Decoding the Chinese
Our new proprietary measure of Chinese financial conditions allows us to extract better the signals from policy changes and movements in financial markets, and examine the spillover effects on key economic and financial variables. We then use this work to inform our outlook for the global economy and markets.
Understanding the Chinese economy requires a clear empirical framework
As China has risen rapidly to become the world’s second-largest economy its business cycle has become more closely aligned with the broader emerging market (EM) cycle. Indeed, the correlation between China and EM now rivals that between the United States (US) and EM. This makes it critical for economists, policymakers and investors to monitor and understand the likely effects of Chinese macroeconomic and policy developments.
In this article we examine the Chinese financial cycle and its spillover effects1. First, we present our newly developed proprietary indicator of Chinese financial conditions (ASICFI). This incorporates the variety of policy and regulatory tools deployed by the Chinese authorities. It also takes account of the complex ways in which changes to those tools are transmitted through the financial system over time.
Second, we develop an innovative model suitable for capturing the transmission and interconnections between Chinese financial conditions and the domestic economy, as well as foreign economic activity and asset prices. We then illustrate the usefulness of this framework for our forecasts and asset allocation decisions.
In most advanced economies, monetary policy decisions are transparent
Measuring Chinese financial conditions
In most advanced economies, monetary policy decisions are transparent and conducted through a small number of instruments. However, Chinese policy and the financial system within which it operates is more complex and opaque. It is also subject to rapid cyclical and structural changes. This means that quantifying financial conditions in a single measure in China is no easy task. With this in mind, we have incorporated the information from 21 series of relevant data2 grouped into five key measures of financial conditions: policy & duration; money & credit; risk premia; volatility and foreign exchange.
We combine the results of our China Financial Conditions Index (CFCI) with our qualitative judgement and knowledge of the Chinese economy. This allows us to develop a more comprehensive understanding of how Chinese financial conditions have evolved over the past 12 years. In particular, as shown in Chart 1, we identify eight main phases of the cycle over this period. We also consider how the relative drivers have changed over the different phases.
As seen in Chart 1 Policy & Duration (which includes interest rates and bond yields), and Money & Credit factors have been the main drivers of the Chinese financial cycle since 2007. By contrast, Risk Premia or returns from risk assets have played a much smaller role, both in absolute terms and compared with financial cycles in the advanced economies.
Chart 1: Characterising the Chinese financial cycleSource: Aberdeen Standard Investments, Haver, Bloomberg, Thomson Reuters Datastream (as of September 2019)
During China’s most recent policy loosening cycle, beginning in early 2018, there was a much weaker transmission from money and loan growth than during past financial cycles. This has lessened the effectiveness of policy stimulus. The natural question is, what might the likely implications of this be for the economy and financial markets?
Capturing the spillover effects of changing financial conditions
Since the financial crisis, the composition and swings in the Chinese financial cycle have corresponded with the mini-cycles in domestic and foreign activity, as well as asset prices. To investigate these effects in more detail we built a model that captures their complex and changing interrelationships.
Using our framework we find that there are strong spillover effects from changes in Chinese financial conditions. As seen in Chart 2, looser conditions in China lift domestic activity and equity prices in the offshore Chinese market. Additionally, they boost global economic activity and asset prices. The extent to which monetary transmission lowers EM bond spreads is particularly large. We also find that there are positive spillovers to US growth and also declines in US financial stress.
Chart 2: Positive spillovers from easing Chinese financial conditions
(2A) Response of Activity Variables
(2B) Response of Equity Markets
and Commodity Prices
China PMI: Chinese composite purchasing managers index; Advanced IP: index of industrial production from the CPB; EMIP: emerging market industrial
production ex. China; US NC: ASI measure of underlying momentum in US activity annualised quarterly growth
EM equity ex China: MSCI EM ex. China Index; DM Equity: MSCI World (ex. EM) Index; Commodity Prices: Goldman Sachs Commodity Price Index; EM BIG: EMBIG spread to worst
Source: Haver, Bloomberg, Thomson Reuters Datastream, Aberdeen Standard Investments (as of September 2019)
That said we also uncover evidence that the majority of these effects have been declining over time by considering a time-varying version of this framework. This indicates the possibility that the efficacy of policy has diminished as China’s debt burden has increased. We also compare the relative effects of changes in US and Chinese economic and financial conditions, finding that US economic shocks have larger effects than Chinese economic shocks. However, Chinese financial shocks have more powerful spillovers than US financial shocks, particularly when looking at the implications for emerging markets.
Enhancing our forecasting process and better informing investment decisions
At any given point in time, our forecasts for Chinese and broader global GDP growth embed assumptions about the future evolution of the Chinese monetary and financial cycle. We then draw on these views to predict how this will be transmitted to the domestic and international economy. In turn, portfolio managers use this information, together with assessments about valuations and positioning in the market, to make asset allocation decisions.
The development of this framework enhances this process in a number of ways. When policy and financial indicators are changing rapidly, and by different amounts and sometimes in contrary ways, we are now able to more efficiently combine the signals, compare the realisations with what we were assuming in our forecasts and portfolio decisions, and make adjustments accordingly.
Equally important, our work provides us with crucial triggers to change these views if Chinese financial conditions and their composition evolve differently from our expectations. For example, the Chinese authorities may make a more concerted and aggressive attempt at stimulus. All other things being equal, this would lead us to revise up our global growth forecasts and increase our allocation to risk assets – although, from a longer-term perspective, it could also amplify already elevated financial stability problems.
The development of this framework has reinforced our caution about the Chinese and broader global economic outlook over the coming year. In the first half of 2018, amid signs that the domestic and global economies were slowing, the Chinese authorities began to cautiously reverse the policy tightening put in place during 2017. This involved cutting bank reserve requirement ratios (RRRs), allowing other market interest rates to fall, while also cutting taxes for corporations.
However, while the Policy & Duration component of the CFCI increased in response to these measures, the Money & Credit component of the index did not respond. In fact, it initially deteriorated further. That was both because the authorities remained reluctant to allow financial imbalances to increase again, and because credit demand remained soft in the sectors that were able to access lending. More recently, the CFCI has turned down again, signalling a modest tightening in conditions compared with earlier in the year.
The upshot is that although there has been a net easing of financial conditions since the start of 2018, it has been modest compared with previous episodes. Not only has the level of the index remained lower than at the peak of past episodes and more recently returned to a neutral level, but Money & Credit has made little contribution to the improvement.
How have we used this information in practice? During 2018 it became clear that the Chinese and global economies were slowing, and the trade war between the US and China was heating up. We took the view through the second half of 2018 that the authorities would continue to ease monetary policy settings. However, because we expected the authorities to continue to restrain the credit impulse, our judgment was that a moderate easing in financial conditions was the most likely outcome.
Table 1: Global economic forecasts below consensus and subduedSource: Aberdeen Standard Investments, Bloomberg (as of September 2019)
Forecasts are offered as opinion and are not reflective of potential performance. Forecasts are not guaranteed and actual events or results may differ materially.
Looking forward, to upgrade our current subdued economic and market outlook we would need to see a combination of: a decisive and broad-based upturn in our CFCI; signs that the policy loosening in the US, Europe and other developed markets indications was being transmitted more powerfully; and indications that the US-China trade war and other geopolitical risks were fading significantly.
In most advanced economies, monetary policy decisions are transparent