A matter of confidence

Two years on from the beginning of the financial crisis, the global economy is tottering. Higher-than-expected US jobless claims in early October weighed on international markets, while traders openly mocked Ireland’s Finance Minister Brian Lenihan in a bungled conference call that was intended to calm worries about that country’s economy: Reports said one trader made chimpanzee sounds while another called out, "short Ireland!"
 
The calls in China are going in the other direction. On October 8, ratings agency Moody’s (MCO.NYSE) said that it had placed Chinese sovereign debt on review for a possible upgrade from A1, the highest level of "upper-medium grade" debt.
 
"The government’s very high financial strength and ample fiscal headroom help mitigate underlying contingent liabilities in the financial system from posing systemic threats," Tom Byrne, a Moody’s senior vice president and author of the agency’s annual report on China, said in a statement.
 
In a recent note, Lu Ting, an economist with Bank of America Merrill Lynch (BoAML; BAC.NYSE) in Hong Kong,  said an upgrade was "long overdue":  Even after recent downgrades, some troubled European economies have higher sovereign bond ratings than China. He suggested the delay reflected doubts about China’s growth potential, the health of its banking system and exaggeration of the government’s fiscal burden.
 
Coming back from the week-long National Day holiday, the Moody’s announcement – and announcements that it was upgrading or considering upgrades for entities as diverse as China Development Bank, Bank of Communications (BoCom; 601328.SH, 3328.SH) China Mobile (CHL.NYSE, 0941.HK) and CNOOC (CEO.NYSE, 0883.HK), helped to push the Shanghai Composite Index above the 2,700-point level for the first time since May.
 
On October 12, the market officially entered bull territory, according to a common definition of the term, rising 20% from its low on July 5. By the time the People’s Bank of China (PBoC) raised interest rates on October 19, it had breached 3,000 points. The overall economic mood has been buoyant.
 
Still, for all the relatively good news, the market was still down by more than 9% between January and mid-October. The SCI is no longer the world’s worst-performing index this year, it is true, but that is hardly a ringing endorsement: It has clawed its way up to be the region’s second-worst performer, ahead of Japan’s Nikkei.
 
Bubble risk
 
There are wider concerns, as well. The PBoC’s rate hike, its first since December 2007, was a response to growing fears of asset bubbles, and followed the raising of reserve requirements for six major banks by 0.5 percentage points – to 17.5% – earlier in the month. Despite Beijing’s efforts to control liquidity and reduce property prices, the average cost of housing in 70 major Chinese cities rose 0.5% in September from August, while property sales values rose 56%, Inflationary expectations have also been building; the country’s consumer price index reached 3.6% in September, up from 3.5% in August and continuing a trend fueled by rising commodity and other input costs.
 
"Clearly deposit rates are hiked more for longer-term deposits, suggesting the government wishes to retain liquidity in banks and curb inflation expectations," said BoAML’s Lu. The PBoC raised the rate for one-year deposits from 2.25% to 2.5%, while the one-year lending rate rose 0.25 percentage points to 5.56%.
 
Higher inflation has created extremely low real interest rates: In August, the one-year lending rate discounted by the producer price index was 0.99%, though this was an improvement over the negative real interest rates seen between February and June this year.
 
Such low real rates have discouraged saving and encouraged investors to place their money into assets like property, with predictable results. Unlike last year, however, when loose monetary policy including massive bank lending helped the SCI to rise nearly 80%, the equity market has until recently resisted the effects of low rates and high liquidity. That has begun to change as Beijing has implemented cooling measures to lower property prices nationally.
 
"Even while house prices have stabilized, the Shanghai Composite Index has risen by almost 16% in the last month," said Stephen Green, head of research for Greater China at Standard Chartered, adding that the rate hike was a "first step" that would begin a process of moving rates higher.
 
While the initial 25 basis-point hike will have at most a limited effect on the market, the prospect of further rises could dampen investor sentiment. If nothing else, it is clear that Beijing considers inflation and asset bubbles to be real threats to the continued health of the Chinese economy: Green noted that interest rate rises require State Council approval.
 
At the same time, the rise of the equity markets is not just a matter of investors looking for a place to park their money. Driven by a fast-growing domestic economy, many companies are quite simply doing well. Moody’s cited BoCom’s strong earnings potential as justification for its upgrade, while it said China Mobile’s debt rating was constrained mainly by China’s sovereign rating.
 
Consumer goods companies received a shot in the arm with news that major cities posted strong year-on-year sales growth over the October holiday: In just the first three days of the break, retail sales in Beijing rose 39.6% year-on-year.
 
September trade data also showed  evidence of strong domestic domand, with imports growing at a seasonally adjusted 29.2% year-on-year. China Southern Airlines (600029.SH, 1055.HK), meanwhile, said rapid growth in passenger and cargo volumes would push earnings up 1,400% for the first three quarters of the year.
 
Further tightening measures, including even higher interest rates, could hold corporate profits down as borrowers are forced to pay more and bank margins shrink. However, there is likely to be little profit in betting on a downside for China in the coming months. The choice to raise rates will help to guard against asset price bubbles, but it also reflects an underlying faith in the resilience of China’s economy, said Wang Tao, head of China economic research at UBS (UBS.NYSE).
 
"We think the market should see the rate hike as a speed bump on the road, as it also reflects the government’s confidence in the strength of economic activity."