Rate hike signals stronger inflationary pressure

Updated: 2011-02-15 06:53

(HK Edition)

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Rate hike signals stronger inflationary pressure

China's latest interest rate hike came as no surprise, but persistent expectations of further tightening moves has caused selling pressure on both the mainland and Hong Kong equity markets after the Spring Festival holidays.

The People's Bank of China (PBoC) announced last week another hike of 25 basis points (bps) each in the one-year lending and deposit rates, taking them up to 6.06 percent and 3 percent from 5.81 percent and 2.75 percent, respectively. Meanwhile, the rates on all other deposits and loans were also raised to varying degrees. It was the third rate hike in the past five months and came in line with our expectations. The demand deposit rate was also raised from 0.36 percent to 0.4 percent after it had been kept unchanged in the first two hikes, while the long-term deposit rates were generally raised more than the short-term ones.

The long-term lending rate was also raised by a further 20 bps this time after two hikes last year, which indicates the authorities are further tightening the property market. Although the 20 bps hike in the long-term lending rate does not seem excessive, the accumulated effect of the tightening policies as well as its symbolic effect will have a marked negative impact on the property market. The lending rate hike indicates the government's firm decision to rein in resurgent property prices, now a hot public topic in the country. We expect the central government to firmly maintain its tough stance over the property market while more cities will launch more detailed monitoring policies on property throughout the year.

Continuous rises in required reserve ratio (RRR) and a further interest rate hike have pinpointed a relatively tight monetary policy in the first half of 2011, a normal reaction to soaring inflationary pressure. The monetary authority has repeatedly indicated the use of the interest rate adjustment, "punitive" (or "differential") RRR hike as well as the yuan exchange-rate policy to control liquidity and inflationary pressure. The PBoC is expected to implement a few more RRR and interest rate hikes this year. RRR is expected to climb above 20 percent while the one-year lending and deposit rates are likely to be raised to 6.81 percent and 3.75 percent by end-2011. The consecutive rate hikes reflects the will of the authorities to push forward the transition of the economic development model due to the fact that it exerts more pressure to become more flexible in terms of the yuan exchange rate going forward.

Meanwhile, based on rough calculations, the interest margin for commercial banks will see some decline after the current rate hike. We also notice two major characteristics of this rate hike. First, like the previous two hikes in 2010, asymmetrical features can be observed: the deposit rate rise exceeds that of the lending rate in general, with a more marked uptrend in the long end of the deposit rate curve. Second, the PBoC raised the demand deposit rate by 4 bps for the first time, which will negatively affect the banks' interest margins.

The rate hike is relatively negative to those banks that adjusted their retail mortgage rates across the board on Jan 1, but relatively beneficial to those that adjusted their mortgage rates gradually in the past year. Our estimates show that the current hike's effect on banks' interest margins and net profits should be neutral. On average, the listed banks should see the net interest margins (NIM) up 1bp and 2011 net profits up approximately 0.2 percent.

Generally speaking, the move should provide less spur to banks' NIM and net profits, compared to the Dec 26, 2010 hike. Going forward, the PBoC is expected to exert further efforts in combating inflation and seeking a balance between inflationary control, economic growth and the benefits to banks. The future rate hikes will likely continue to have a neutral influence on banks' NIM. Given the PBoC's policy of continuous monetary tightening and lack of strong momentum in economic fundamentals, the banking sector's valuation should not see a large increment in the near term.

Moreover, the rate hike may indicate an intensification of the inflationary pressure in coming months. Although the consumer price index saw some mitigation in growth in December 2010 due to a zero tail-raising effect and the central government price control measures in the past few weeks, the inflation figure is expected to have rebounded in January and will probably hit a new high after February, owing to the Chinese Spring Festival holidays and widespread droughts in northern China.

Peter Pak is executive director of BOCI Research Limited. The opinions expressed here are entirely his own and do not represent BOCI or any other affiliated companies within the group. Nothing in this article constitutes an investment recommendation.

(HK Edition 02/15/2011 page2)