Illustration: Peter C. Espina/GT







It might be hard to fathom a raging bull market amid tightening liquidity, as China's real interest rate has fallen to new lows that used to portend an interest rate or reserve requirement ratio hike.



Historic-low real interest rates have been the real culprit behind the bubble in bond, property and commodities as well as the fast depreciating yuan. With inflation expectation rising, growth may not continue as expected as investment will likely fall with curbs to the property market. As such, the Chinese economy is stuck between mild cyclical reflation and outright stagflation. It will continue to traverse an L-shaped trajectory, as it has since 2012.



Already, we have seen a bout of new curbs on property purchases. These new measures to deflate the property bubble include increasing the percentage of down payment, restrictions on second-home purchases, tightening lending standards to those with outstanding mortgages and requiring buyers to have a local hukou. So far, this latest round of property impediments has not tamed the burgeoning bubble, rather property prices continue to surge.



It's worth paying particular attention to the fact that, contrary to the popular belief - that curbs on property will "force" funds to rotate out of the property sector and into stocks - property curbs instead tighten liquidity and hurt equities. History suggests that property purchase restrictions tend to be followed by declining market return, or even outright market downfall, as can be seen in September 2007, January 2010, April 2010, January 2011 and February 2013 after property curbs were initiated.



The reason for a falling market as a result is that property transactions tend to be a monetary multiplier with the newly created credits associated with home loans. These transactions also accelerate monetary velocity with derivative purchases of furniture and appliances after closing. As such, property curbs will indeed have a liquidity tightening effect. Such decline in liquidity offers a good explanation to the ensuing disappointing market return historically.



In another scenario, if interest rates were to be kept stable to soothe the volatility during deleveraging, then the yuan will have to bear the brunt of economic adjustment.



Recently, the onshore yuan has been depreciating rapidly towards 7, well pass the range of 6.8-6.83 - where the last phase of yuan appreciation started in 2010. With a half-open capital account, rapidly plunging real rates with rising inflation pressure is a sure-fire recipe for currency depreciation. Should this scenario intensify, it would not be a surprise to see tighter control on cross-border capital flows to slow down capital outflows induced by rapid yuan depreciation.



If capital control is used to slowdown onshore yuan depreciation, then on- and off-shore exchange rates will divert, obliging market interventions such as cutting offshore yuan supply and raising offshore yuan borrowing costs. And that higher interest rate offshore will eventually roil other asset prices, such as equities. Eventually something will have to bend in this high-wire act.



Also, falling foreign exchange (FX) reserves portend further depreciation pressure and capital outflows. Globally, countries that have been hoarding US dollars are seeing their FX reserves decline fast, except Japan. Saudi Arabia's reserve is hurt by falling oil prices. And the petrodollar, a form of liquidity that used to support the US treasury market and provides offshore US dollar supply, is rapidly drying up. Meanwhile, China's reserve has declined from $4 trillion to close to $3 trillion, together with a depreciating yuan.



The recent onshore yuan depreciation has not caused market panic, contrary to last August and early this year. The consensus is that the onshore yuan is reflecting weakening economic fundamentals, and thus other asset prices will not have to adjust - similar to the effect of a weakening yen on the Japanese economy and market. This view is not entirely correct. The difference is that Japan holds large investment positions overseas, whereas China's asset allocation is still largely yuan denominated. A depreciating yen will make Japan's overseas investment more valuable, which is not necessarily the case for the onshore yuan to China.



FX reserve accumulation has been the most important channel of money creation in China. Onshore yuan depreciation will not affect stocks as long as the People's Bank of China is seen not intervening with the precious FX reserve. A discharge of FX reserve will mean tightening macro liquidity. The goal of exchange-rate reform is to let the market determine where onshore yuan should trade, and it appears this objective is being achieved fast. The build-up in speculative long positions in the US dollar also indicates further dollar strength, and thus a weaker onshore yuan.



Falling FX reserve, tighter money and falling property prices are more commonly observed when the economy is struck in stagflation, while in reflation, the economy tends to see falling interest rates and rising stock and commodity prices. Thus, 2017 is destined to be a year of epic changes and volatility.



The author is managing director and chief China strategist at BOCOM International, the investment banking and brokerage arm of Bank of Communications Co in Hong Kong. bizopinion@globaltimes.com.cn