February 2019

China is experiencing a broad economic slowdown. GDP growth fell to a 28-year low of 6.4% year on year in the fourth quarter of 2018, as weaker domestic demand combined with escalating trade tensions to weigh on business and consumer sentiment. The strong fiscal and monetary policy response from the Chinese authorities to this slowdown should help to support growth, but will also have a significant impact on cash investment options and cash returns in 2019.

Policy response designed to support growth

In early 2018, with economists predicting solid economic growth, China introduced new asset management product regulations that were designed to cut leverage and reduce risks to the economy by curbing activity in the shadow banking sector. However, the regulations were unexpectedly restrictive, leading to higher borrowing costs and a sharp slowdown in the availability of funding. The private sector, which accounts for over 50% of Chinese tax revenues and over 80% of employment creation, was especially hard hit.

The Chinese government reacted quickly with tax cuts and additional infrastructure spending to support growth. Meanwhile, the People’s Bank of China cut repo rates, reduced the reserve requirement ratio and introduced targeted credit easing. The cumulative effect of these actions can be observed in the massive increase in liquidity (CNY 4.9 trillion¹) into the banking system and the subsequent decline in market driven interest rates that made the Chinese bond market one of the best performing in 2018.

Lower rates means reduced cash returns

For short-term cash investors, this combination of lower interest rates and new asset management product rules has reduced potential returns and increased investment complexity. In 2018, as repo and Shibor rates declined sharply, yield-sensitive retail money market funds sought to offset lower returns by lengthening duration and buying even lower credit quality issuers – dramatically increasing risk. Triple-A funds, with more restrictive guidelines and a focus on liquidity and security, also suffered a decline in yields.

Meanwhile, the private sector remains under pressure despite the government’s stimulus efforts. This is because China suffers from a capital allocation problem rather than a lack of liquidity. Funding is available, but it isn’t reaching the parts of the economy that need it most. Instead, bank loan rates are at record highs and banks are still funding themselves via costly methods like structured funding.

Yields are likely to continue to trend downward

Ultimately, China must unblock its monetary transmission mechanism to boost growth. Nevertheless, given the authorities need to continue to support the economy while deflating a credit bubble, it is likely that liquidity will remain abundant and short-term interest rates will continue to trend downwards in 2019.

Unfortunately for cash investors, this implies lower yields. However, with default and downgrade risks intensifying, and interest rate volatility increasing, the temptation to add lower quality credit or extend duration to boost returns should be resisted. Despite lower yields, investors should continue to focus on safety and security if they want to avoid jeopardising principal.

To read more our liquidity insights, visit www.jpmgloballiquidity.com

1. Includes total liquidity released by reserve requirement rate cuts; plus increases to the standing lending facility, medium term lending facility and open market operations.