Source: Bloomberg

There is strong empirical evidence to support the hypothesis that China allowed real interest rates to rise as it maintained the RMB peg with a rising dollar during 2013-2015, and then guided real interest rates down after it abandoned the peg. Falling real interest rates correspond to higher PPI growth and profits growth. That is the foundation of China’s stock market recovery. Whether “governance” comes in as a factor is not falsifiable.

Real interest rates (the difference between the 3-year bond yield and the average of PPI and CPI) reached nearly 6% in 2015, as you can see above. This was a primary cause of the stock market crash of July 2015.

The rise in real interest rates was the result of China’s misguided efforts to maintain the RMB-US dollar exchange rate. When China finally allowed the RMB to depreciate in August 2015 in response to the stock market crash, the market responded badly. Chinese companies had taken on vast amounts of dollar debt anticipating a continued strong RMB, and were forced to pay it down and substitute RMB debt during the past year. That is the source of the $1 trillion reduction of Chinese official reserves, which reflected a corresponding reduction in foreign-currency liabilities of the corporate sector.

Source: Bloomberg

Once real interest rates declined and inflation rose, industrial profits recovered, and the stock market along with it.

Source: Bloomberg

Chinese companies were able to reduce leverage, prompting a strong rally in financial stocks.

Source: Bloomberg

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