Shangai Composite index: boom times

Tearing Down the Great Wall
Forex Fundamental Analysis Reports | Written by KBC Bank | May 29 07 16:27 GMT |
Tearing Down the Great Wall
Summary
China is constantly in the news as policy adjustments and regulation changes are quickly following one another. It is high time for a recap, but also an outlook.

The Chinese economy is booming, so policy makers have been trying to cool it down, but efforts have only recently emboldened with rate hikes and upped reserve requirements. Also the yuan trading band was widened. This will permit more yuan gains in the future we feel.

The central bank has also launched it reserve diversification scheme, aimed at upping returns. It will have side effects though such as diminished appetite for US Treasuries and more for higher risk instruments such as foreign equities.

The impact on the other currencies has been limited, but more yuan strength should ultimately help other Asian currencies strengthen versus the USD too. A crackdown on Chinese stocks would be of help to the risk averse yen.

The economy is booming, so hard that the word 'overheating' has been used frequently. Policy makers stepped in, at first hesitantly and with timid steps, with mostly administrative action, aimed at state-owned companies and banks through direct control or political suasion.

This didn't seem to help though and now the most stringent actions to date are undertaken, with the stress on financial market compliant actions (rather than administrative): firstly, upped reserves requirements and upped policy rates; Banks have to put aside 11.5 % cash reserves from June 5 onwards; secondly, the yuan trading band is widened from 0.3% to 0.5% daily change versus the USD. Thirdly, policy rates were hiked to 3.06 % for deposits and 6.57% for loans on one year. More will come. We will explain why.

First, we take a look at these 3 actions:

The bank reserve requirement
Now on average banks have a 13% reserve ratio, so this required norm at 11.5% is still a catching up of regulation, which should go on over the next months. This can go quite fast, as the previous required reserve adaptation (from 10.5% to 11.0%) was only some 3 weeks ago! It is really helping tightening monetary conditions at the very short end of the curve. 7 day repo rates have surged from 2.00% just a month ago to the 2.50% zone this week (and will probably go higher still in our view)

Policy rates
As mentioned above, policy rates were hiked. This was aimed at encouraging savings and discouraging stock market speculation.

In the process, the spread between the one - year deposit rate (now standing at 3.06%, + 27 bp) and the one year benchmark lending rate (6.57 %, + 18 bp) is diminished. This is probably also done to encourage banks to find other ways of non-interest income. More such steps will be need though to make an impression, as in April 2006 the PBOC had hiked lending rates by 27 bp, while keeping deposit rates unchanged. 2 more 27/18 bp rate hikes this year should do the trick of unwinding that, but more could be needed to really cool down the economy as just the neutral rate is judged to be at around 5%…it is however obvious that the rate hike cycle got off to a slow start in October 2004 with only a second rate hike in April 2006, but is speeding up now.

The spread between US and China also diminishes as a consequence. China had taken the view of keeping a large difference in yield between deposits in yuan and USD so as to fend of hot money coming into the country. This idea hasn't been working well, as hot money keeps pouring in betting on yuan appreciation.

The timing and combination of all the above mentioned actions (May 18), is targeted to impress, as a Chinese delegation just a few days later arrived in Washington to discuss the US-China Strategic Economic Dialogue. (May 22-23)

The yuan band
One can argue about the real impact of the band widening, as it seems a very limited event by its own merit. The band has been tested only once since it was installed almost 2 years ago (this 'test' was quite recent though on April 30). Also, the widening doesn't necessarily imply a direction, only a green light for more volatility. Also it regulates intra-day changes, not inter-day changes.

Still, it is clear to us that this action has a signal function to the US, telling us that more appreciation will be permitted. Without a change, this would have meant that the 0.3% band intraday would have been tested, forcing intervention. The government however doesn't want to be seen hindering flexibility, as that would give China bashers an extra argument. By widening, this risk is avoided. The yuan has appreciated some 6.2% since its 2.1% revaluation in July 2005. The past 12 months the speed of appreciation has already picked up. Now in May a new re-acceleration is being made in or view…



USD/CNY: ever faster appreciation?

