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Keynotes

• On 12 January 2010, China unexpectedly announced to hike the required reserve ratio (RRR) for big banks by 50 basis points to 16%
• We believe the exit strategy has taken place since July 2009
• The recent action of the central bank can help to manage inflation expectations
• Exports turn positive after a consecutive drop of 14 months.
• The China government has implemented more policies on curbing property speculation
• We are positive towards this recent hike in RRR and we continue to like China based on its strong estimated earnings growth and attractive valuation.

China unexpectedly announced to raise the proportion of deposits that big banks must set aside as reserves. The required reserve ratio (RRR) for big banks will increase by 50 basis points starting from 18 January 2010. Hence, the reserve ratio for big banks will increase from its existing level of 15.5% to 16%. However, for those small banks mainly deal with rural cooperatives to aid agricultural output, RRR will remain unchanged at 13.5%. A 50-basis-point-hike in reserves is expected to remove about 300 billion yuan of liquidity from China’s economy. This article is going to analyse the rationale behind this rate hike and the outlook in the near term.

China’s New Loan Hit a Record High in 2009

After the rebound in economic growth in 3Q09, the government has changed its policy direction. Although the central government will continue to maintain an accommodative monetary policy, the content is slightly different from what it was in the beginning of 2009. The government said that the monetary policy will continue to enhance the relevance and flexibility of the policy. We believe that the central government will implement its policy in an appropriate and responsive way. That is, we are expecting that the government will continue to tighten bank lending on both property and equity speculation and to quell inflation expectations. At the same time, we are quite confident that the government will continue to support projects relevant to infrastructure, social security in order to promote economic development. In fact, according to the data from the new loans, China has apparently begun to tighten its credit requirements.

Chart 2 shows the breakdown in new loan growth in China last year. In the first half of 2009, there was a total of about 7.4 trillion yuan of new loans, which consists of short-term loans, medium- to long-term loans, trust loans and other loans. Among this 7.4 trillion yuan of new loans, about 47.4% were categorised as short-term loans and other loans. However, the new loan contributor changed significantly in the second half of 2009. From July to November, there was only about 1.8 trillion yuan of new loans. Interestingly, the figure shows that short-term loans only accounted for 19% of the new loans while other loans accounted for -60% of the new loans made in the second half of the year. We can see that the Chinese government has started out an exit strategy by limiting the short-term loans. We suspect that these short-term loans and other loans are the major source of credit used for speculation in the property and equity markets.

According to the China International Capital Corporation, about half of the long-term loans made in the first half of 2009 were used for infrastructure projects. Infrastructure projects generally need to refinance for 2 to 3 years after the project has launched. Hence, it is expected that new loans in the next few years will remains at a high level. As of end November, about 6.3 trillion yuan of long-term loans were made and it accounted for 68% of the total new loan. We believe that new loans will continue to maintain at a high level, and the total new loans in 2010 will be around 8 trillion yuan.

A Move to Curb Inflation Expectations

In the latest Central Economic Work Conference, the government announced that one of the key working areas of policy makers is to manage inflation expectations. In fact, we find that the growth in money supply may have given us some implications towards the inflation outlook. Chart 3 shows that the growth in M2 is leading the consumer price index (CPI) by a few months. CPI raised 0.6% in November 2009, an increase for the first time since February 2009. With a strong growth in money supply, we believe that inflation will pick up very soon in the first quarter of 2010. As inflation is becoming a more serious issue for China, the government’s recent measure of the RRR hike will hopefully manage inflation expectations. Besides, the hike will also help to remove excess liquidity in the banking system.

However, we are not expecting the People’s Bank of China (PBoC) to hike benchmark interest rate unless the RRR will be back to the pre-crisis level of 17.5%. Hence, we are expecting another 1.5% increase in RRR this year.

Exports Finally Turn Arounde

China’s exports climbed 17.7% year-on-year in December 2009. It was the first increase in 14 months. Imports also increased 55.9% year-on-year in December (Chart 4). In 2009, China’s exports fell 16% and imports dropped 11.2% as compared to 2008. Trade surplus dropped to $196.1 billion. However, although China recorded a drop in exports in 2009, China still overtook Germany as the world’s biggest exporter of goods in 2009. A comeback in exports shows that a global recovery is gaining momentum. As such, we expect the Chinese government will be more aggressive in implementing its exit strategy.

Limit Credit to Counter Property Speculation

Before the unexpected hike in RRR this January, the Chinese government announced a couple of policies to control an overheating property market. For example, after the annual economic meeting in late 2009, the government ensured to maintain the continuity and stability of its economic policy. At the same time, they will continue to promote the protection of a large-scale construction of homes. The government will also enhance market supervision as a way to stabilise the market and prevent the house prices in some cities to move up too fast. In addition, the government targets to increase supply of ordinary housing, support self-use homes and curb speculation.

Besides the policy direction mentioned above, the government has set a down payment requirement for land purchases for at least 50% of the total price. The government did not have any requirement on the down payment in the past. Hence, we believe it may affect developer’s plans in purchasing new land as the need of cash increases. In addition, the government also imposes a sales tax on homes sold within 5 years of their purchase, increasing the time period from 2 years.

We expect the Chinese government will continue be more active in managing the speculative activities. We believe the government will take more measures to curb property prices in order to lower the risk of building up an asset bubble.

Our Forecasts

Two days before the exports data announced, China PBoC 3-month note issue reference yield increased unexpectedly. The 3-month note yield increased about 4 basis points from 1.328% to 1.3684%. Two days after the exports data announced, China PBoC 1-year bills yield raised about 8 basis points from 1.7605% to 1.8434%. Based on better-than-expected exports figures, market has already anticipated an increase in RRR.

We expect that the reference yield of both the 3-month note and 1-year bills will continue to increase in the first half of 2010. In fact, the yield of the 3-month note and 1-year bills in September 2008 is at 3.3978% and 4.0583% respectively. Yields are likely to come back to their pre-crisis levels. Good economic data with an increase in reference yields may be a signal of a further potential increase in the RRR.

According to the official China Securities Journal released in early January this year, Chinese banks lent about 100 billion yuan each day and there is a total of 600 billion yuan of new loans made in the first week of January 2010. It is expected the new loans will be more than 1 trillion yuan in January alone.

We think an increase in benchmark rate is not likely to happen in the first quarter of 2010. However, the RRR, the reference note and bills yields will continue to increase to remove excessive liquidity in the market.

Conclusion

In terms of valuation, Chinese companies listed in Hong Kong are trading at an attractive level. Any short-term correction might provide an excellent chance for investor to invest. It will come as no surprise to see government’s more tightening actions in 2010. Investors should bear in mind that the government will executive its exit strategy only when the economy is in a good shape. As a result, we are positive towards this recent hike in RRR and we continue to like China based on its strong estimated earnings growth and attractive valuation.

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