China: Inflation and monetary policy outlook
- Unlike previous cycle, PBOC is not expected to tighten drastically soon
- Bond defaults will rise further if government support wanes amid increasing redemptions
- Implications to our forecast: we expect the LPRs to stay steady in the coming months
- Implications for investors: We are still comfortable with CGB duration
The recent surge in factory-gate prices also adds to inflation worries. Yet, unlike previous cycle, the authority is not expected to tighten drastically anytime soon. Not least because the pickup in producer prices has in large extent been propelled by global supply bottlenecks. The pass-through effect is limited hitherto. Despite April’s headline PPI jumped 6.8%, producer prices of consumer goods edged up a mere 0.3% (see here).
Barring the resurgence of COVID-19, the recovery in household consumption should spur gains in service prices later this year, particularly for catering, travel, and entertainment. But the process will be gradual and moderate, as evidenced by the still low core CPI reading and the subdued durable goods prices. Falling food prices may also help keep inflation at bay as pork production continues to recover.
Mirroring this is the unbalanced recovery. Both industrial output and investment buoyed by strong exports and a hot property market in April. However, retail sales growth softened to 4.3% on an average two-year basis from 6.3% in March. The setback suggests consumer demand is yet ready to replace investment as a driver of growth.
An over-tightening would jeopardize the growth recovery. Efforts to restrain debt growth has already led to a significant slowdown in credit impulse. April’s total social financing growth weakened the second consecutive month to 11.7%, as shadow financing contracted, and corporate bond financing as well as bank loans slowed. M2 slumped to 8.1% from as high as 11.1% in mid-2020. Note that the authority’s goal is to keep credit expansion roughly in line with nominal GDP growth, which we forecast will be in the 12%+ terrain this year.
A sharp turn in policy would also send a shock to the financial markets, which are currently pricing in a relatively benign scenario. The 10-year sovereign yield has fallen to the lowest level in eight months. Debt repayment is another concern. About USD1.3tn (RMB8.4tn) of domestic debt payable by May 2022, compared with USD1.0tn and USD0.8tn in the US and Europe respectively.
Challenges are particularly acute for state-linked firms, with RMB1.38tn of onshore bonds coming due in 3Q. That’s the fourth-straight quarter the figure will be larger than RMB1.3tn. A string of defaults by SOEs since late-2020 raised concerns about government backstop for such firms, amplified recently by worries surrounding China Huarong Asset Management Co. That put the onus on PBOC to ensure sufficient liquidity buffers, especially as banks’ excess reserve ratio has remained low for several months.
We expect the LPRs to stay steady in the coming months. Should inflation pressures gather further momentum, regulators could roll out targeted measures to tackle the rising raw material prices. The China Iron and Steel Association is already working with the Dalian Commodity Exchange to reform the delivery system to reduce market speculation. Other potential policies include a further tightening of credit growth from specific sectors and releasing certain metals stocks by the State Reserve Bureau.
On the rates front, shorter-term rates are not showing any signs of upward pressures, leading to increasing demand for duration. We have been comfortable with CGB duration since 4Q last year and recently reiterated our stance (see here). We have re-centered our 2Y and 10Y CGB yield forecast to 2.75% and 3.30% respectively. We think CGB will be one of the more resilient govvies in Asia even as Fed taper risks loom in 2H21. While price gains are likely to be more muted from here on, we think that the yield and stability offered by CGB is compelling. We still have a running long 30Y CGB idea (see here).
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