China hikes the interest rates

China hikes the interest rates

China raises benchmark deposit and lending interest rates of all duration by 25bp. We have long anticipated this badly- needed rate hike. Although it is far from enough given China's inflation level, Chinese policymakers are probably going to pay more attention to structural issues for some time.

Interest rate hikes will do some good

We have been calling for an interest rate hike, and the People's Bank of China finally did it after a three-month pause. The main reason for this timing is that June CPI (due on July 15th) is expected to jump much higher (SG 6.4% yoy; Consensus 6.2%). Like always, the central bank wants to anchor inflation expectations.

We think the dampening impact of this rate hike on the real economy will be limited, as market interest rates are already well above benchmark rates. On the positive side, it may slowdown the deceleration in deposit growth and helps redirect money back to the formal banking system, instead of the fast expanding unregulated shadow banking system. In the first half of 2011, all sorts of financial innovation in China raised CNY8.5 trn capital, more than double of total bank lending. The funding difficulties of small- and medium- sized enterprises (SMEs) are also partly due to PBoC's over-reliance on quantitative tightening. (Cf. Economic News, “Let the PBoC do its job”.)

H2 Policy: macro prudency with micro adjustments

PBoC's hike, in our view, also sends a signal that it intends to maintain prudent macro policy, which was also flagged by its Q2 monetary policy meeting minutes. So don't hold your breath for a 360-degree turn in China's monetary policy. At the same time, given the obvious softening in China's growth momentum, micro-level adjustments will take place to address specific difficulties of certain sectors in the economy. Local government debt, SMEs' funding, affordable housing, and private consumption will be the focuses.

So to summarize, we expect the policy theme for H2 is macro prudency with micro adjustments. This interest rate hike will probably be the only big monetary policy move for some time, as policymakers shift more attention to structural issues. Based on the development so far, our central scenario is to see no more interest rate hike, but there is a risk to see one more if inflation surprises and growth turns out to be more robust than thought. Today's decision to hike the same amount to lending and deposit rates also seems to suggest that the central bank doesn't want to affect the profitability of commercial banks who are severely affected by local government debt.