Three Developments in China

After depreciating earlier this year, China's yuan now appears to be carving out a trading range.  The dollar has been confined to roughly CNY6.20-CNY6.2650 since early April. 

Recent data lends credence to our view that the Chinese economy was stabilizing with annualized growth a little above 7%.  Although officials have clearly indicated a reluctance for large scale measures, this does not mean that officials are doing nothing.  

In fact, both monetary and fiscal measures have been deployed.  Local and central government expenditures rose 25% year-over-year in May.  This compares with a 9.6% increase in the Jan-April period.  Last week, the central government approved new infrastructure spending for roadways, railroads and ports.   It is not clear how much this represents new money or the acceleration of spending that was already authorized. 

It is also notable that the increase in spending took place as revenues slowed.  Revenue seems to be a contemporaneous or even a lagging indicator.  Government revenues rose 7.2% in May from a year ago.  In April, revenues were 9.2% above year ago levels.  

The PBOC has been targeting reductions in reserve requirements for banks with desired loan books and has been largely limited to relatively small and rural banks. There was a cut in April and earlier this month.   PBOC has widened the number of banks to four more banks today, including Industrial Bank and China Merchant Bank.  These four banks have about CNY7.7 trillion of loans as of the end of Q1.  A 50 bp cut in the required reserve ratio (RRR) frees up about CNY40 bln of liquidity.  An estimated CNY320 bln of liquidity has been generated by the reserve reductions since late April.  

The latest data also suggests that capital inflows into China slowed markedly in May.  China reported that foreign exchange holdings in the banking system, which includes the central bank, rose to CNY29.541 trillion from CNY29.502 trillion.  The difference is a proxy for the new flows or about CNY39 bln ($6.25 bln).  This is down from CNY116.9 bln in April.  

A couple of forces seem to be at work.  With the yuan not in a clear uptrend, Chinese exporters are incentivized not to convert their foreign currency earnings.  The loss of the yuan's uptrend and an under-performing equity market may have discouraged foreign investors from bringing money into China.   Direct investment flows, to be reported on June 16 is expected to also slow from the 3.4% year-over-year pace reported in April.  

In turn, this suggests that reserve growth in Q2 may not match the $127 bln increase reported in Q1.  Reserve growth does not appear to be a function of China's trade account, but rather seems to be more a function of the capital account.  Recall in Q1 China's trade surplus stood at almost $17 bln down from $90 bln in Q4 13, when reserves grew by about $160 bln.  Reserve figures from Q2 will be published on July 9. 

Separately, the US TIC data out earlier today showed China reduced its US Treasury holdings in April for the third consecutive month.  The $160 bln growth in Q1 reserves coincided with a $3.5 bln decline in US Treasury holdings. With $1.263 trillion of Treasuries, China remains the largest holder, according to the TIC data.   According to the TIC data, China's holdings peaked in November 2013 near $1.317 trillion.  China's investors appear to have sold into the US Treasury market rally.  It did not deter it.