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1 Global Economics & Strategy Inflection Point November 2011 China Faces Higher FX Sterilisation Costs as Policy Eases in 2012 China s FX reserve accumulation will slow further into early 2012 because of weakening external demand, and the PBoC has tentatively begun to ease reserve requirements (initially for some regional rural banks), as FX sterilisation and inflation pressures abate. However, marginal sterilisation costs will rise considerably given the divergence between domestic and foreign yields and thus the cost of carry as bill issuance replaces the reserve ratio to offset reserve accumulation. China has seen explosive growth in money supply and credit since 2008, with the PBoC s Total Social Financing comprehensive credit measure having risen by a cumulative 90% of GDP in and total leverage rising to about 250% of GDP. The efficiency of China's balance of payments sterilisation has deteriorated with the use of the required bank reserve ratio (RRR) as the preferred sterilisation tool since 2007, which has been undermined by the sharp decline in formal bank lending as a share of total credit growth, allowing considerable leakage of reserve accumulation into the real economy. Key Points China s 21.5% RRR is very high by historical experience and global standards, and required reserves have reached 30% of GDP and 45% of PBoC assets. The decline in RMB bank lending share of total credit blunted the impact of RRR hikes in containing credit growth, but in Q3 that share surged to 74% from just 54% in H1, suggesting that the PBoC has at least temporarily reined in the shadow banking system and has the leeway to relax policy. The ratio of M2 to nominal GDP in China reached 182% in 2010 (and almost certainly an understatement, given on-going upward PBoC revisions to M2 composition and growth), injecting excess liquidity into domestic asset prices and above all real estate - required bank reserves now offset 67% of foreign assets, or 6 times the proportion sterilised by PBoC bills outstanding. Rising sterilisation costs coinciding with a widening of the interest rate differential between China and the US/Europe (and a shift in official holdings to very short duration foreign bonds) as much as policy tightening objectives drove the PBoC s rapid series of RRR hikes and the role of PBoC bills has been effectively reduced to smoothing out liquidity fluctuations as reflected in SHIBOR rates. The continuous injection of new RMB from PBoC FX sterilisation places a big burden on the banking system when over a fifth of its deposit base is generating a 1.6% return, which makes tight monetary policy very difficult to sustain, and that is exactly the dilemma now faced. A reversion to OMO sterilisation will increase the structural pressure for further interest rate liberalisation and RMB appreciation from a purely technical central banking perspective, but both also would accelerate the long delayed rebalancing of the country s economy and thus serve a wider macro agenda both domestically and globally. REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 1 of 11

2 China has both a trade and capital account surplus and China but is also a net importer of foreign currency on both. In order to manage the exchange rate within its targeted band and the surpluses in trade and capital flows, the PBC steps in and buys the excess dollars at a fixed rate, and accumulates them as official reserves. In exchange, it issues RMB, expanding the domestic money supply. For every dollar of the $3.2 trillion in official reserves China held at end Q3, the PBoC has injected the equivalent quantity of RMB into the Chinese economy. All that new RMB issuance would fuel inflation so the PBOC has to offset its foreign exchange purchases by taking an equivalent amount of RMB back out of the economy, usually by forcing banks to hold higher reserves (the Required Reserve Ratio or RRR) or by selling them special government bonds (Open Market Operations or OMOs). In effect, the PBoC has to use its tightening tools to counteract the loosening effect of its FX purchases, and keep money supply from exploding (which it in fact did in 2009/10). When it buys dollars with RMB, it expands the money supply, which would lower interest rates. It has to sell bonds or raise reserve requirements just to cancel that effect, and keep interest rates from falling. If it actually wants to tighten policy, it has to exceed that breakeven threshold by selling even more bonds or hiking reserve ratios even higher. Source: PBoC Maintaining the currency peg means that anything less than full sterilisation effectively represents net monetary loosening. Despite the on-going liberalisation of interest rates, quantity-based instruments remain monetary policy tools of choice in China to control liquidity, and in turn, inflation. The benchmark one-year lending rate on the other hand resides as the direct policy tool to achieve low inflation objective through influencing term interest rates and (arguably given the lack of capital market depth) economic activity. PBC bills, government deposits and reserve requirements have been the three most important channels in sterilising the domestic inflationary impact of China s foreign exchange reserve build-up and combined funded 90% of its US$3.2 trillion of foreign reserves outstanding by mid The PBoC has come to favour the RRR over other sterilisation tools such as open market operations that use short-dated instruments like repos, foreign exchange swaps and central bank bills on the liability side and outright sales of government bonds on the asset side, to offset persistently large-scale injections of base money through purchases of foreign currency in the foreign exchange market. Since late 2007, the balance of required reserves at the PBC has dominated over bills in sterilising the liquidity generated by reserve accumulation. Bills and required reserves each financed some 30% of China s REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 2 of 11

