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What China's Unexpected Rate Hike Tells About Chinese Equities?
November 3, 2010

The Chinese central bank caught the market by surprise by raising the benchmark interest rate by 25 basis points. This has been the country's first rate hike since December 2007. This article discusses the clues behind the rate hike and the implications to the Chinese equities.


Author : iFAST Research Team



Untitled Document
CHART 1
CHART 2

KEYPOINTS

  • The Chinese central bank hiked rate unexpectedly by 25 basis points
  • The decision to hike rate is in line with our earlier research view. We pointed out earlier that inflation and asset bubbles have been building up in China
  • The deposit rates were raised more than the lending rates on average. This shows that the policymakers intend to discourage the trend of deposits switching to current account as well as minimise the impact of aggressive rate hikes to the economy
  • We think the frequency and magnitude of subsequent rate hikes is going to be smaller than those in the previous rate-hike cycles. The policymakers will likely continue to use a mix of policy measures to absorb excess liquidity with more focus on the interest rate policy tools
  • We think a rate hike is a healthy signal to the equity market. As we’ve seen in the last rate hike cycle starting from 2004, the Chinese equities indeed made a decent bull run

Following the unexpected hike of the reserve requirement ratio (RRR) of six major Chinese banks on 11 October 2010, the Chinese central bank caught the market by another surprise by raising the benchmark interest rate by 25 basis points, effective on 20 October 2010. This has been the country’s first rate hike since December 2007 (Table 1).

Table 1: Chinese benchmark interest rates
Effective Date Target Rate
20 Oct 2010 1-year lending rate 5.56% (+25bps)
1-year deposit rate 2.50% (+25bps)
23 Dec 2008 1-year lending rate 5.31% (-27bps)
1-year deposit rate 2.25% (-27bps)
27 Nov 2008 1-year lending rate 5.58% (-108bps)
1-year deposit rate 2.52% (-108bps)
30 Oct 2008 1-year lending rate 6.66% (-27bps)
1-year deposit rate 3.60% (-27bps)
09 Oct 2008 1-year lending rate 6.93% (-27bps)
1-year deposit rate 3.87% (-27bps)
16 Sep 2008 1-year lending rate 7.20% (-27bps)
21 Dec 2007 1-year lending rate 7.47% (+18bps)
1-year deposit rate 4.14% (+27bps)
15 Sep 2007 1-year lending rate 7.29% (+27bps)
1-year deposit rate 3.87% (+27bps)
Source: PBOC and iFAST Compilations
* Monetary tightening actions are highlighted in BOLD.

Rate Hike in line with our Research View

Ironically, few days earlier, Zhou Xiaochuan, the governor of the People’s Bank of China (PBOC) hinted during the semi-annual meeting of the IMF and the World Bank that the central would keep the benchmark interest rate unchanged this year.

Nonetheless, the decision to hike rate is in line with our earlier research view. On 28 September 2010, we conducted a press conference in our Hong Kong office and addressed the concerns over inflation and asset bubbles in China. We also shared that we expect the PBOC may hike key interest rates over the next quarter.

Recent economic indicators have pointed to a reversal of the credit tightening condition which we saw in 1H10. For instance, both M2 growth and new loan have picked up for two straight months after bottoming in July. Notably, the pick-up has been faster than expected, suggesting the ample liquidity may induce further inflation pressure. Moreover, China’s CPI growth has stayed above the 3% target since July 2010. Since the benchmark deposit rate remains unchanged at 2.25% over the period, the real interest rate - the difference between the CPI growth and the 1-year deposit rate - has become more negative. Before the announcement of the CPI change in September, the negative real interest rate has lasted for seven months.

Therefore, given such economic backdrop, this rate hike is a better practice than other tightening tools including RRR, central bank bills and etc. We largely welcome this proactive move which pre-emptively curb inflationary expectation. Although a rate-hike cycle has kicked off, we think the frequency and magnitude of subsequent rate hikes is going to be smaller than those in the previous rate-hike cycles.

Given the RRR is now close to the all-time high, we think there is more room for a hike in the benchmark interest rate over the RRR. The PBOC will likely continue to use a mix of policy measures to absorb excess liquidity with more focus on the interest rate policy tools.

Clues behind the rate hike

Investors should also note that the magnitude of rate hikes vary across different maturities (Table 2).

