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Analysis

China's 'Surprise' Rate Hike: Another Step Toward Normal

By Adam Wolfe

EXECUTIVE SUMMARY

The People’s Bank of China (PBoC) hiked the one-year deposit and lending rates by 25 basis points (bps) after the local markets closed on October 19. In contrast with consensus, RGE had been foreseeing a modest hike to the lending and deposit rates—a stance we reaffirmed in our most recent China Monthly—despite signals that the central bank was content to tighten credit conditions with quantitative measures. (On October 11, the PBoC initiated a temporary required reserve ratio [RRR] hike of 50 bps for the largest state-owned banks.) Following the interest rate hike, one-year deposits will pay 2.5% starting on October 20, when the benchmark one-year lending rate will increase to 5.56%. The 25-bp move seems to signal the end of the abacus-based 27-bp hikes we had come to expect from the PBoC.

Further out on the curve, the PBoC opted for an asymmetrical hike, which RGE had been arguing was a possibility. The central bank hiked the five-year lending rate by 20 bps and the equivalent deposit rate by 60 bps to 4.2%, which will result in a minor squeeze on net-interest margins for the banking sector as the five-year spread will fall to 176 bps from the current 216 bps. The large margin between lending and deposit rates encourages banks to push out as much credit as regulators will bear, which necessitates quantitative measures to control credit growth. The asymmetrical hike may be a step toward liberalizing the cap on deposit rates, which would help the PBoC manage monetary conditions through price signals.

Baby Step or Giant Leap?

  • Monetary and credit conditions in China remain loose for an economy growing at a near-10% pace. Today’s interest rate hike is a minor step toward normalization, not a signal that policy conditions will become restrictive in Q4 or 2011. As in the past, the PBoC leaned on moral suasion first, then tightened quantitative measures and only now is reaching into the tool box of more market-oriented central banks. Interest rates are a lagging indicator of monetary conditions in China, and this move can best be interpreted as a signal of policy continuity (”moderately loose”) going into 2011.
  • This is the first interest rate adjustment from the PBoC since December 2008, though quantitative measures and moral suasion have resulted in some tightening in 2010. RRRs were hiked three times in H1 2010 for a total increase of 150 bps, locking up roughly RMB950 billion (US$140 billion) of liquidity. The temporary RRR hike for the six largest banks in October will lock up another RMB150 billion or so through December. This latest move, however, was completely offset by the central bank’s net RMB181 billion injection into the interbank market through open-market operations in the same week, due to the expiration of a massive RMB295 billion of central bank bills.
  • China's banks look set to exceed the State Council’s RMB7.5 trillion target for new lending in 2010. Chinese banks' 2010 new lending reached RMB6.29 trillion in September, when banks lent RMB595 billion. To achieve the target, lending would have to slow to a pace of RMB400 billion per month. New loans have averaged RMB700 billion each month in 2010, putting the banks on course to overshoot the annual target by about RMB500 billion, as RGE forecast last year in “China Macro: 5Qs for 2010.”
  • Broad money supply (M2) and loan growth have exceeded nominal GDP growth since Q4 2008, though both are less supportive of growth than they were in 2009. Banks' capital raising this year has produced some acute and temporary liquidity shocks in the interbank market—as described in “Red Light, Green Light: China's Monetary Policy Gets Stuck in Traffic”—but the PBoC's stance remains supportive of growth. Today’s modest interest rate hike will alter the balance only slightly.

Figure 1: Back to Normal?

Source: PBoC, National Bureau of Statistics of China, RGE

  • Deposit rates remain sharply negative, and the modest hike will have little long-term effect on Chinese asset prices. The domestic stock market on October 20 may follow the lead of global markets and treat this as a “risk off” signal, but 25 bps will not have a significant effect on the erosion of wealth produced by Chinese savings accounts. The peak season for Chinese real estate started with a bang in September, with a 52% m/m jump in transactions, and there is little reason to believe this hike alone will reverse the trend.

Figure 2: Negative Deposit Rates Still Positive for Real Estate

Source: PBoC, National Bureau of Statistics of China, RGE

  • In the past, Chinese interest rates have had little effect on consumer prices, and today’s 25-bp hike will not change that equation. China’s inflation is currently the product of a food price shock, which should dissipate in the coming months as demand pressure from the holiday season lessens and the autumn harvest proves less disastrous than expected. Moreover, Chinese authorities may continue selling some of their food stocks in the domestic market, as they have for edible oils. Weak global demand has directed more Chinese production toward the domestic market. The resulting jump in the domestic supply of consumer goods and the discounting needed to move some of the goods—not to mention the aggressive expansion of capacity in some sectors like automobiles—will provide deflationary pressures next year to partially offset rising demand-side pressures from wage increases.
  • It is too early to tell if today’s interest rate hike is another band-aid measure aimed at temporarily affecting liquidity conditions or a serious attempt to improve China’s monetary policy management. RGE has long argued that China needs to begin a process of hiking interest rates to a more market-based level. As China internationalizes the renminbi, quantitative measures will prove less effective in curbing loan and money supply growth. If the latest move is the PBoC's first step in that direction, it would be a positive one for global rebalancing, China’s financial sector and the rise of the renminbi as a global reserve currency.
  • Along with most risky assets globally, 12-month non-deliverable forwards (NDF) for USD/CNY weakened after the rate hike was announced, from 6.4015 to 6.4448, due to a repricing of the market’s expectations for Chinese monetary tightening (analysts had pushed back consensus expectations  for interest rate hikes to Q2 2011). The NDF market now signals 3.1% USD/CNY appreciation in the next 12 months, down from 3.8% yesterday. The market seems to expect that interest rates will assume a greater share of the burden in curbing consumer price inflation than currency appreciation. For now, we hold to an expectation of modest USD/CNY appreciation of 3-4% on an annualized basis.
  • In RGE’s view, neither the modest interest rate hike nor USD/CNY appreciation will have much effect on domestic consumer prices. Very few items in the consumer basket are sourced from abroad, and interest rates only really affect consumer prices through asset markets, which themselves have only a tangential effect on domestic prices and consumer confidence. Instead, the PBoC is likely to inch forward by hiking both interest rates and allowing more CNY appreciation as China gradually liberalizes its capital account. This will be a long-term process with several stops and starts in response to short-term liquidity conditions. But if the soft landing RGE expects for China’s economy comes to fruition, capital account liberalization could occur sooner than expected, barring a serious “currency war” scenario.

Rachel Ziemba contributed to this report.

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