3 foreign exchange reserves outstanding in 2005 but by mid-2011 the RRR funded 67% of foreign assets at the PBoC, or 6x the bills outstanding. Monetary Base Exploded by Almost RMB 9Trn in A major factor behind the increased use of the RRR is the attempt to sterilise foreign exchange interventions at reduced cost. This choice also serves the current Chinese monetary policy framework that is still oriented to quantitative targets, notably M2 and CPI growth. While increased reserve requirements have tightened domestic monetary conditions with fewer rate hikes, they have increased the cost of bank intermediation in China and may prove counterproductive to financial market development, which remains critical to rebalancing the economy toward consumption and services from fixed investment and exports. Rising sterilization costs coinciding with a widening of the interest rate advantage held by China its developed market export markets as much as any policy tightening objective have driven the PBC s rapid series of RRR hikes and relatively subdued level of OMOs via the money markets. The RRR of large banks has been raised 12 times since January 2010, from 15.5% to 21.5%, a record high, as China s FX reserves have reached about 50% of GDP. Source: PBoC, NBS The reserve deposit base was extended to include some margin deposits (deposits as collateral for banker acceptance and letters of credit) in September 2011, aiming to curtail off-balance sheet lending while signalling continued tight policy bias. As a share of GDP, China s level of required reserves is now more than twice as high as developed and most other EM economies, at almost 30%. It is also extremely high relative to the balance sheet of the PBoC when compared to international peers at 45% of total assets (50% including excess reserves). Meanwhile, the benchmark 1yr bank lending interest rate has been increased only five times since January 2010, from 5.31% to 6.56%. REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 3 of 11

4 Source: PBoC The current benchmark RRR on local currency deposits at 21.5% but only 5% for foreign currency deposits while the required reserves on local currency deposits earn 1.62% but are unremunerated for those on foreign currency deposits. In addition, reserve requirements differ across banks from time to time and are based on various formal and informal rules. Since late 2008, the PBC has also adopted a more formal two-tier reserve requirement system, whereby the RRR for 6 or 7 largest commercial banks has since been 200 bps above that applied to most other smaller commercial banks. In early 2011, the PBC rolled out a pilot scheme of dynamic differentiated RRR. Under the scheme, the RRR for an individual bank varies on a quarterly, and sometimes even monthly, basis, taking into consideration its contribution to the deviation of aggregate credit growth from the historical trend, implementation of the government credit policy and other regulatory factors such as its leverage ratio and capital adequacy. Foreign Assets Have Doubled to 83% of PBoC Total Since 2000 Dec-10 Dec-05 Dec-00 Assets (% Total) Foreign Assets 83% 61% 40% Claims on Government 6% 3% 4% Claims on Depository Corporations 4% 12% 34% Claims on Other Corporations 4% 13% 22% Other Assets 3% 11% 0% Liabilities (% Total) Foreign Liabilities 0% 1% 0% Deposits of Government 9% 7% 8% Reserve Money 71% 62% 93% Bonds Outstanding 16% 20% 0% Other Liabilities 4% 10% 2% Total Balance Sheet (100m RMB) 259, ,676 39,395 Source: PBoC REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 4 of 11

