China Sneezes and the US Catches a Cold

The US economy was progressing nicely until (roughly) the end of May. Real PCEs had been increasing for about a year, business investment was picking up, inventories were being restocked and the ISM manufacturing and non-manufacturing indexes were at strong levels.Then things turned from a progressing recovery to the appearance of a significant slowdown very quickly. One of the primary causes of this situation is developments in China -- specifically its interest rate policy as it developed through out the first part of the year.

In late 2009 and early 2010, the PBOC started to curb loan growth and increase interest rates:

China’s “real worry” is asset bubbles as capital flows into an economy awash with money and the nation emerges from the crisis into a “boom time,” central bank adviser Fan Gang said.

Moves by the central bank this year to curb liquidity were “timely and necessary,” Fan told a forum in Beijing today. “Although globally we’re still talking about the crisis, China and some developing countries now are facing another boom time.”

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The central bank has this year guided bill yields higher at auctions and ordered lenders to set aside a larger proportion of deposits as reserves. The banking regulator has specified a lower target for credit growth in 2010 and Premier Wen Jiabao has also pledged to counter excessive property-price increases.

This was followed by more lending restrictions in early February:

China’s government, seeking to stem property speculation, told banks to raise interest rates on third mortgages and demand bigger down payments for such loans, a person with knowledge of the matter said.

The China Banking Regulatory Commission warned lenders of the risks associated with “hot money” flowing into the property market, the person said, requesting anonymity because the agency hasn’t published the measures. Mortgage defaults in China are rising, the person said without giving figures.

However, PBOC's concerns didn't end there. In early March the bank stated rising commodity prices were a concern:

The People’s Bank of China is concerned about rising global commodity prices, central bank deputy governor Su Ning said today while attending a parliamentary meeting in Beijing.

This was followed several days later with the following statement:

The People’s Bank of China will keep a moderately loose monetary policy and “reasonably sufficient” liquidity, according to a statement from the central bank distributed before a press briefing in Beijing today.

The bank will promote steady monetary and loan growth while strictly controlling loans for new projects.

However, rising prices were a concern later in March:

Inflation expectations are rising in China, making it more difficult for Premier Wen Jiabao to meet his 3 percent full-year price target and adding to the case for an interest-rate increase.

The number of Chinese households expecting prices to gain in the next three months increased in a quarterly survey conducted in February, the central bank said on its Web site today, citing seasonally adjusted data. It didn’t give numbers.

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Chinese officials assessing when to end stimulus measures are balancing asset-bubble and inflation risks against concern that a “double dip” global slump remains possible. The world is counting on China to be an engine of growth as unemployment restrains the recovery in the U.S. and Europe grapples with the Greek debt crisis.

In mid-April, the PBOC stated they were concerned about real estate appreciation, and acted to curb real estate lending:

China’s surging property market is having its “last madness” and speculators can’t fight a government resolute about curbing asset-price inflation, central bank adviser Li Daokui said.

Investors “don’t realize how strong and resolute the political will is among top leaders to curb price gains,” Li said in an interview broadcast by the state-run Central Television yesterday.

Property prices surged 11.7 percent in March from a year earlier, the most since records began in 2005, government data showed this week. The State Council yesterday raised mortgage rates and down-payment ratios for second homes to cool the market and damp inflation expectations as the world’s third- biggest economy accelerates.

However, China's moves to curb real estate speculation may prove insufficient:

China’s third increase of bank reserve ratios this year left benchmark interest rates and the yuan’s peg to the dollar unchanged, risking the need for more concerted effort to contain property prices and inflation in coming months.

The requirement will increase 50 basis points effective May 10, the People’s Bank of China said on its Web site yesterday. The current level is 16.5 percent for the biggest banks and 14.5 percent for smaller ones.

The latest move adds to a government crackdown on property speculation after record price increases in March and came on a holiday weekend, with Chinese markets shut today. Within an hour of the central bank announcement, Finance Minister Xie Xuren said that officials remained committed to expansionary policies to cement the nation’s recovery.

China is still going to grow -- they're simply trying to do it at a slower pace.

Simply put, China's central bank is looking at a slowdown scenario. As a result, expect anyone that deals with China to slowdown. And that "anyone" category is literally every other country on the planet.

Here is a chart of the FXI and the SPY. Notice how the FXIs have led for the last two years.