China has abandoned its ‘growth at all cost’ push and is sticking with its deleveraging and structural reform policy despite the trade war with the US and COVID-19 shocks. This has resulted in a constrained growth environment.
Demand-pull inflation has been capped. In turn, this has meant cost-push price pressures have been limited. The result is dormant consumer price inflation (CPI). We can see no fundamental economic reasons for Chinese bond yields to rise significantly this year. Even the recent rise in yields of US Treasuries will, in our view, not change matters.
Therefore, the risk of Chinese monetary policy being tightened this year to counter inflationary pressures should be low. Greater financial discipline, however, should be evident as Beijing moves to rein in financial risk by pushing bad players to exit the system.
Economic recovery accompanied by further deleveraging, a structural rebalancing and Beijing’s retreat from its implicit state guarantee policy will, I expect, keep the yields on five-year Chinese government bond in a range of between 3.0% and 3.5% this year. This macroeconomic backdrop is also benign for Chinese stocks beyond some near-term consolidation/correction.
No more ‘growth at all cost’ policy
Inflationary pressures are particularly likely to emerge when the growth mix is inefficient, i.e. resources are misallocated to inefficient sectors. This creates additional demand without enhancing productivity. The change in China’s macroeconomic policy objective since President Xi came to power has improved the country’s economic structure and helped reduce inflation risk.
China’s efforts on a structural rebalancing and environmental controls since 2015 have cut excess capacity, notably in the steel, coal and cement sectors. The process has become a structural force containing inflationary pressures.
Throughout the current down cycle, China has abandoned its ‘growth at all cost’ policy by not pursuing massive reflation via injections of liquidity (see exhibit 1) that would buoy all sectors. Its support measures have been targeted and selective, with liquidity not going into sectors, such as the property market, where there is excess capacity.
No inflationary pressures
Despite the recent return of mild producer price inflation (PPI), it has not filtered down to the CPI (see Exhibit 2). Statistically, there has been no significant correlation between China’s PPI and CPI. Economically, the constrained growth environment in China’s ‘new normal’ economy has prevented cost-push price pressures from spilling over into consumer prices. The People’s Bank of China is targeting to cap CPI inflation at 3.0% year-on-year.
Core CPI inflation has been quiescent for a long time, while headline CPI has been driven by food price inflation. The outlook this year is for lower food price inflation, notably in vegetable and pork prices as the prices rises caused by flooding and swine flu last year are unwound.
Therefore, there are no economic reasons to anticipate a return of inflationary pressures in China anytime soon that could trigger tighter monetary tightening and significantly higher bond yields.
The US factor
Finally, the recent spike in US Treasuries yields is unlikely to change the Chinese yield environment. In our view, this time around, it will not lead to a ‘taper tantrum 2.0’ for China (and Asia) because the pace and the magnitude of the rise in US real rates are likely to be much lower than during the 2013 tantrum.
In May 2013, when the Federal Reserve (the Fed) indicated that it would taper quantitative easing, it was not specific about either the timing or the intended rate policy. Markets sold off on the fear that rate hikes were imminent, pushing up 10-year US real yields by 150bp in the four months between April and August 2013.
This time around, markets generally expect US real yields to rise only moderately over the next 12 months. The Fed has already pushed back against any tapering talk. The US central bank has also made it clear that it intends to have a longer lead-time both between communicating any tapering intentions and any actual tapering and between actual tapering and policy rate normalisation.
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