5 Surging M2/GDP Ratio a Proxy for Excess Liquidity. Sterilisation happens when the central bank tries to gain control of the reserve money in face of an exogenous increase in Net Foreign Assets (NFA), by taking opposite actions with Net Domestic Assets (NDA). In other words, as the NFA increases, NDA should decrease as a result of sterilization so that reserve money is kept unchanged in this way, preventing the broad money supply from soaring. Any increase in reserve money or broad money supply should be seen relative to nominal GDP growth. In that context, the surge in the M2/GDP ratio since 2007 indicates a significant loss of PBoC control. Bill issuance via OMO reduces the domestic assets by taking the excess liquidity out of the system, while RRR increases reduce the money multiplier. From the PBC s perspective, increasing the level of required reserves as an attempt to sterilize affects the liability side of its balance sheet works in a similar way to open market operations, but the real economy impact of the alternative tactics is potentially very different. Source: PBoC, NBS Using PBC bills to sterilise the effects of FX intervention now entails significant costs, which are not likely to diminish anytime soon given the outlook for developed world policy rates. Consequently, the PBC has a natural preference for lifting the RRR to sterilise excess liquidity. In recent years, the bank has continued to make slow progress in liberalizing interest rates; in particular, it has reduced the level of excess reserves held in the financial system, in order to make banks more sensitive to money market interest rates. (A higher excess reserve ratio indicates that banks are flush with liquidity and the need for banks to borrow from money markets is reduced. As a result, banks are less sensitive to the short-term interest rates that the PBC has considerable influence over). If the interest paid on required reserves is equal to the interest on central bank bills, the two methods have the same impact on the central bank. The cost of sterilisation using required reserves has always been lower than open market operations, since the central bank pays minimum interest on required and excess reserves, but particularly so since Open market operations in China mainly include bond issuance and short term repo operations (usually within 91 days). There are also non-market tools such as transferring the deposits from the commercial banking system to the central bank and window guidance ( moral suasion ). However, the effect of changing required reserve ratios may be limited, since depository institutions tend to maintain high excess reserve ratios due to a lack of alternative investment channels as the PBoC has traditionally paid interest on both required and excess reserves. An increase in the required reserve ratio has to some extent driven a decline in the excess reserve ratio, leaving the money multiplier largely unchanged. The excess reserve ratio has fallen sharply in recent years, REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 5 of 11

6 declining from 8% in 2001 to 1.5% in H Since , the decline in the excess reserve ratio has been largely driven by the reduction in interest rates paid on excess reserves by the PBoC (as lower interest rates paid on excess reserves discourage banks from hoarding liquidity in the form of excess reserves). Source: NBS, PBoC, Fitch PBoC Monetary Definitions Net Foreign Assets (NFA) = Foreign assets- Foreign liabilities Net Domestic Assets (NDA) = Claim on depository corporations + Claims on other financial and non-financial corporations +Claim on government + Other assets - Deposits of financial corporations excluded from Reserve Money - Bond outstanding - Deposits of government - Other liabilities Reserve Money = NFA + NDA M2 = Reserve Money x Money Multiplier An increase in foreign exchange reserves leads to an accumulation of foreign assets, which is a component of the reserve money (i.e. the money base). When the PBC buys foreign currency from a Chinese exporter, it has to pay in local currency. The exporter then can deposit the payment in commercial banks, which raises the commercial bank s reserve level above the minimum level of required reserves and enables the bank to expand loans. Consequently, the central bank s balance sheet will show an increase in NFA and an increase in reserve money on the liability side. An increase in foreign reserves causes monetary expansion and thus puts inflationary pressures on the economy, resulting in an appreciation of the real exchange rate. To offset the expansionary effect of the increasing foreign reserves, the central bank can sterilize the foreign assets by taking opposite actions with NDA, or implement other offsetting monetary policies. However, there are structural reasons why sterilization may be weaker when implemented via the RRR on bank balance sheets, as the formal bank sector which the RRR targets has rapidly declined as a share of total credit since 2006, falling to just 54% of the total in H1 this year. REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 6 of 11

