Scrambling for liquidity

By Rodney Diola


Months before China announced its recent interest rate hike, multinational companies in China were already experiencing issues with the US dollar and renminbi liquidity in the country. The government had tightened reserve ratios for banks early in the year and continued to tweak them tighter as the year progressed.

As the Chinese government is mopping up excess liquidity in China’s financial system in the aftermath of the economic stimulus programme, liquidity in both US dollar and renminbi have turned into key issues for corporate treasurers, notes Lisa Robins, head of treasury and securities services, China at J.P. Morgan. “There was less supply of available credit, even though there was a much stronger loan demand from customers anxious to better manage their operating flows.”

“Being a financial institution operating in China, we have learned to live with evolving priorities as they relate to monetary policy,” observes Robins. “Three years ago, they were loosening and then tightening before the financial crisis. And then loosening again and tightening after that.” Most US multinational clients in China are taking no chances, trying to be as liquid as possible in the near to medium term to avoid a liquidity crunch in case credit facilities become harder to come by or costlier to obtain.

Hike surprise

When China’s central bank announced on October 19 that it would raise key rates by a quarter percentage point, it caught global markets by surprise and sent stocks, commodities and emerging-markets’ currencies lower on worries that the global economy might grow more slowly. It also accelerated the slide of the US dollar against other major currencies.

Bankers and economists are divided over how the hike will help sustain China’s long-running economic success. Some say the move may cool the country’s hot property markets while others believe it will have little direct impact on the real economy or the renminbi and actually reflects confidence in the strength of China’s economy.

The myriad of questions thrown up by the rate hike reveals how much China’s moves are being monitored across the globe. Financials markets recognize the leverage China has in shaping the global economy in the next 10 years. There are conflicting assessments: HSBC economists suggest that the move could exacerbate the property bubble in China as the higher interest rates attract more external funds into the country.

The rate hike might widen the rate differential between China and the global market, according to HSBC, and hence attract more capital inflows. But the impact would be limited by the existing capital control measures. With higher interest rates, people are likely to continue holding on to their renminbi (instead of opting for foreign-denominated assets) and this will increase liquidity chasing property assets. Cash-rich multinationals operating in China could hold off paying dividends to foreign shareholders to be able to hold on to their renminbi and have the excess cash working for them by parking it in Chinese assets that could include real estate, among others.

However, a briefing by Société Générale warns against trying too hard to divine what could happen next. If the Chinese regulators find that their move is slowing the economy more than they had originally intended, they can decide to immediately change tack. This happened before, at the height of the global financial crisis, when China reversed moves to restrict growth of loans by banks and instead pushed for measures to stimulate the economy which was faltering because of a collapse in demand from major markets such as the US and Europe.

Negative real interest rates

It seems as though the move has created more questions than answers: What exactly do the Chinese regulators seek to accomplish? How will this affect the management of foreign exchange reserves and the value of the renminbi? Will China eventually tighten its capital controls? Is China entering an extended cycle of rising interest rates?

In a report, BNP Paribas described the 25bp rise as the clearest indication yet that China has officially ended its “appropriately loose” monetary policy that had been in place since December 2008, and is continuing its exit to a prudent monetary policy for 2011. BNP Paribas says the tightening suggests a shift away from growth towards a structural quality and risk management bias, early on in the 12th Five Year Plan (covering the period from 2011 to 2015).

China’s robust tightening rather came out of the blue and is much stronger and earlier than market consensus had expected. On hindsight, the market may have paid too much attention to exchange rates and the US Federal Reserve’s quantitative easing, BNP Paribas adds. The People’s Bank of China (PBOC) hiked benchmarked one-year deposit and lending rates by 25bp to 2.50%. One-year lending rates were raised 25bp to 5.56%. “With the PBOC recently expressing confidence on the use of quantitative easing tools to manage liquidity and arguing that a greater exchange-rate flexibility would help to reduce inflation, the urgency of normalizing the extremely low nominal and real interest rates was overlooked.”

HSBC economists say that since March, China has been running negative real interest rates. While the one-year deposit rate stood at 2.25% in August, the consumer price index (CPI) had risen 3.5% year-on-year, a 22-month high. In fact, the 2010 quarterly CPI figures indicate an acceleration in the increase: from 2.2% in the first quarter, 2.9% in the second to 3.5% in the third quarter.

The rate hike does not change the fundamentals of the problem, and unless the PBOC drastically increases interest rates, depositors will continue to get negative interest rates in the coming months.

In a way, HSBC comments, the rate hike was completely justified, considering that there was growing public concern about negative interest rates, inflation and rising asset prices eating up household incomes.

HSBC sees the additional property control measures announced in late September as a sign of Beijing’s determination to rein in property prices amid a strong rebound in transaction volume. “Besides the administrative measures, interest rate is the most powerful tool to raise the borrowing costs and curb speculative and excessive housing demand.” HSBC says investment will continue to find support from over 100,000 ongoing infrastructural projects and accelerated public housing construction. It notes that consumers will gain from a boost in their interest rate income, considering that the longer-term deposits got a higher margin of rate hikes.

Speculative concerns

Robins says J.P. Morgan is intent on further expanding its operations in China, particularly with the latest regulatory developments in terms of the renminbi international trade settlement programme. However, with the currency increasingly in the spotlight as it moves towards a broader internationalization, Robins suggests that the US government should focus its efforts on issues related to market access, while at the same time encouraging China to further develop its domestic consumer base. “If there were a stronger market demand for US products, then we may start to see something of a rebalancing of trade.” She adds that most American companies in China are still operating profitably.

Robins says she is realistic about her expectations on the extent China will liberalize its capital account, possibly allowing greater flexibility in foreign money coming in. “The Chinese government is concerned about speculation. This is the reason why companies seeking working capital loans have to demonstrate where the money will ultimately be used, that it will not be used for purposes other than they were intended. Until concerns about speculative investments are addressed, the restrictions will continue.”

This article was published in the November 2010 issue of The Asset magazine
The Asset website is at http://www.theasset.com