So we wake up this morning with the news that the official PMI data shows a contraction in Chinese manufacturing activity for the first time since February 2009. This follows the HSBC survey published a couple of weeks ago which similarly illustrated a contraction. In this context it’s easier to understand the reduction in RRR yesterday afternoon. That reduction added some $63bn of liquidity to the Chinese economy.
Clearly the Government sees that the economy is not in for an easy ride. I mean after steadily raising the RRR in 12 steps since January 2010 from 15.5% to 21% (a record), and then leaving them since June 2011, this is a watershed moment. While commentators yesterday lauded the move as the PBOC’s attempt to steer the economy to a soft landing I would prefer to describe the move as follows: A long running policy of loose monetary conditions led to an influx of speculative capital. The change in direction (i.e. to tightening in Jan 2010) combined with a huge acceleration in housing construction has killed the boom, created distress and the PBOC is now waking up.
Initial loosening is generally greeted with joy (note markets were buoyed somewhat way before the announcement of combined central bank activity yesterday to put a band aid on the Euro crisis). However, within time the market will see that the damage that precipitated the change in monetary policy is too big for a gentle loosening. As such I expect Chinese economic conditions to continue worsening (today’s PMI data is one example), and the PBOC to take more agressive moves to loosen credit conditions. This will heighten the impact on those assets that were tied to the prior boom. In this case I would expect damage to significant parts of the EM equities, fixed income, and commodity complex, in addition to pain in the domestic real estate market. Don’t say I didn’t warn you.
Also note – there’s a chance this could spill over to the banking system.
PS – some additional color on the PMI data. New orders 47.8. Export orders 45.6. Note that the export sector’s value added accounts for only 10% of GDP (yes – only 10%). As such, domestic weakness is most likely to be the driver of GDP deceleration in the coming months. Index of finished goods inventory rose to a record high. Tobacco, transport equipment and petrol were above 54. Below 43 were textiles, chemical fiber and plastics, and ferrous metal. The biggest losers were electrical machinery and special purpose equipment.