7 Source: NBS, PBoC, Fitch To control inflationary pressures, the PBC has raised reserve requirements and mandated bank interest rates, and directed still predominantly state controlled banks to limit their lending. These actions do not affect the monetary base directly, but they limit the extent to which the monetary base can support a bigger money stock and thus drive CPI inflation. The massive accumulation of FX reserves to the current 50% of GDP is not costless; the larger the stock of FX reserves the greater the potential quasi-fiscal cost if the return earned on the foreign assets is less than the interest paid on the PBC s sterilisation bills. The PBoC could try and recapitalize itself by earning profits from increased seigniorage, (i.e. printing more currency) or it could be recapitalized by the government but at the cost of losing some of its monetary policy independence and heightening the risk of a major domestic inflation problem. The PBC s sterilization operations impose considerable cost on the banking sector; China maintains an interest rate ceiling on bank deposits, which currently ranges from 3.50% for 1yr savings deposits to 5.50% for 5yr deposits. The requirement that 21.5% of deposits for large banks be reserved earning only 1.62% interest at the PBoC is an implicit tax on the banking sector (which the BIS estimates to cost 0.3% of GDP), restricting banks from allocating a larger portion of their portfolios to higher yielding loans and investments. Between 2003 and 2009, the PBoC neutralised about 40% of the impact of reserve inflows on the monetary base by selling bonds to domestic banks but the monetary base still expanded sharply over the period. In the absence of this offsetting policy move, the monetary base would have grown more closely in step with the explosive growth in FX reserves. In 2010, the PBoC s accumulation of FX reserves only accounted for 73% of the expansion in the monetary base, according to IMF data. When the PBC sells bonds or raises bank reserve requirements, it has to pay interest on those balances; if it doesn t want to print money to buy dollar reserves, it has to borrow the sterilisation funds and has to bear the cost of carry. In the classic Trilemma, the more the central bank absorbs from the domestic financial system in this way, the higher interest rate it has to pay to attract the funds, which at some point begins to exceed the return its getting from investing its FX reserves (which are predominantly in sub 2-year US Treasuries). As their central bank s quasi fiscal losses surge, most countries historically are eventually forced to abandon sterilization. China can evade this constraint by obliging state-run banks to provide the PBoC with funds at below-market rates, shifting the carrying losses from the central bank onto the banking system. The end result is basically the same as sterilisation i.e. banks stuck with a huge portion of their balance sheet REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 7 of 11

8 they can t loan out, and must either hold as bonds or reserves. Either the PBoC pays market rates on those holdings and bears a huge cost of carry (i.e. rising sterilisation costs), or it pays below-market rates and the banks take the hit. Either way, the continuous injection of new RMB from the PBoC buying up dollars places a big burden on the banking system that makes tight monetary policy very difficult to sustain. Source: PBoC, Fed M2 Growth Has Reverted to Trend, but Understates Liquidity Excess While the definition of M2 in China is broadly in line with the international standards, it is too broad to be considered as representing the classic purchasing power used for transactions'. Reflecting the underdevelopment of capital markets as a result of financial repression' for decades, a large part of household deposits at banks that comprise M2 are actually long-term savings (or a form of financial investment) instead of for transaction purposes, and therefore do not represent actual and perhaps even potential purchasing power. This is one underlying reason why China's trend M2/GDP ratio is one of the highest in the world. When the long-term saving component of M2 is stable, the change in M2 primarily reflects the change in money supply/demand for transaction purposes. However, when the long-term saving component becomes unstable, the change in M2 will not necessarily reflect the change in money supply for transaction purposes, and drawing implications of the change in the headline M2 growth to the inflation outlook can be misleading. Source: PBoC REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 8 of 11

9 The PBoC has quietly expanded the definition of M2 money supply, and used it in the October monetary statistics, which showed that M2 increased by 12.9% y/y. The new definition includes both non-depository financial institutions deposits and social housing funds on top of the existing M2 measure. All adjustments towards the previous M2 figures are not published at this stage except for October 2010, which the statement said was RMB72.35 trillion, and which is how they arrived at the 12.9% growth for October The M2 for October 2010 under previous criteria was just under RMB70trn, so based on the revised October 2010 figure, the old measure was understating broad money growth by over 3%. M2 has become less reliable as the shadow banking system exploded since 2007/8, and the bank has previously mentioned that they are developing a new measure of broadest money supply or so-called M2+; it hasn t explained why it only added two new deposit categories into M2 at this stage (i.e. still excluding off-balance sheet financial products), although it is progressively bringing bank off-balance sheet financial activities within its remit and these are likely to be included in coming months. Ineffective sterilisation of NFA accumulation via the RRR has contributed to excessive M2 growth since 2008, but the problem is likely to worsen given structural upside pressure on the money multiplier medium-term. The fast increasing issuance of credit and debit cards by banks has allowed consumers to keep more cash in the form of bank deposits rather than currency in circulation. Unlike currency in circulation, bank deposits can be used by financial institutions to offer loans, increasing the multiplier on each unit of money in the economy. Improved financial mechanisms for inter-bank clearing have reduced the need for financial institutions to hold precautionary liquidity in the form of excess reserves at the PB0C. With the PB0C paying ever lower interest on these excess reserves, financial institutions have an incentive to shift more of their excess reserves into loans to the wider economy, increasing the money multiplier on the monetary base. Source: PBoC REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 9 of 11

