China Monetary Developments

Chinese banks have signaled the intention to cut back on new loan issuance, but the PBOC has not changed its declaratory or operational policy. It is not imposing new and lower loan quotas. It appears to be using its moral suasion. This initially weighed on Chinese stocks. July-Aug is typically a slow month for loans in any event, but the resumption of IPO sales seemed to compound the impact of the removal of the punch bowl and the Shanghai Composite fell 10% from its high set earlier this month.The longest losing streak of the year--four days-- for the Shanghai Composite was snapped earlier today. It is becoming clearer that as the banks ease the growth rate of new loans, the government is stepping into the breech.

First, the PBOC has been generous in its provisions of liquidity into the banking system. For the second consecutive week, the PBOC was a net provided extra funds in its money market operations and this is helping to drive down the key 7-day repo rate, which fell 11 bp this week to 1.39%.

Second, the Chinese government appears to be encouraging the development of a domestic corporate bond market that would help compliment banks as a key element in the distribution of capital. Recall that in the US for every dollar a large corporation will borrow from a bank, it will raise 2 in the capital markets by issuing bonds or stock. Europe and Japan are nearly the exact opposite way around. China also has depended on bank loans.

In order to make Chinese corporate bonds more attractive, the National Association of Financial Market Institutional Investors and sixteen underwriters apparently agreed last week--minutes released earlier today--that new five-year notes in the interbank market must yield at least 4.2%, vs around 3.9%, which is the yield of a recent corporate issue.

Part of the problem that Chinese officials are wrestling with is that yields on new corporate bonds have dropped below those in the secondary market, which officials believe is a function of the market power of companies over the banks.

Chinese bank loans thus far this year are around CNY7.7 trillion (~$1.1 trillion). This is more than ten times the Chinese bonds sold in the interbank market.

Meanwhile, the yuan is trading quietly in the middle of this year's range against the dollar. With Chinese exports still falling and CPI ands PPI in negative territory, the market has generally abandoned ideas that the yuan will appreciate against the dollar over the next 12-months.

Most market participants seem fairly dollar negative and recent bullish/bearish sentiment numbers are among the most extreme seen in recent times. The Chinese essentially re-pegged the yuan to the dollar just as the dollar began recovering early in H2 08. The best chance of getting more yuan flexibility might be more likely if the consensus is right and the dollar continues to fall.