PBoC Tightening Unlikely To Be Aggressive

by Win Thin

News service is quoting China government economist saying that the central bank is seen as behind the curve and may need to hike twice more this year.  He added that an alternative would be hikes in commercial bank reserve requirements, and sees CPI inflation rising to around 4% in October from 3.6% in September.  Our base case remains that of a modest tightening cycle over the next year, perhaps 25 bp per quarter for 100-125 bp of total hikes.  While we acknowledge that the situation remains very fluid (after all, China officials were downplaying tightening risks just this month), we do not think there is a case for aggressive PBOC tightening given current conditions.

We go back to the most recent tightening cycle for clues on monetary policy.  PBOC started hiking in April 06 with a 27 bp hike in the 1-year lending rate from 5.58%.  That month, CPI rose 1.2% y/y while GDP grew 11.5% y/y in Q2 08.  Pace of tightening started off modest, as next hikes were 27 bp in August 06 and then 27 bp in March 07, which took the rate to 6.39%.  That’s when the PBOC started to get much more aggressive, and followed up with 18 bp in May 07, 27 bp in July 07, 18 bp in August 07, 27 bp in September 07, and then the final 18 bp hike in December 2007 that took the 1-year lending rate to 7.47% for a total of 189 bp of that cycle.  The 1-year deposit rate was hiked from 2.25% to 4.14% over that same period but we note that it remained negative in real terms throughout most of that tightening cycle.

We note that the commercial bank reserve requirement was hiked several times starting in July 06 that took it from 7.5% up to 14.5% in December 2007.  After that, even though the lending rate was kept steady, the PBOC continue to hike the reserve requirement in H1 08 to a peak of 17.5% in June 08.  During that more aggressive period of tightening in 2007, China’s GDP was still accelerating and inflation was rising sharply from 3.4% y/y in May 07 to a peak of 8.7% y/y in February 08.  Retail sales were accelerating to over 20% y/y around then too.  Loan growth was close to 20% y/y, while Fixed Asset Investment (FAI) is only growing around 20-25% y/y.

Let’s compare that with current economic conditions.  Q3 10 GDP growth slowed to 9.6% y/y from 10.3% y/y in Q2 and was the second straight quarter of deceleration.  CPI inflation accelerated to 3.6% in September from 1.5% at the start of 2010, while retail sales have accelerated to 18.8% y/y in September from a more modest 15-16% pace at the start of 2010.  Loan growth is below 20% y/y, while Fixed Asset Investment (FAI) was growing around 30% y/y.  So overall, the mixed economic backdrop suggests that further tightening will be seen, but not an aggressive path. 

Currency gains are likely to be used to limit imported price pressures.  During the PBOC hikes in 2006-2007, CNY appreciation was quite significant and encompassed gains vs. USD of 1.5% in Q2 07, 1.3% in Q3 07, 2.8% in Q4 07, and the peak of 4.2% in Q1 08.  In other words, the PBOC used a combination of rate hikes, reserve requirement hikes, and currency strength to help battle rising price pressures.  That’s what we see happening in 2011 too.  Markets have actually pared back CNY appreciation expectations after the surprise PBOC rate hike, with 12-month NDFs now pricing in 3.2% gain vs. close to 4% at the start of the week.  If anything, our study of the previous tightening cycle suggests that the PBOC will allow greater CNY appreciation than what the market is pricing in currently.  Investors should think about establishing long CNY positions at these cheaper levels. 

Win Thin | Global Head Of Emerging Markets Strategy