China's growing reserves
It has been a well covered item over the past years that the booming economy in China has been responsible in supporting rising commodity prices. Sometimes the large growing foreign exchange reserves of Asian countries were also named as the reason for low yields on a global scale. Now the clout of China is growing beyond those markets, as also equity markets seem to come within range.

This question of 'impact on equities' coincides with talk of a new investment Fund big set up before the end of the year from Forex Reserves, up to an initial amount of 200 B $, to invest in higher rewarding instruments.

Now, the country's total forex reserves amount to an estimated 1.2 billion $ Traditionally these are invested in low risk, but also low yielding instruments. This mountain of reserves is high enough to give it safety, as it wanted a high insurance after the Asia crisis. This requirement has been met (most standards indicate the reserves are high enough, such as the import coverage ratio and short-term debt coverage ratio). We remember Vice PBOC Governor Zhou said it was enough when the reserves hit the 1 trillion $ mark back in 2005! Commentators even argue that 700 B $ would be enough for the insurance against financial risk purpose, freeing up a huge flow of money, if desired. Besides, the reserves are expected to grow some 250B $ annually over the next years. (for this year this 'target' will be overshot, probably reaching 400 B $…)



Forex reserves rise

The reserves management is run by the State Administration of Foreign Exchange (or SAFE) and is primarily invested in US treasuries and USD. Sterilisation has occurred through domestic bills and bonds on the liability side. There is a positive rate difference for now. But as rates go up in China to cool the economy, and the USD is weak, there is a huge risk for capital losses. US Treasury yield will not be high enough (even after the recent surge) to compensate potential forex losses. A search for increased return is thus logical.

The Fund
In fact, pre-announcing this China Fund, the first big deal was the 3 billion $ stake in the Blackstone Group private equity group at its IPO. This is a clean and very sharp break from the past's cautiousness as this is a high risk vehicle. The signal function as a first step is very obvious.

China can follow the example of Singapore (with funds such as the Singapore Government Investment Corporation, or Temasek, which after starting out with a few billion now holds 100 B$). The 'China Fund', as we will call it, will be run by Lou Jiwei, former vice Finance Minister. It may be a completely new vehicle, but it could still be an adaptation of the Central Huijin Fund, which holds state owned bank shares, or why not both (like in Singapore).

The Chinese also elaborate other ways to help net outflows out of China (and the yuan) through for instance the less strict Qualified Domestic Institutional Investor scheme, which however hasn't lived up to expectations so far. Earlier this month financial institutions were allowed to buy overseas stocks and related structured products. A lot of joint ventures have been erected with this target. This week, US Secretary Paulson has announced that China agreed to up the quotas significantly (from 10B to 30 B$ ) that Qualified Investors can invest abroad and that restrictions on the type of investments that can be made will be lifted further. This should really help private outflows too. In the same vein, last year 10 financial institutions received the right to manage the first overseas investments of the 50 B $ State pension Fund.

Both private-sector and (mostly) government-led initiatives for capital outflows may have an impact on global stock markets and help to alleviate appreciating pressure of the yuan, as it diminishes the balance of payments surplus.

Of course, the strength of the domestic equity market for now holds back interest for going abroad. That will come probably when the domestic equities stagnate, or worse, the bubble bursts. All the reason more for the PBOC not to invest in Chinese equities...

Equities
Talking about the devil: equity markets in China weren't that impressed on Monday after the announcement of the new set of measures. Record highs were even set! This means that for instance the Shanghai Composite Index rose an impressive 50% this year-so-far.



Shangai Composite index: boom times

But the policy tightening hasn't finished yet. More actions will be undertaken we feel. Underestimating Beijing's resolve is risky. More direct and hash steps can be taken.

In 1996 an article in the People's daily on 'excessive speculation' halted stock markets bullishness at that time, for instance. Regulators could slow down new stock fund launches, reserve requirements more upped, crackdown on loans used for stock investments, a ban for added investments in Chinese stocks by Chinese firms, etc.

