Did China just hit the panic button?

Yesterday's record intervention by the Chinese government to push down interest rates is the strongest sign yet of a Chinese slowdown. The RBA must pay attention.

The Chinese economy has slowed and some wise heads are painting yesterday’s intervention in the repo market from the People’s Bank of China (PBoC) as a sign of panic. All key economic indicators from GDP, to inflation, to house prices, to international trade confirm a slowing in economic activity.

The 64-Yuan questions are exactly how much has the economy has slowed. Will it keep slowing or are we getting near a turning point that suggests better economic times in the late 2012 and into 2013? China, already the second largest country in the world, is on track to over take the US as the world’s largest economy in the next few years. This inevitably means that what happens in China is critical for the global economy.

Yesterday, the PBoC unexpectedly injected a record Yuan220 billion (A$33 billion) in to the interest rate repo market as it moved to push interest rates lower. The action suggests all is not well, although this view is not shared the Reserve Bank of Australia.

The RBA, which in recent years has ramped up its China research effort, including opening an office in Beijing, released the minutes from the August Board meeting at about the same time the PBoC was intervening to drive interest rates lower. According to the RBA assessment, in China "there were signs that investment growth had steadied and some early indications that conditions in the housing market had also improved a little in recent months.”

This view sits oddly with a raft of other news and it could be the case that the RBA is looking at developments in China through rose coloured glasses.

This is certainly the view of Glenn Maguire, the Asia and China economic specialist and Principal of Asia Sentry Advisory.

In a case of Glenn versus Glenn (Stevens and Maguire), Mr Maguire feels that the PBoC "hit the panic button” with its intervention in the swaps market and that the policy action "points to a renewed weakening in Chinese output.” [my emphasis].

Maguire’s view is backed by a range of other hard evidence. Prices for iron ore, coal and other base metals are falling and the Chinese authorities are working to run down the current excessive stockpiles of these and other raw materials.

Iron ore and coal prices have fallen sharply. Reuters are reporting that China steel futures have fallen for seven consecutive sessions to reach a record low. This slump in steel production is impacting on iron prices which are now around 35% lower than the peak in early 2011 to be at a 3 year low. Iron ore prices have fallen in all but three sessions in the last 6 weeks.

The Chinese economic weakness is showing up in the data from other countries.

South Korea, the 15th largest country in the world and Australia’s fourth largest trading partner, is in trouble. In the first 20 days of August, Korea’s exports were a thumping 12.4% lower than a year ago, a clear sign the Chinese slowdown is spreading through the region. Japan’s export performance is also deteriorating to the point where the trade balance has registered rare deficits in five of the past seven months, with the two surpluses being wafer thin.

The chill wind from China is also being felt in Australia. Annual growth in Australia’s exports of goods and services has averaged just 1.6% in the three months to June, down from growth of 11.0% at the end of 2011 and 22.6% at the end of 2010.

Financial market reaction to policy changes in China is curious. When there is an easing, like yesterday, there is inevitably a knee-jerk jump in share prices, commodity prices and even the AUD. The reasoning behind the moves appear to be that traders think that easier policy will under-score growth and with it demand for raw materials and with that, overall economic activity.

The harsh reality suggests that the market reaction should be more muted. The policy action is only taken because the economy is softening and the PBoC is judging more negative risks ahead.

As Maguire notes, "the background chatter in Beijing continues to be of policy makers highly reluctant to cut the RRR in fear of reflating the property market. As we have noted before, the cost of greater policy prudence in China will be a tolerated hard landing.”

This sobering interpretation of events means that one of the biggest threats to the Australian economy comes from further weakness in the Chinese economy both directly and as this weakness spreads throughout the region.

The RBA would be well advised to take off the rose coloured glasses and consider the raft of news that suggests all is not well in Australia’s dominant export market.