Some Thoughts On Potential PBOC Tightening Path
by Win Thin
We don’t want to get too caught up trying to guess the timing of the PBOC’s moves. Suffice to say that over the next year, it will continue to use a combination of policy rate hikes, reserve requirement hikes, and currency strength to help limit inflation pressures. We go back to the most recent tightening cycle for clues on future PBOC 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 06. 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 lending rate to 6.39%. That’s when inflation accelerated and so the PBOC started to get much more aggressive. It followed up with 18 bp hike in the lending rate 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 tightening in that cycle.
We note that the commercial bank reserve requirement was also hiked steadily in 50 bp increments 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 to peak at 12.6% y/y in Q2 07 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 around 20% y/y then, loan growth was close to 20% y/y, and Fixed Asset Investment (FAI) was growing almost 30% 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 4.4% in October from 1.5% at the start of 2010, while retail sales accelerated to 18.6% y/y in October from a more modest 15-16% pace at the start of 2010. Loan growth is edging towards 20% y/y, while FAI is slowing to around 25% y/y. So overall, the mixed economic backdrop and rising inflation suggests that further tightening will be seen, but not as aggressive a path as seen in 2006-2007.
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 2.3% gain vs. close to 4% before PBOC first hiked rates in October. 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.