China will Adjust Monetary Policy Shortly

Developments in the coming days will likely push the People's Bank of China into easing monetary policy the near-term.  Many have been looking for a follow up move since the PBOC surprised the market on November 21 by cutting interest rates for the first time in two years.

Tomorrow HSBC will release its preliminary manufacturing PMI for December.  It is expected to slip below the 50 boom/bust level for the first time since May.  It is not that the PBOC acts on the basis of the HSBC PMI measure.  It has its own PMI.  It is not to be released until December 31.  It was just above 50 in November. 

The recent string of economic data has shown a continued loss of momentum for the economy, illustrating the need while the easing of price pressures shows the PBOC has room to ease policy.   Technical factors provide a sense of urgency.  Liquidity is drying up ahead of the end of the year.  It is being exacerbated by a rash of IPOS to be brought to market next week.  In addition, the Medium-Term Lending Facility, through which the PBOC injected CNY 500 bln in September is set to expire this week.  

The slowing of China's economy has both cyclical and structural characteristics.   Chinese officials appear to be embracing the structural decline.   The annual China Central Economic Work Conference was held last week.  This conference set the broad economic objectives, within the five-year plan, including GDP.  An announcement of the results is not expected until next year, but the press has been speculating that the 2015 growth target will fall to 7.0% from 7.5%.  

There are three other developments in China to note.

First, since the November 21 rate cut, the Shanghai Composite rallied through last week's high 27%.  The pullback in the middle of last week saw a bit more than a 38.2% retracement (2845 and low was set   2807).  

Other observers date the current move as having begun on October 31, when the Bank of Japan surprised investors by stepping up its asset purchase program, but it does not change the technical picture much.  The rally was closer to 30%, and the retracement objective was 2821. 

The equity rally does not appear to have drawn much support from the much anticipated Hong Kong-Shanghai equity link that was launched in the middle of November. In addition to the anticipation of lower interest rates, the Shanghai rally appeared to be sparked by retail investors.  The advance was scored on heavy volume and record margin use.  Chinese officials have appeared to be encouraging investors to move from the wealth management products of the shadow banking to the equity market and exchange-traded products.    However, the pace of the move did spur words of caution from Chinese regulators and a change in some collateral rules (use of corporate bonds). 

Second, the year-old Shanghai free-trade zone has not lived up to many expectations.  Nevertheless, the experiment has been sufficient for Chinese officials to try to duplicate it.  Before the weekend, China announced it will be setting up three new free-trade zones in Guangdong, Fujian and Tianjin.

Third,  tomorrow China will likely announce an upward revision to its measure of the size of the economy.   The size of the economy may increase 5-10% (~$450 bln to $900 bln) because of new methodological changes that have already been adopted in other countries.  Most important will be the re-classification of research and development expenditures as part of investment not consumption.  

Another important methodological change will come calculating the value of home ownership  based on a rent approach.  The current approach was made necessary by the under-developed rental market in China.  The new approach will bring it into line with other countries.  The current approach likely under-estimates spending on housing, which Chinese figures show has been declining as a share of overall spending since 2006.  

The official measure of the size of the China's economy will likely be boosted by the inclusion of the 2013 census.  Assuming the past can be a guide to the future, the past couple of censuses have lifted China's GDP by about 1% a year under review.  It has been five years since the last census.  The census results are expected to be reported tomorrow, but it is not clear that they will be incorporated into the GDP revisions immediately.  

The anticipated revisions to China's GDP, even if it produces a slight upward revision to growth rates in recent years, it will not, in our view, impact the PBOC decision to ease policy.  One impact of a larger GDP though will be that imbalances, whether debt or the current account surplus, will be a somewhat smaller part of the overall economy, newly measured.