MNI China Money Week: PBOC Hikes Not Policy Tightening Signal

--PBOC Seen Not Following Fed To Avoid Damaging Economy

--PBOC May Keep Long Rates High, Short Rates Low With Sufficient Liquidity

     BEIJING (MNI) - The increases in money market instrument interest rates by

the People's Bank of China on Thursday won't have a substantial impact on the

domestic bond market as the hikes do not signal a start of a monetary policy

tightening cycle, traders and analysts say. 

     On Thursday morning, the PBOC hiked its seven-day and 28-day reverse repo

rates by five basis points each to 2.50% and 2.80%, respectively. It also

increased its one-year Medium-term Lending Facilities (MLF) rate by the same

amount to 3.25%, after the Federal Reserve announced on Wednesday that it had

increased its fed funds rate target by 25 basis points to 1.25% to 1.5%, as

expected.

     However, the PBOC did not change its benchmark interest rates. The

benchmark deposit rate remained unchanged at 1.50%, while the benchmark loan

rate was stable at 4.35%.

     --RATE HIKE NO SURPRISE

     The PBOC's rate hikes came as no surprise to the bond market, with the

yield on the most-actively traded 10-year China Government Bond (CGB) falling

1.5 basis points to 3.910% and the yield on the 10-year China Development Bank

(CDB) bond dropping one basis point to 4.8350% on Thursday after the PBOC

announcement. Traders said the move had already been priced in.

     "The fact that PBOC did not roll over its MLF loans [due to mature this

month] all at once as in the past several months triggered concern among traders

about a [PBOC] rate hike. So the previous boost [to the bond market] caused by

the China Development Bank's move to replace long-term bonds with short-term

issues has to some extent been counterbalanced," a Beijing-based trader at an

asset management company said. "I estimate that if there had been no rate hike,

then the CDB bonds would have fallen 5-8 basis points more [during the past

week]."

     An easily overlooked interest-rate swap (IRS) product indicated that a

larger rate hike had been priced in. 

     "The fixed-deposit-repo-based IRS saw its bid and offer prices go up to

2.96% and 3.00% [respectively] last Thursday, with the seven-day fixed repo at

2.77% at that time. This showed the market was pricing in a 20 basis point

interest rate hike at that time," the trader said. "Even though there is very

little trading volume in this product, the deposit-repo-based IRS still shows

something as the deposit repo is the benchmark rate for the interbank market."

     --NO PBOC TIGHTENING CYCLE

     A more fundamental reason that bond market did not react badly to the rate

hike is that very few investors believe it was a signal of a monetary policy

tightening and also believe the PBOC has been trying its best to calm the

market.

     "The PBOC has made it clear that the size of the rate hike is 'slight',

showing that the PBOC is paying very close attention to market expectations and

is trying to avoid generating market fears about a potential tightening of

monetary policy," analysts at Guotai Junan Securities said. "The intention to

take care of bond market [sentiment] is obvious."

     Analysts at China International Capital Corp. (CICC) noted that the PBOC

took remedial steps when market interest rates rose earlier in the fourth

quarter -- including initiating a 63-day reverse repo, increasing treasury

deposit auction amounts, and increasing communications with the market -- all of

which indicates the PBOC does not want to see interest rates rise too much.

     Traders said the PBOC has firm control of interbank market liquidity

conditions.

     "Recently, short-term money is relatively loose, but long-term money

remains very tight," a central China-based interbank trader at a commercial bank

told MNI. "By injecting more long-term funds via its one-year MLF and reducing

short-term liquidity injections through reverse repos, the PBOC is helping

financial institutions to borrow longer-term money, showing the  precision the

PBOC has in controlling overall liquidity conditions."

     --PBOC WON'T FOLLOW FED

     Sun Guofeng, head of the PBOC finance research institution, said last week

that emerging economies, including China, need to begin to normalize their

monetary policies to coordinate with developed countries, triggering market

worries about tighter PBOC monetary policy.

     But traders said it is unlikely the PBOC will simply follow Fed rate hikes

considering the current downward pressure on Chinese growth.

     "Fed Chair Yellen said the Fed will probably gradually hike its interest

rate over the next several years, not just next year," another Beijing-based

bond trader at an asset management company told MNI. "So if the PBOC simply

follows the Fed rate hikes and the Fed tightens its monetary policy for years,

that will mean the PBOC will tighten its monetary policy as well for years. But

is that really possible?" 

     "Our economy is durable, but not so much that it can hold up under a

constant tightening of monetary policy," the trader continued. "I believe the

PBOC will show monetary policy independence."

     --NEW POLICY MIX

     A more likely policy mix, analysts say, is relatively high longer-term

interest rates combined with sufficient liquidity and relatively stable interest

rates in the shorter-term portion of the market.

     "The PBOC needs to follow the Fed interest rate hike to maintain a

relatively wide yield gap [between Chinese and U.S. bond yields] and to

stabilize the [yuan] exchange rate to provide a suitable environment for

deleveraging," Ming Ming, the analyst at CITIC Securities said in a report on

Thursday. "The five basis point rate hike this time shows the PBOC is likely to

hike its open market rates in small increments more frequently in the future so

as not to spook the market." 

     "In an environment in which interest rates are likely to remain high, it is

necessary for the PBOC to provide enough liquidity to keep short-term interest

rate stable," Ming said. "In detail, the PBOC will continue to provide liquidity

via targeted required reserve ratio cuts, open market operations and standing

lending facility [loans] to provide sufficient liquidity, so as to increase its

support for inclusive finance [for small businesses and farmers] to adjust the

structure of the credit market and to ensure steady economic growth."

     Analysts also reminded investors that it is possible the PBOC will raise

its benchmark interest rates next year.

     "If the Consumer Price Index rises to around 3% next year, the benchmark

deposit rate is 1.5%, which is quite low. Raising the benchmark deposit rate can

also help banks bring in new deposits and so alleviate their shortage of deposit

funds," Ming said. 

     "But the benchmark loan rate is unlikely to rise because the PBOC wants to

support the real economy. So an asymmetrical rate hike could happen, with an

increase in the benchmark deposit rate while keeping the benchmark loan rate

unchanged," he said. 

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

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