ASIAN WEEKLY ECONOMIC INSIGHTS

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1 ASIAN WEEKLY ECONOMIC INSIGHTS Global Economic Research May 25, 2007 Anthony Chan Asian Sovereign Strategist Global Economic Research This document reflects the views of AllianceBernstein as of the dates cited. No representation or warranty is made concerning the accuracy of cited data. Nor is there any guarantee that any projection, forecast or opinion will be realized. The views expressed may change at any time. References to stocks, securities or investments should not be considered recommendations to buy or sell. The value of investments, and the income from them, can fall as well as rise and you may not get back the original amount invested. Past performance is not a guide to future performance. The value of overseas securities will be subject to exchange-rate fluctuations. Under no circumstances should this information be construed as investment advice. Nor should it be construed as sales or marketing material for any financial instrument, product or service sponsored or provided by AllianceBernstein or its affiliates or agents.

2 Asian Economic Perspectives China s Three-Pronged Tightening Grabs Headlines but Delivers Little The latest attempt by the People s Bank of China (PBOC) to rein in liquidity, announced last week, is three-pronged, involving higher interest rates, tighter bank reserve requirements and a wider trading band for the renminbi (RMB). Such a multifaceted approach by the PBOC is unprecedented. While the strategy is headline-grabbing, however, the measures, considered individually, amount to little more in our view than another baby steps policy response. The outcome even for those fully accustomed to China s gradualist approach to economic tightening is disappointing. We sense, though, that policymakers are beginning to understand the true nature of the factors that drive China s short-term capital inflows and we suspect that, as a result, the PBOC s deposit-rate hikes will be more aggressive in future. Share Markets Close Higher To recap, the latest measures include: 1) hiking the one-year lending rate by 18 basis points to 6.57% and the one-year deposit rate by 27 basis points to 3.06% 2) raising commercial banks reserve requirement ratio (RRR) by another 50 basis points to 11.5%, and 3) widening the RMB daily trading band against the US dollar to 0.5% from 0.3%. Faced with a red-hot local stock market fuelled by abundant liquidity in the economy, policymakers obviously hoped the approach would send a strong signal to local equity players that Beijing is serious about preventing a bursting of the stock market bubble. The measures were too mild, however, and achieved little: China s A-share markets in Shanghai and Shenzhen closed higher on three consecutive days this week. As we have argued on previous occasions, China s current monetary measures might, at best, prevent an explosive buildup of excessive liquidity in the system but will do little to reduce the abundant liquidity already there. It is easy to suspect, too, that the RMB band widening was timed ahead of this week s Sino-US Strategic Economic Dialogue meetings where it might support arguments that the RMB exchange rate has become more flexible. If that was indeed a consideration, our view is that the move will backfire, and that the marginal 0.2% increase in the trading band will only reinforce US Congress view that China has yet to make any meaningful progress towards a flexible currency regime. Bank Deposits Migrate To Equities The market had hoped for a 54 basis point increase in both the lending and deposit rates. In the event, the PBOC raised the benchmark one-year lending rate by a mere 18 basis points, well below the 27 basis point increment of each of the last four rate rises. This highlights the political sensitivity around the lending rate and the constraints on the central bank s policy independence. Obviously, the larger 27 basis point increase in the one-year bank deposit rate was intended to squeeze commercial banks interest rate margins in the hope of slowing credit expansion. We doubt though that such a marginal change will have much impact. Following the hike, the real interest rate on the oneyear term deposit has merely increased to around zero percent from negative territory (Display 1). To have an economic impact, nominal deposit rates would need to move up a few hundred basis points. This would obviously be too big a margin squeeze for the banking system to absorb. As it is, the PBOC faces the difficult task of preventing a leakage of funds from bank deposits to the stock market. Households earn 3% to 5% interest a year on term-deposits ranging from one to five years, whereas the local A-share market has risen by more than 200% cumulatively since the beginning of ASIAN WEEKLY ECONOMIC INSIGHTS 2 AllianceBernstein Fixed Income

