.6% y/y, from +13.5% in December. Medium and long term corporate bank lending, a barometer of corporate sector demand, increased +43.4% y/y to RMB 1.52 trillion, whilst medium- and long-term household loans, mainly mortgage loans, rose to a record high of RMB 0.63 trillion. This suggests that PBOC's recent tightening measures have yet to feed through the housing market. We believe a few months' data would be needed to see the effectiveness of these measures.