The inflation question

From "China: PBoC hiked RRR by 50bp to manage liquidity and overall monetary conditions" by Wang Qian, Grace Ng and Jiang Lu, J.P. Morgan economists, November 10

The latest RRR [reserve requirement ratio] hike, following the 25 basis point  hike on key policy rates last month, is a further move by the central bank to withdraw excess liquidity in managing overall monetary conditions. Indeed, an RRR hike remains a cheaper and more high-profile move than open market operations for liquidity management, with one-year People’s Bank of China bill yield at 2.3437% vs 1.62% interest on required reserve. With regard to the overall macro policy, as China’s near term growth concern fades, policymakers are turning their focus on the inflation front. In addition, Chinese policymakers are concerned about the impact of the Fed’s QE2 on global liquidity, and the impact on China especially through capital inflows, given the significant gain in FX reserves in 3Q. Looking ahead, we expect the central bank to continue to focus on liquidity management, through intensified sterilization, and further credit controls in the coming months, with at least one more 50 basis point RRR hike in the coming months. We look for two 25 basis point interest rate hikes through the course of 2011. On the currency front, CNY appreciation, albeit gradual, will continue to be part of China’s monetary condition mix. Though our forecast for CNY/USD remains unchanged at 6.6 for year-end and 6.3 by end-2011, the pace of appreciation could accelerate somewhat if imported inflation pressure rises further.

From "China A-share monitor: ‘Inflated’ expectations" by Shirley Zhao and Michael Kurtz, Macquarie analysts, November 15

China’s 2006-2008 inflationary episode provides useful data to assess potential stock implications. In general, inflation the last time around "helped" A-share companies’ gross profit margins in the cycle’s early stage (i.e. 2006-2007), while hampering margins later on (2008). But different sectors exhibited different characteristics:

Inflation victims: oil and gas, utilities, steel, non-ferrous and auto. These sectors suffered from margin squeezes during the entire inflation cycle, due to overcapacity (steel, non-ferrous), government-controlled selling price (oil, utilities), or incomplete pass-through of costs (autos).

Early-stage beneficiaries/later-stage victims: capital goods, consumer staples, info tech, transportation, chemicals and telecom. These sectors benefited from increasing demand during inflation’s early stage while costs lagged due to old inventory, contract prices, and/or belated salary increases.

"Pure" beneficiaries: Only coal, for which gross margin rose and fell with CPI, favored by self-owned coal mines and a flexible pricing mechanism.

Steady margin gains regardless of inflation: consumer discretionary, health care and real estate all benefited from the dominant trends of urbanization and social safety-net reform. Within discretionary, home appliance gross margins increased from 1.3% in 2006 to 5.3% in 2009.