Equity Market Commentary 27 December 2010 Summary On 25 December 2010, the People s Bank of China (PBoC) announced that it would be raising its benchmark interest rates by 25 bps, marking the second time that the central bank has hiked its rates since 2007. Looking ahead, we expect the Chinese authorities to use a mix of stronger currency policy, higher interest rate, higher reserve requirement and qualitative measures such as price controls to curb inflation pressures. As we had reiterated in our note on the first interest rate hike on 19th October, monetary tightening is not necessarily a bearish signal, based on China s historical experience. Tightening represents a show of China s confidence in the economy and an attempt to nip inflation in the bud. Whilst there may be some caution in the near-term, we believe that equity investors will still benefit from the current environment of moderate inflation in China, solid economic growth and some degree of monetary tightening over the medium term. We believe that China s inflation will taper off in the second half of 2011 or even earlier as food supplies increase, government intervenes to curb speculation and high base effects from the previous year. Once these signs appear, we believe earnings growth and valuation rerating should drive the markets higher.
China s Interest Rate Hike Announcement On 25 December 2010, the People s Bank of China (PBoC) announced that it would be raising its benchmark interest rates by 25 bps, marking the second time that the central bank has hiked its rates since 2007. The latest round of tightening now involves increasing both the one-year lending rate and deposit rate by 25 bps to 5.81 per cent and 2.75 per cent respectively. The demand deposit rate is kept unchanged, but deposit rates of other durations have been raised by more than 25bps. At the same time, the PBoC said it would fix the Chinese yuan at a rate of 6.6305 yuan per US dollar, about 0.1 per cent stronger, after the currency strengthened by 0.5 per cent over the past week. The move came after the central bank hiked the reserve requirement ratio six times this year, and increased the benchmark lending rate on 19 October. The aim is to rein in the accelerating price pressures in China, as CPI inflation hit 5.1 per cent year-on-year in November up from 2.9 per cent in June. The rate hike is necessary as negative real interest rates widened further. We had expected this move although the timing may have surprised most market participants, coming just before the year end. Looking ahead, we expect the Chinese authorities to use a mix of stronger currency policy, higher interest rate, higher reserve requirement and qualitative measures such as price controls to curb inflation pressures. We believe that CPI inflation is likely to peak in fourth quarter of 2010 or early first quarter of 2011. There are already signs that soaring food prices which contributed largely to the CPI increase are cooling off. Moreover, the pace of economic growth is also showing signs of moderation. Hence, we do not expect this round of interest rate hikes to be as draconian as in 2007 when GDP growth accelerated to over 13 per cent, CPI inflation touched 6.5 per cent and interest rates were hiked by a cumulative 135 bps. While there are still policy headwinds, we expect the PBoC to hike interest rate just twice more in first quarter of 2011 for a total of 50 bps and then put rates on hold in the next quarter to gauge the effectiveness of the tightening measures. At the same time, we expect the Chinese yuan to appreciate by 1-1.5 per cent per quarter against the US dollar in 2011. As we had reiterated in our note on the first interest rate hike on 19 October, monetary tightening is not necessarily a bearish signal, based on China s historical experience. Between 2006 and 2007, we saw seven interest rate hikes and 11 reserve ratio rate increases amid a strong wave of market
momentum. Tightening represents a show of China s confidence in the economy and an attempt to nip inflation in the bud. As a comparison, we note that India had already raised interest rates a number of times this year, but the market has still done well, with MSCI India up over 15 per cent in US dollar terms year to date 2010. Whilst there may be some caution in the near-term, we believe that equity investors will still benefit from the current environment of moderate inflation in China, solid economic growth and some degree of monetary tightening over the medium term. We believe that China s inflation will taper off in the second half of 2011 or even earlier as food supplies increase, government intervenes to curb speculation and high base effects from the previous year. Once these signs appear, we believe earnings growth and valuation rerating should drive the markets higher.