China – Weakness across the board

　　·China's manufacturing PMI shows across-the-board weakness
 　　·Companies are beginning to retrench - jobs are being lost and purchases of raw materials are falling
 　　·RRR cut is the pivot we have been waiting for, but PMIs will remain weak until Q2-2012
 　　China's PMI data tells a simple story: an across-the-board, deepening slowdown in the country's manufacturing sector. Today, we take a quick run through the numbers and give our outlook for monetary policy following yesterday's reserve requirement cut.
 　　Export orders dipped into sub-50 territory in August, and the fall-off in orders accelerated (45.6 in November). Even more importantly, overall orders are now falling month-on-month (m/m) too, as Chart 1 shows. Several PMI indicators (export orders and employment, for instance) suggest that overall manufacturing growth has basically stalled in the last three to four months. The services sector has performed better, but has also slowed - the October reading for non-manufacturing was 57.7. This slowdown is no bad thing, given the over-heating of H2-2010/H1-2011, but as the balance of risks has shifted, policy now needs to respond.
 　　Manufacturing companies, which officially make up about 50% of GDP, are beginning to retrench. Purchases of raw materials fell in November m/m for the first time in this cycle (Chart 2), while the survey suggests that companies cut workers in November for the second consecutive month. Inventories spiked up to a reading of 53.1 (the fastest acceleration in inventories since the PMI series began in 2005), suggesting that it will take some time for companies to work through inventories before they ramp up production again. More cash will be locked up in stock, too.
 　　Inflation concerns need to be parked firmly on the sidelines - the sub-component for input prices was 44.4 in November, suggesting deflationary pressures are breaking out upstream, as Chart 3 shows. We look for consumer price inflation (CPI) of 4.3% y/y in November, and for producer prices to rise by only 3.1% y/y.
 　　
 　　
 　　And now Beijing pivots, and loosening is on the agenda
 　　We had called for a reserve requirement ratio (RRR) cut before year-end (against market consensus that it would happen in January at the earliest; On the Ground, 23 November 2011, 'China - The falling RRR'). It happened a little earlier than we expected; the 50bps move is effective 5 December. Our analysis suggested that inter-bank liquidity would have become tight at the end of December, so the People's Bank of China (PBoC) is front-running that in an attempt to ensure that banks have enough spare funds to lend out in December. Early reports suggest loan growth in November may have been weak. There is also a strong possibility that there was some co-ordination with western central banks' action to cut interest rates on USD swaps yesterday.
 　　The public nature of the RRR move - which would have been passed by the State Council - is a clear signal that Beijing now sees the balance of risks as lying with growth rather than inflation. It has taken them a long time to come round to this view, and all kudos to them for holding the line until now. The spin will be that this is 'micro-loosening' and the official monetary policy for next year will still be the same (“prudent”). But this is a big move: it signals that China is now in loosening mode, and that the bank-lending quota will be expanded. Given the liquidity crunch we see coming before Chinese New Year, we expect another RRR cut in January (a total of four in 2012).
 　　
 　　
 　　However, much debate about the speed of the monetary policy shift clearly remains. The Central Economic Work meeting usually takes place in November, but it appears to have been postponed to early December, suggesting that key policies for 2012 are still to be determined. Rhetoric in the quasi-official press suggests that official policy (“prudent” monetary policy and “pro-active” fiscal policy) will be retained, but the substance of such slogans is clearly open to interpretation. A few months ago, “prudent” monetary policy meant RRR hikes, not cuts.
 　　The PMIs will likely stay weak into Q1-2012, since monetary loosening is likely to be slower than in 2008. We expect the economy's prospects to perk up in Q2-2012, though, and expect 8+% real GDP growth for 2012.
 　　We do not currently look for interest rate cuts in 2012. The PBoC-set rates are already too low for this economy. But as liquidity is injected into the inter-bank system and excess reserves rise, de facto lending rates will likely fall (8.06% was the weighted average one-year rate in Q3-2010, against 6.56% administered rate). Most importantly, we expect the discount rate on drafts to now come down more. As Chart 4 shows, this rate has already come down, but only to a still-high 8+%. Many SMEs finance themselves in this way, and the high costs have been hurting them.