Even a capital gains tax could be discussed, but presently still judged a too extreme tool (risk of crash), but even a hint of this could be enough to cool down equities over there…

Impact on US assets
Chinese FX reserves/ Fund diversification could impact US Treasuries hard if the allocation shift is more pronounced. About 1/3 of China's FX reserves is believed to be held in Treasuries, or over 420 B $. Slashing its existing holdings is probably no option therefore, but future holdings and thus new inflows could be seriously impacted by this choice to use higher return fund(s), especially at the longer maturities where China is believed to have been playing a significant role in the past.

The impact on the USD could be felt, but more limited. Indeed, the diversification of the Fund doesn't imply necessarily a change from the appr 70% USD allocation of the reserves, but just a change of asset classes. The choice of US company Blackstone demonstrates this. Still, it could have an impact, also if other countries would diversify, we think for example of the Middle East, where this week Kuwait has just given up its dollar peg for a basket of currencies.

A lot will obviously depend on the mandate of the Fund managers, but if one searches for higher return, one cannot deny that emerging countries or even the UK or Australia could offer very attractive alternatives to the US, so the risk is obviously for a lower dollar demand out of China.

Impact on the yen
In principle more yuan flexibility gains is a positive for the Asian currencies, including the yen. So far, this theory has lifted up for even one inch into the air. The yuan has strengthened over the past years, the yen has not versus the USD, much to the contrary. Market statistics cannot demonstrate a strong yuan-yen link.

Only brief spells of yen strength have been noted in times of risk aversion. A Chinese equity crash would be such a moment to watch out for.

True diversification of currencies would be yen positive as it is a well-known fact that the yen is underweight in most central bank holdings.

What next?
China will continue tightening monetary conditions to cool down the economy and the stock markets through a combination of rate hikes, upped reserve requirements, yuan appreciation and more administrative actions.

The yuan will be permitted to appreciate; we even feel a faster appreciation will be permitted. PBOC's Zhou this week said “the current reform pace is good”. Actually, the current yuan appreciation sped up in May and is higher than previously. A continuation of the current pace would imply a USD/CNY rate of 7.35 by end 2007. Moreover a trade-off between either risking trade barriers in the US or otherwise Chinese exporters seeing tighter margins due to the stronger yuan make the choice for the latter easy.

Forex reserves have risen enough to use as insurance policy in case of a new 'Asia crisis'. Now it is time to use it as a counterweight for the softening dollar as this would deplete the reserves. More return has to be found. The China Fund will be erected for that purpose and will invest in riskier assets and potentially also in other currencies than the USD. Combined with other actions, and due to the sheer potential size of such a fund, and its power of self-fulfilling prophecy, this could hurt USD/Asia.

We believe China's policy makers communicate through signals rather than big official policy change announcements. They have a plan and carry it out with precision. The timing of their combined actions is no coincidence either as a high level Chinese delegation visits Washington. All is well planned, just like the eventual outcome: rates will be hiked, reserves ratios upped, the yuan will be more flexible (read strengthen), financial sector developed and opened up. This will take time. Ultimately one must bear in mind that China wants a flexible currency, as it also wants to have an independent monetary policy.

The US will ask for speed in reform, including yuan appreciation. The Chinese will deliver in bits and pieces, trying not to go too fast and risk a market crash. The Chinese policy is consistent with its 3 guidelines: self-initiative, control and gradualism. These remain the guiding principles for the future. China has learnt the hard lesson of Japan, which adopted the Plaza Accord to let the yen appreciate fast against the dollar and then suffered heavy consequences for a long time.

With the Blackstone deal, China has entered a new era. The US has been happy with China as financier, buying and holding US Treasury paper. Now China wants to start buying US companies. Recall that a first such attempt was blocked off as CNOOC tried to buy US oil company Unocal for 18.5 B $ in 2005. In another takeover Lenovo did buy the PC arm of IBM for 1.5 B $. The US will have to live with China's new role and greater clout. US Secretary Paulson took a first step this week, as he said 'any investment in the US is welcome'. This invitation will be accepted.

KBC Bank & Insurance
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