3 Hopes Rise for More Sterilization Increases in the reserve requirement ratio for commercial banks are now occurring monthly. We have little fresh comment to make with regard to the latest move, but we would like to stress one important point. China s accumulation of forex reserves is set to continue at US$40 billion (around RMB300 billion) a month during the coming year. Full absorption of this incremental inflow would require a 200 basis point hike in the RRR every month. In reality, of course, the central bank s regular sterilization bond programme will help to mop up some of the fresh liquidity. As noted earlier, however, rather than reduce current levels these measures will at best neutralize the increase in liquidity. This situation may ease. In China, commercial banks reserve assets fall into two categories: required reserves (set by the central bank s RRR) and excess reserves. The latter consists of excess cash deposited overnight with the PBOC. Excess reserves have been falling for two years as commercial banks have shifted their cash holdings to required reserves to meet the cumulative 400 basis point rise in RRR. We estimate that, consequently, commercial banks excess reserves ratio has declined from around 6% 7% (of total deposits) in 2005 to about 3.5% (Display 2). This has led some economists to argue that the marginal effect of future RRR hikes in curbing credit creation will be greater as the excess reserves cushion will soon disappear. We agree with the logic of this analysis but do not expect a continuous decline in the excess reserves ratio, given the acceleration of the country s reserves accumulation from an average of around US$20 billion a month in 2006 to some US$40 billion a month this year. Sterilization should increase later in the year, though, once China s new investment corporation which has not been officially named, but which we refer to as the State Foreign Exchange Investment Corporation (SFXIC) becomes fully established. The transfer of US$200 billion US$300 billion of forex reserves from the State Administration of Foreign Exchange Reserves (SAFE) to SFXIC will be financed by the latter s issue of an equivalent value of RMB-denominated bonds to the local banking system (see Asian Weekly Economic Insights, China s New Investment Fund Unlikely to Rattle Markets for Now, March 30, 2007). RMB Outlook Remains Unchanged The widening of the RMB trading band to 0.5% from 0.3% lacked credibility because the old band had been little used. After the 2.1% one-off revaluation of RMB/US$ in July 2005, China widened its official daily currency trading band to 0.3%; it was also supposed to manage the exchange rate with reference to a trade-weighted currency basket. In reality, however, we estimate that the exchange rate has touched the lower band once only in January 2007 and that RMB/US$ spot has barely tracked movements of a theoretical currency basket (Displays 3 and 4). Had a currency basket been used, RMB/US$ would have depreciated since late 2006 and the current spot rate would be around 8.20 instead of The latest change may presage a further widening of the band later in the year. We think, however, that one China economist has summarized the situation very neatly: It is like widening a threelane highway to a five-lane one, but it doesn t really matter because China only drives in the middle lane. We believe the band widening is primarily a political gesture and we see no reason to change our expectation for an annualized 5% 6% appreciation of RMB/US$ this year. PBOC Has Scope for Higher Deposit Rates The performance of the A-share markets since the latest policy initiative should give China s policymakers food for thought. We believe that they are beginning to see that the real driver of shortterm capital inflows is the staggering performance of the country s asset markets initially property investments, now local stock markets. What is needed in order to deter speculative inflows is a truly flexible exchange rate which exposes the RMB to meaningful two-way risks. This is a tall order which the Chinese authorities are unlikely to accomplish. The implication for interest-rate policy is that the interest-rate differential has little bearing on short-term capital inflows. Beijing, therefore, ASIAN WEEKLY ECONOMIC INSIGHTS 3 AllianceBernstein Fixed Income

4 should worry less about the spectre of yen carry traders speculating on the RMB. This in turn means that the PBOC from now on may be more aggressive in hiking deposit rates. Anthony Chan Global Economic Research May 25, 2007 ASIAN WEEKLY ECONOMIC INSIGHTS 4 AllianceBernstein Fixed Income

5 Display 1: Real Deposit Rate Remains Low Real Interest Rates (%) YEAR LENDING RATE (1) 1-YEAR TERM DEPOSIT RATE (2) (3) (4) Source: CEIC Data and AllianceBernstein estimates Display 2: Excess Reserves Ratio Falls Excess Reserves Ratio (Percentage of Total Deposits) (%) Source: CEIC Data and AllianceBernstein estimates ASIAN WEEKLY ECONOMIC INSIGHTS 5 AllianceBernstein Fixed Income

6 Display 3: Former +/ 0.3% Curreny Trading Band Was Hardly Used Percent Difference Between Mid Rate and Daily High/Low Bid, RMB/US$ (%) OFFICIAL UPPER TRADING LIMIT +0.3% (0.1) (0.2) (0.3) (0.4) OFFICIAL LOWER TRADING LIMIT 0.3% Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Source: Bloomberg and AllianceBernstein estimates Display 4: And Spot Rate Has Not Tracked a Currency Basket RMB/US% Spot and Theortical Trade-Weighted Currency Basket (RMB/US$) SPOT RATE TRADE-WEIGHTED BASKET Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Source: Bloomberg, CEIC Data and AllianceBernstein estimates ASIAN WEEKLY ECONOMIC INSIGHTS 6 AllianceBernstein Fixed Income