10 Conclusions China s 21.5% RRR is already very high by historical experience and global standards, and reserves have reached 30% of GDP and 45% of PBoC assets. With FX reserve accumulation easing further into early 2012 because of weaker external demand, particularly from Europe, the PBoC is likely to ease reserve requirements across the board, but beginning with second tier banks, as sterilization pressure overall abates. As open market operation tools (such as repos and PBC bills) tend to be more flexible and create fewer credit market distortions, the bank has undershot on the level of its bills outstanding and needs to rebalance the mix of various sterilisation tools it employs, even if the political pressure to underpin growth by releasing bank capital for lending wasn t becoming acute. The on-going structural problem remains China s exchange rate peg, which significantly hinders the PBoC s ability to tailor monetary policy to strictly domestic objectives. This stems from the Impossible Trinity or Trilemma model which states that it is impossible for a country to achieve monetary independence, exchange rate stability and financial openness simultaneously. In the last decade, the spread between the 1yr bank lending and saving deposit rates averaged 3.4% compared to a 1.4% average in the 1990s. However, wide bank net interest margins simply shift the cost of financial repression to depositors from banks and further depress consumption growth versus GDP. The real rate of return on 1-yr bank saving deposits averaged a negative 2.5% YTD to end September. The IMF has stated that a 1 percentage point increase in the real rate of return on bank deposits lowers the urban household saving rate by 0.6 percentage points, which is crucial to support the medium term economic rebalancing narrative when the consumption share of GDP is just 34% or half typical EM Asian levels. Rising real deposit rates are part of the solution to China s glaring economic distortions. Given the prospects of an extremely easy policy stance in developed through mid-decade as deleveraging progresses fitfully, the attractiveness of the RRR as a sterilisation tool for the PBoC with its already hugely leveraged balance sheet is clear. Marginal sterilisation costs will rise considerably as OMOs replace the RRR, given the divergence between domestic and foreign 1-3 year yields and thus the PBC s cost of carry. Overreliance on the RRR has exacerbated the stimulus led credit bubble given the incentives for depositors to seek positive real returns outside the banking system and the willingness of borrowers to pay well above official rates for funds. Pricing capital rationally remains the only way to help the economy make the transition to a more sustainable 7-8% trend growth rate through the rest of the decade. Overall, a reversion to OMO sterilisation will increase the structural pressure for further interest rate liberalisation and RMB real appreciation from a purely technical central banking perspective, but both also would accelerate the long delayed rebalancing of the country s economy and thus serve a wider macro agenda both domestically and globally. Author: SEAN MAHER Consultant Strategist KT ZMICO Securities Co., Ltd. ktzmicoresearch@ktzmico.com REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 10 of 11

11 DISCLAIMER This document is produced using open sources believed to be reliable. However, their accuracy and completeness cannot be guaranteed. The statements and opinions herein were formed after due and careful consideration for use as information for the purposes of investment. The opinions contained herein are subject to change without notice. This document is not, and should not be construed as, an offer or the solicitation of an offer to buy or sell any securities. The use of any information contained in this document shall be at the sole discretion and risk of the user. KT ZMICO RESEARCH RECOMMENDATION DEFINITIONS STOCK RECOMMENDATIONS BUY: Expecting positive total returns of 15% or more over the next 12 months TRADING BUY: Expecting positive total returns of 15% or more over the next 3 months HOLD: Expecting total returns of between -15% and +15% over the next 12 months SELL: Expecting negative total returns of 15% or more over the next 12 months AVOID: Expecting the stock to be materially affected by fundamental changes in the future (i.e., regulatory changes, etc); however, the impact cannot be assessed/reflected in the current forecast SECTOR RECOMMENDATIONS OVERWEIGHT: The industry, as defined by the analyst's coverage universe, is expected to outperform the relevant primary market index by at least 10% over the next 12 months. NEUTRAL: The industry, as defined by the analyst's coverage universe, is expected to perform in line with the relevant primary market index over the next 12 months. UNDERWEIGHT: The industry, as defined by the analyst's coverage universe, is expected to underperform the relevant primary market index by 10% over the next 12 months. REFER TO DISCLOSURE SECTION AT THE END OF THE NOTES page 11 of 11