15 July 2021
China’s reserve requirement ratio cut was larger and sooner than markets expected, but it should be viewed as a targeted boost to economic activity, not the beginning of an easing cycle. China’s economy looks just fine.
The recent cut to the reserve requirement ratio (RRR) in China has made some market participants question whether this heralds a slowdown in the country’s economy. The 0.5% cut – a RMB 1 trillion liquidity injection – came sooner and in larger size than the market expected. Does China know something that the rest of the world doesn’t? In extremis, the move could be seen as a reaction to expectations of slower growth, and the beginning of an easing cycle by the People’s Bank of China (PBoC). Indeed, the pace of growth in China has slowed recently, likely due to several factors, including new mobility restrictions due to the delta variant, as well as a glut of supply in certain parts of the economy. However, we note that these factors are likely temporary, and that China’s economy is still expected to grow 8.8% in 2021 – an elevated level by most standards. A truer interpretation of the policy move would be that the PBoC has simply modified its policy by injecting liquidity into the financial system, encouraging banks to increase their lending, thereby supporting smaller enterprises, which have been impacted by higher raw material costs, and boosting economic activity. The statement issued by the PBoC made clear that this is an adjustment to policy and markets should not expect an easing cycle. The fundamental picture in China looks robust, especially as the Chinese authorities continue to work towards their advancement strategy: as the world emerges from the Covid pandemic, China remains strategically focused on enacting a broader restructuring to improve corporate governance and the sustainability of business models, reduce systemic risk and prevent cost increases for corporates.
The RRR cut should support small enterprises, whose profit margins have lagged due to higher costs
Chinese government bonds look relatively attractive versus other global bonds: the 10-year yield on Chinese debt is 2.96%, having fallen over the past month from almost 3.2%. The 30-year part of the curve yields 3.54%, down from around 3.7%. Yields could fall further, although on balance, the move is unlikely to be dramatic. Instead, with a spread over 10-year US Treasuries of more than 160 basis points (bps), Chinese local government bonds look like an attractive carry trade. Elsewhere in Chinese fixed income, certain parts of the credit market are also starting to look interesting. Spreads in single-B real estate, for example, have widened sharply in recent weeks (from 939 to 1,461 bps), meaning that for investors with a higher risk appetite looking for capital gains, certain names may prove rewarding – although dispersion and idiosyncracies in this part of market mean that selectivity will be crucial. (Data as of 15 July 2021).
Local Government Special Bond issuance in 2021 has amounted to less than one third of the annual quota, which suggests that the second half of the year could see a significant increase in supply. Ultimately, this will impact the credit markets rather than the China government bond markets and reinforces the need for caution in credit. The technical backdrop for government bonds remains supportive: with CNY-denominated bonds making up 7% of the global aggregate index, demand from overseas investors should persist. Anecdotally, we have also observed an increase in institutional interest in the market; as the Chinese economy and financial system continues to open up, demand for Chinese debt should be supported.
What does this mean for fixed income investors?
We do not view the recent policy action by the PBoC as a sign of a problematic economy; instead, it represents a medium-term liquidity injection aimed at supporting economic activity. In this environment, with Chinese growth expected to continue at a strong – albeit lower – pace, Chinese government bonds look attractive; while yields might not have further to fall, we see a backup as unlikely. For investors looking further afield, corporate credit might present opportunities, but, as ever, it will pay to be selective, especially given the supply backdrop for the rest of the year.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum