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					CN: Interest rates must rise — March 8, 2013


China: Interest rates must rise
DBS Group Research                                                                                                                                                                                                         8 March 2013

                              We have long argued there is no room for complacency in monetary management
                              in spite of moderating economic growth for six straight quarters. Despite the
                              economic downtrend, asset prices have managed to defy gravity. The macroeconomic
                              tightening program was somewhat successful in restraining investment-led growth
                              and the ascent of asset prices. However, economic forces are back at work again
                              ramping up inflation risks over the medium-term. This is in spite of the lower
                              annual CPI target of 3.5% set at the National People’s Congress. A holistic approach
                              to the formulation of monetary policy will be beneficial to the long run betterment
                              of the economy. As such, interest rates must rise in China.
                              It is now clear that administrative controls on property transactions cannot hold
                              the floodgates shut forever. On March 1st, ahead of the National People’s Congress,
                              authorities had imposed a 20% capital gains tax for existing home sales in order
                              to cool down the market. The ever-growing demand for property precipitated
                              the surge of property prices, which in turn contributed to elevated inflation
                              If “real interest rates” are calculated alternatively as nominal deposit rates minus
                              inflation of property prices (that is, deflating by housing prices instead of the
                              CPI), it is easy to explain the solid demand for properties – real rates have been
                              in negative territory for many years. From this perspective, monetary policy
                              should be tighter than otherwise. As shown in Chart 1, the differences between
                              conventional and alternative measures of real deposit rates are significant, which
                              may lead to the central bank to draw different conclusions on how monetary
                              policy should be conducted. At present, the PBoC bias leans towards tightening.
                              Wages are escalating nationwide (Chart 2). Although wage data are not published
                              frequently, they influence inflation expectations just the same. In fact, expectations
                              of future wage hikes amongst manufacturers remain high in spite of moderating
                              growth. The persistent surge of wages is not only a reflection of declining

                              Chart 1: Differences between conventional and alternative measures of real deposit
                              % pa, 3mma                                                                                                                                                                                                    % pa, 3mma
                                 15                                                                                                                                                                                                                           5
                                 10                                                                                                                                                                                                                           4
                                  0                                                                                                                                                                                                                           1
                                 -5                                                                                                                                                                                                                           0
                                -10                                                                                                                                                                                                                           -1
                                -20                                                                                                                                                                                                                           -4
                                -25                                                                                                                                                                                                                           -5

                                                         Alternative measure of real deposit rates                                                                                    Real deposit rates (RHS)

Chris Leung • (852) 3668 5694 •

CN: Interest rates must rise — March 8, 2013

                           Chart 2: Wages have quadrupled in the past decade

                           Index: 2000=100
                                                             Average annual wage

                             2000   2001     2002   2003   2004   2005   2006   2007   2008   2009   2010   2011

Authorities should not    surplus young labor but is also a direct result of the state’s regulatory mandate
anchor monetary policy    to improve labor’s income prospects over the medium term.
to the CPI alone
                          Price reforms in necessities such as water/electricity/fuel will also exert upward
                          pressure on end consumer prices. For instance, costs of medicine, private school
                          tuition and transportation have been escalating in the past few years. Although
                          they form a small portion of the CPI, the sum of these items makes up a large
                          portion of household expenditure. In fact, the CPI merely describes the present
                          situation of food and rental inflation. Although food prices are thankfully
                          retreating from their peaks, inflation expectations on food remain elevated as
                          the economic recovery gains traction. As for the residence component of the
                          CPI, it is largely out of line with reality, because the rental market in China is
                          actually quite small. Should authorities solely anchor monetary policy to the
                          recent downtrend of the CPI, and cut interest rate and reserve requirement
                          ratio in response, both the scale and magnitude of the asset bubble would
                          rocket to unprecedented levels.
                          When the push for urbanization kicks-in nationwide later this year, the pressure
                          on prices will increase. China’s urbanization rate is expected to rise to 53.4% by
                          the end of this year from 52.6% last year. China is likely to roll out a layout this
                          year to guide the country’s urbanization drive in an orderly and healthy manner.
                          According to a draft plan on social development presented by the National
                          Development and Reform Commission to the National People’s Congress, accelerated
                          construction spending was listed as one of the six major missions for 2013. The
                          plan, involving around 20 city groups, aims to attract investment of CNY 40
                          trillion (US$6.42 trillion).

                          Two approaches
                          Against this backdrop, interest rates in China must rise over the medium term.
                          Of course, China can lift rates the conventional way – by altering benchmark
                          rates. But the same outcome could be achieved via interest rate liberalization,
                          which the central bank had restarted last year by raising the ceiling on the
                          benchmark deposit rate and lowering the floor on the benchmark lending rate
Money supply growth is    simultaneously. The experimentation last year confirmed that: (1) all banks raised
not easy to control       deposit rates for fear of losing deposits to each other; (2) lending rates did not
                          go down because of higher risk premium amid more stringent risk controls.
                          Finally, quantitative easing programs conducted by other central banks around
                          the world increases the risk of capital inflows and a resultant boost in money

CN: Interest rates must rise — March 8, 2013

                           supply. Funds outstanding for foreign exchange at financial institutions increased
                           by CNY 683.7 billion in January, even more than the whole of last year’s 494.6
                           billion, threatening to drive up inflationary risks. More importantly, this is the
                           part of money supply that the PBoC has little control over. Even the domestic
                           portion of money supply is increasingly difficult to be controlled as the growth
                           of total social financing [1] has quickened over the past year. Financial instruments
                           such as trust loans and corporate bond financing saw much faster rates of
                           growth than conventional RMB bank loans. That explains the constant worry
PBoC has flagged           over the proliferations of China’s wealth management products. Real rates are
inflation risks in its     too low forcing liquidity everywhere for yields regardless of risks.
monetary policy report
                           It is heartening to see that authorities have accounted for these inflation forces
                           when formulating monetary policy. First, the PBoC neither cut the reserve requirement
                           ratio nor interest rates even at a time when the CPI was decelerating. Second,
                           the PBoC has increasingly used repo operations to control liquidity in the banking
                           system. Third, the government has reiterated that administrative controls on
                           the property market will remain. Authorities know well the considerable impact
                           on property prices if the reins are cut loose. That explains why administrative
                           controls on the property market will likely remain in place in spite of completion
                           of leadership transition. Finally, PBoC has acknowledged in its 4Q12 Monetary
                           Policy Report that “due to different factors, demand and supply curves will
                           probably become steeper, making prices more sensitive to demand expansion”,
                           reflecting its vigilance against inflation over the longer run.
                           The medium-term outlook on China’s interest rate trend is clear. The central
                           bank can either choose to raise benchmark rates or achieve the same result by
                           deepening interest rate liberalization. Pursuing the latter route would be more
                           consistent with China’s desires to internationalize the renminbi, which implies
                           fewer controls over the capital account and the need for interest rates to be
                           market determined.

                           [1] Total social financing is equal to the sum of RMB loans, foreign exchange
                           loans, entrusted loans, trust loans, bankers’ acceptances, corporate Bonds, non-
                           financial corporate stocks, insurance benefits, insurance company’s investment
                           property etc.

CN: Interest rates must rise — March 8, 2013

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