Chinese Monetary Policy And Stocks

While the latest rate cut is clearly positive and is long overdue, the PBoC is still behind the curve. Monetary conditions remain far too tight, and further easing is likely.

Speaking at China’s annual parliamentary hearing, Premier Li Kequiang noted that, “The downward pressure on China’s economy is intensifying,” and that 2015 would be a tough year for growth. Indeed, the Chinese government downgraded its official target for growth to ‘around’ 7%.

Amidst this sober evaluation, China’s monetary conditions index has continued to deteriorate, driven by both rising real rates and a rising currency. This is disconcerting for asset prices, especially domestic A shares, as the market has rallied strongly since mid last year and is no longer cheap. The rally has partly been driven by expectations of policy easing and an improvement in monetary conditions – which have clearly failed to materialize.

For now our China strategists maintain a neutral rating on domestic A shares, as the risk-return profile of this asset class is roughly balanced. On one hand, there is a strong case that the PBoC should continue to ease, which will eventually lead to improvement in monetary conditions and a bid up in stock prices. On the other hand, the market may disappoint if investors decide that policy easing so far has not been effective and the PBoC continues to drag its feet. In this environment, any aggressive directional bet would be premature.

Deteriorating monetary conditions also bode poorly for investable Chinese stocks, but the case for this asset class is strengthened by attractive valuation. Chinese investable shares are still trading at hefty discounts to their historical averages – which justifies risk-taking, especially within the broader backdrop of monetary easing. The case for relative outperformance of Chinese investable stocks versus the EM benchmark is more compelling. China is among the few countries that have ample room for monetary easing, and Chinese stocks are still trading at discounts to their EM and global peers despite the past two years’ sharp outperformance. Chinese investable stocks will likely continue to be positively rerated going forward.

Guess What Country?

Here is a guessing game from BCA’s Geopolitical Strategy: what European country did The Economist refer to as incapable of pursuing structural reforms and bent on redistributing income? A country run by policymakers looking to ease monetary policy and stimulate with government spending, but incapable due to constraints of their euro area membership. Clue… the analysis was penned in 1999. Can you guess correctly?

The following are all sentences written by the venerable editors of The Economist in a single article about one European economy:

  • Some of the blame for this can be laid at the door of a tight macroeconomic policy… fiscal policy has been kept in check by the need to comply with the single-currency countries’ “growth and stability pact”. These constraints still bind: left to itself, country X might respond to its latest bout of weakness with lower interest rates and a bigger budget deficit, but it no longer has these options.
  • The ECB’s president has said that country X’s problems are not cyclical but the result of too little basic reform to social security, the labor market and so on.
  • In the longer run, the main factors tugging down country X (and indeed European) economic performance do indeed remain structural and microeconomic: a byzantine and inefficient tax system, a bloated welfare system and excessive labor costs.
  • But the fear lingers that the ruling center-left party remains bent on redistributing income at the expense of big business.
  • Another big reason not to invest is the cost of hiring and firing workers… The welfare state is largely financed by payroll taxes, half of which are paid by employers and half by individual workers. As welfare costs have swollen, non-wage labor costs have shut up too.
  • “The jobs market doesn’t really deserve to be called a market,” says one disgruntled company manager.
  • Progress will come only gradually, however. “We got 90 minutes extra shopping after a decade’s debate, or nine minutes a year. Call it the country X’s way,” sighs Random Economist, chief economist at Random Bank.
  • The main barrier is politics: this government, like the last one, worries that such reforms will be unpopular if they are widely perceived as a handout for the rich at the expense of the average citizen.
  • The other big challenge for the government is to defuse country X’s welfare timebomb.
  • The government could also do the economy a favor by speeding up privatization and further deregulating the underdeveloped services sector.
  • Unfortunately, progress in most of these areas is likely to be agonizingly slow — indeed, it could even go into reverse. The country X government has already backtracked on the efforts to cut pension entitlements that were made by its predecessor.

Any luck? Let us review the clues from above excerpts:

  • The country in question could do with less austerity and easier monetary policy, its policymakers appear to want to pursue reflationary policies, but its euro area membership is a constraint on both.
  • The euro area partners of the country in question are calling for reforms, with the ECB president specifically calling for labor market reforms.
  • Red tape, bureaucratic incompetence, and overregulated service sector are all impediments to growth.
  • Labor market is in woeful need of reform.
  • Politics stands in the way of progress, the ruling center-left government is opposed to reforms, wants to redistribute wealth, and is unwilling to pursue privatizations.

France? Nope. Italy? Nope. Belgium? Nope. Greece/Portugal/Ireland? Nope on all counts!

Would it help if we said that the article was written in 1999?

Let’s give everyone a few moments to think about it…

A

MOMENT

TO

THINK

ABOUT

IT

The answer is Germany.

Yes, in 1999, The Economist wrote a “world is ending” feature on Germany that lambasted its politics, its economy, and any hope of reforms. And yet a few years later, the very center-left government that The Economist proclaimed to be “bent on redistributing income” and backtracking on reforms accomplished a set of labor-market reforms that are today the golden standard of successful, pro-market, policymaking. In fact, the Hartz IV labor market reforms were so positive for Germany that they have become a ubiquitous example of successful pro-market reforms.

The point of this note is to emphasize the folly of linear thinking. Mediterranean Europe has dragged its feet on pro-market reforms for decades, lulled into complacency by the success of the euro area and the Maastricht Treaty-induced convergence of borrowing rates. This is true. However, the gravy train is over. Without painful structural reforms, these economies will underperform for decades.

We would be skeptical of success were there no evidence of nascent reform efforts. But, both Spain and Portugal are rapidly moving up the ease-of-doing-business surveys. Meanwhile, Madrid’s labor reforms have brought down Spanish’s labor costs and exports are booming. Both France and Italy are led by precisely the type of right-leaning social democrats that Germany’s Gerhard Schröder emblemized back in 1999 when The Economist rained on his parade. We could go on… but won’t because this is a blog post.1 The point is that there are green shoots of reform all around Mediterranean Europe, but most of us remain too constrained by old ideas and assumptions to even notice them.

As the economist Herbert Stein used to say, “if something cannot go on forever, it will stop.” The Mediterranean Europe’s penchant for dragging its feet on reforms cannot go on forever. It will stop. On the other hand, the penchant for lazy analysis to extrapolate linearly will probably go on forever.

1 You can read some of our thoughts on structural reform efforts in Europe in BCA’s Geopolitical Strategy Special Report, “Europe: Is Political Risk Back?” dated October 8, 2014, available at gps.bcaresearch.com.