1. An inherent conflict appears to be developing in the growth-inflation dynamic. That China was, at best, only slowing modestly was a view consistently held throughout the region. A reacceleration of growth and the return of pricing power threaten the inflation picture over the medium term. These anomalies, coupled with the difficulties in gauging the effectiveness of administrative controls, suggest that the policy debate on the next step remains intense.
2. The focus on the RMB continues to be acute. Our strongest impressions: a realization is forming across the region that it is now a matter of when, not if, something happens.
3. China, not the US, remains the region's focus. We presented a US growth slowdown view and there were practically no client questions / reactions to this. In general, clients were quite relaxed about Asia's future.
4. There is very little – if any – policy coordination. Central bankers do not seem to expect to be briefed ahead of a move by China.
Our Take: Policy makers are preparing the route toward currency flexibility but have a strong aversion to revaluation. The State Administration of Foreign Exchange (SAFE) said on its official website that rumors of a RMB revaluation are "without basis" and that "It's unwise to adopt a one-off revaluation of the RMB." Instead, SAFE said that "It is China's independent decision to improve its forex mechanism and it must consider the social and economic ability to absorb the change." And in a statement on its website, the PBOC said that China should "further let the market mechanism play a fundamental role in allocating resources, and continue to appropriately adjust the money supply." The central bank also reiterated the policy of keeping the USD/RMB exchange rate "basically stable at a rational, balanced level."
Our main takeaways are as follows:
(a) SAFE's reference to the "decision to improve the FX mechanism" likely refers to developing financial markets in preparation for some flexibility. It is consistent with the government's commitment, stated during the G7 meeting, to "push ahead firmly and steadily to a market-based, flexible exchange rate."
(b) However, a large up-front revaluation is not favored. Our view is that changing the regime while allowing only modest or no changes to the level of the peg could be problematic, given the market's one-sided expectation of RMB appreciation. In this context, raising interest rates exacerbates the imbalance by attracting more inflows.
(c) While it does not say so explicitly, the PBOC's reference to "market mechanism" is suggestive of interest rate hikes going forward. This is in line with our view that we could see a 25bp hike in lending and deposit rates around October-November this year.
Deutsche Bank, after October's rate increase
Now what? Markets were fairly volatile overnight as they tried to comprehend the implications of the PBoC's decision to raise interest rates for the first time in nine years. The Bank raised its 1-yr deposit rate by 27bps to 2.25% and 1-yr benchmark lending rate by 27bps 5.58%. Slightly larger increases were implemented for longer maturities. In addition, upper limits on lending rates have been abolished and commercial banks are now allowed to set deposit rates below benchmark rates.
The market's initial reaction was to sell every growth sensitive asset, with the base metals and the commodity currencies singled out for particular attention – after all, this tightening increases the risk of a hard landing in China, with dire consequences for the global economy. Right?
Well, we think not, for the following reasons. China's economic policy goals have not changed one iota. As we have said before, China needs to absorb perhaps 20 million displaced and newly urbanized workers each year, and thus needs to maintain GDP growth of around 8-9%. Even after this rate hike, with inflation running at 5.2%, much of China's rate structure remains negative in real terms.
Policy could not be said to be tight on any definition. China has been relaxing some of the administrative controls implemented earlier this year. This hike, and those that will presumably follow over the next 12 months, will to a large extent substitute for these controls as they are relaxed further.
Certainly, we think that China's move to greater use of market-based mechanisms for controlling policy should be welcomed. Those hopeful that a similar tact may be taken in FX policy will be heartened, although we doubt that today's announcement should be taken as a sign that this will happen soon. For that reason we think that the implications for the Treasury markets are further watered down. In fact, we don't think that the implications for commodity markets are that clear-cut either – to the extent that China's moves to policy tools that impact more broadly across the economy, rather than tools that have targeted some resource-intensive sectors in the economy, demand for the base metals may be stronger rather than weaker. Still, in the near-term, the market will see this regime shift as adding to uncertainty, thus assets sensitive to increased risk aversion may under-perform for a while. This could give further downside impetus to oil prices over coming sessions.
Citibank: China's Policy Path
The resilience of China's economy strengthens the case for an interest rate hike and a currency revaluation but policy makers currently appear to be focused on improving market mechanisms for rates and the currency.
A key question for global investors is how long policy makers in Asia will wish to accumulate dollar reserves at a rapid pace at the current mix of asset prices and exchange rates. With China's economy still growing rapidly, market expectations have revived that China will allow its currency to appreciate soon (and slow reserve accumulation) in order to cap inflation. In our view, China's policy makers are likely to hike rates this year by 50 basis points. We also expect a modest widening of China's exchange rate band in early 2005. However, a large currency revaluation, while likely over the medium term, remains improbable next year.
Despite this year's administrative restrictions, China's overheated economy has shown only limited signs of moderation. Inflation-adjusted GDP still appears to be rising from a year ago at about a 9% pace. On a seasonally adjusted basis, our estimate of third-quarter activity accelerated to about 11% annualized from the April-June interval. Third-quarter domestic demand indicators also appear robust. Throughout most of 2004, monthly exports have risen by more than 30% from a year ago, while foreign direct investment has accelerated in recent months, leaving it up by more than 20% cumulatively from the year-ago period.
The economy's resilience has revived expectations of near-term currency appreciation, perhaps helping to accelerate the buildup of official foreign exchange reserves. At end-September, these reserves reached US$515bn, up by more than US$110bn from the end of 2003. In the latest three months, the increase totaled US$43bn, reflecting capital inflows in excess of trade and FDI patterns.
Against this background, the government is likely to adopt new tightening measures to slow investment and contain inflation. In the July-September period, fixed asset investment rose by more than 25% from a year ago. At more than 40% of GDP, the level of capital formation appears unsustainable. Annual headline consumer price (CPI) inflation dipped to 5.2% in September from 5.3% in August, and further moderation is likely. However, core inflation (which excludes food) is likely to rise over time, reflecting increased materials prices and strengthening consumer demand.
While the oil price spike will help to dampen investment, it also strengthens the case for battling inflation in China, which had experienced double-digit inflation as recently as 1995, and where inflation expectations may not be well anchored. One large economic model suggests that a sustained oil price increase of US$10 per barrel would trim GDP by 0.7% to 1.0% but raise prices by 0.5%. Given China's current policy stance, the risk is that the latter increase becomes embedded in private behavior (including wage and price setting).
For the moment, however, policy makers are focused more on improving market mechanisms than on interest rate or currency shifts. On the rate front, commercial banks this year have been allowed to charge lending rates from 90% to 170% of the base lending rates set by the central bank. Over time, the authorities appear inclined to control only the floor level for lending rates and the ceiling level for deposit rates, while leaving the determination of most other interest rates to the markets.
With regard to the yuan, China is officially committed to move toward a flexible exchange rate system, but there remains no timetable. Recently, one central bank official suggested that the exchange rate will still be regarded as stable if the currency appreciates or depreciates by 3%, while another argued that a float within a band ought not affect the job market or exports significantly. Proposed changes include: (1) improving the monitoring of the capital inflows; (2) realizing national treatment for both domestic and foreign-funded companies; and (3) regularizing currency management for both businesses and individuals. However, none of these changes will reduce the rising incentives for a revaluation if, as we expect, underlying inflation trends deteriorate over the medium term.
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