For the deposit rates, the hike magnitude increase as maturities lengthen, from a 20 basis-point increase for the 3-month deposit to a 60 basis-point increase for the 5-yaer deposit. Notably, the rate of demand deposit remains unchanged. These suggest the PBOC intends to discourage the trend of deposits switching to current account as evidenced by a higher M1 growth over M2 growth (M1 includes currency in circulation and demand deposits, while M2 includes time-deposits on top of M1) (Chart 1). As displayed in Chart 1, if M1 grows more than M2, the CPI is likely to accelerate, inducing inflation pressures. Raising the long-term rates more than the short-term rates can encourage depositors to lock up their money in the long-term deposits, rather than moving them to the more liquid short-term deposits, thereby constraining the M1 growth.

On the other hand, the lending rates for a loan longer than a year were increased by 20 basis points while the lending rate for a 1-year loan was raised by 25 basis points. This shows that the PBOC attempts to minimise the impact of aggressive rate hikes to the economy by providing a cushion to the infrastructure and investment projects, which are more likely to involve in longer-term loans.

Overall, the deposit rates were raised more than the lending rates on average. Apparently it may hurt the net interest margin of banks with heavy long-term loans. However, we think such move is an early sign to reform China’s interest rate system for a more market-oriented regime. As depositors are rewarded for more interests and lenders are paid relatively less interest (due to a smaller increase in the leading rate), the economy can grow more efficiently.

Table 2: Adjustment of RMB Benchmark Deposit and Lending Rates, Effective on 20 October 2010
Before Adjustment (%) After Adjustment (%) Change (percentage point)
Deposit
Demand Deposit 0.36 0.36 No Change
3-month 1.71 1.91 0.20
6-month 1.98 2.20 0.22
1-year 2.25 2.50 0.25
2- year 2.79 3.25 0.46
3-year 3.33 3.85 0.52
5- year 3.60 4.20 0.60
Lending
6-month 4.86 5.10 0.24
1-year 5.31 5.56 0.25
1 to 3-year 5.40 5.60 0.20
3 to 5-year 5.76 5.96 0.20
Over 5-year 5.94 6.14 0.20
Source: PBOC and iFAST Compilations

Rate hike not necessarily bad for equities

While many commentaries assert that raising the interest rate is negative to the equity market, we think it is premature to draw such a conclusion without having analysed the relationship between the economic cycle and the interest rate cycle.

The impact of a rate hike is twofold. On one hand, it increases the interest burden of debt-heavy companies and discourages companies’ incentive to borrow, which may constraint the growth of loan and money supply. As the liquidity available in the market is limited, equity markets might be under pressure. On the other hand, a central banks are used to prevent the economy from overheating and foster a long-term economic growth by monetary tightening. Therefore, a rate hike indeed sends the market a healthy signal that the country’s economy is moving from a recovery to a sustainable growth phase. Furthermore, corporate profits generally move in sync with economic cycle, suggesting that profits are more likely to increase as the economy grows. Hence, if these earnings are reflected in share prices, equity markets should move up accordingly.

For those who think a rate hike is bad for equities, Chart 2 tells a different story. As we’ve seen in the last rate hike cycle starting from 2004, the Chinese equities indeed made a decent bull run. For the Chinese A-share markets, the first rate hike appeared to have hurt the equities initially, but the subsequent rate hikes had limited impact on both markets which eventually moved up quite significantly. While the PBOC hiked rates by 216 basis points over the same period, the Shanghai and Shenzhen A-share markets surged 280% and 307% respectively. Moreover, the Chinese H-share market represented by the Hang Seng China Enterprise index went up 249% in the last rate-hike cycle.

We think the effect of monetary tightening can be offset by a better growth outlook, thereby supporting the equity market. The better-than-expected 3Q10 GDP growth (+9.6% year-on-year) suggests the underlying growth momentum remains solid, and concerns over an economic slowdown is simply overdone. The risk profit of China’s economy has shifted from growth to rising inflation and asset price risks. We welcome the PBOC’s pre-emptive action in curbing these risks.

Moreover, as we pointed out earlier that the valuation for both A-share and H-share markets are close to the historical low and a discount to the historical mean, we think it represents a good entry point for long-term investors.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


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