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Hawks Coming to Roost

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Expiries for Sep24 NY cut 1000ET (Source DTCC)

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Two-Way 3Y Midcurve Puts

--Yuan May Trade At 6.5-6.6 Against U.S. Dollar By End-2017
--M2 May Rise As Much As 10% y/y In 2018
--GDP May Expand 6.5% In 2018
--Deleveraging May Ease Somewhat in 2018
--China Won't Necessarily Follow Fed Rate Hike
     BEIJING (MNI) - China is unlikely to ease controls over the value of its
currency or allow free capital outflows for at least a decade for fear of a
possible massive exodus of money, a senior official close to the People's Bank
of China told MNI.
     The central bank will also keep the value of the yuan in a strict range of
between 6.5 to 6.6 against the U.S. dollar until at least the end of this year
to support exports, the official said in an interview last week, declining to be
identified because of government policies against officials making unfiltered
comments. 
     Echoing PBOC Governor Zhou Xiaochuan, the source said the central bank
doesn't consider now to be the right time to relax its hold over the exchange
rate or to reform the rate-formulating mechanism, which takes into account FX
market demand, the rates on a basket of other major currencies and the so-called
counter-cyclical factor -- essentially an undisclosed "X" factor the central
bank uses to reduce price swings.
     "The yuan is still facing depreciation pressure, so the counter-cyclical
factor is needed when the yuan exchange rate sees sharp volatility driven by
irrational herd effects," the official said. "The priority for exchange-rate
policy this year is maintaining basic stability," he stressed.
     The currency has shown unexpected strength this year, gaining 4.52% against
the dollar versus a 7.02% drop last year. Despite some analysts predicting it
would weaken past the psychological mark of 7 against the U.S. dollar, it has
rebounded, strengthening to as high as 6.4350 this year. 
     Some prominent academics and former government officials in China have been
calling for the liberalization of the exchange rate, saying that now is the best
opportunity to push forward the yuan's "internationalization" through liberal
reforms of the currency. But the official MNI talked to dismissed the argument
for the liberalizing move.
     "The two elements in the liberalization process -- a completely
free-floating rate and convertibility of the capital account -- are not likely
to take place for at least 10 years," the official said. 
     A free-floating exchange rate could lead to a sharp depreciation of the
currency, and full convertibility could encourage an exodus of capital, such as
illicit incomes, which might lead to social and financial chaos, the source
said.
     "That is why the regulator has a tight grip on forex reserves, even as the
size seems enormous and excessive relative to what the country needs conducting
normal trade," the source said. 
     China's foreign-exchange reserves in October saw the ninth straight monthly
increase to $3.1092 trillion, the highest level in a year.  
     Having $3 trillion in forex reserves allows the bank to step in to stem any
surge in capital outflows, with the central bank preferring to maintain a
significant buffer, the source said.  
     On the government's deleveraging campaign in the financial sector,
financial tightening measures next year won't be as "harsh" as they were this
year for fear they could harm the economy, the official said. As a result, broad
monetary supply (M2) may accelerate next year, partly due to the lower base of
comparison this year, the official said. Year-on-year growth of the M2, which at
8.8% last month was the lowest ever, may rise well above 9% or even break 10% in
2018, the source said.
     The source contended that M2 is no longer a fair indication of the real
economy's demand for liquidity. The sharp drop seen this year has reflected a
reduction in deposits by non-banking institutions, a result of the deleveraging
campaign, he said.
     This is in line with the third-quarter PBOC Monetary Policy Report released
late Friday, in which the central bank explained that the relevancy and
predictability of M2 data had declined, while recent financial deleveraging had
further slowed M2 growth.
     According to the PBOC report, the weighted average lending rate picked up
to 5.76% in the third quarter, rising 9 basis points from the second quarter.
The interest rate on general loans picked up by 15bp to 5.86%, while the average
mortgage rate rose by 32bp to 5.01% in the third quarter, about where it was in
2015. 
     Market interest rates will remain at a high level for another couple of
months given the ongoing deleveraging, keeping bearish pressure on bonds, the
source noted. 
     The rise in China's market rates this year means China's interest rate has
already risen relative to the U.S., so even if the Federal Reserve hikes its
rate next year, China won't necessarily follow, the official said.
     However, the sources noted that China needs to further optimize its
interest rate formation mechanism. 
     "Unlike in the U.S., in China, our push for an interest rate corridor is
still in the trial stage," the source said. 
     Under the PBOC's trial system, the policy target is the pledged seven-day
interbank market rate of the deposit institutions as a benchmark, while the
rates on Standing Lending Facility (SLF) instruments and excessive deposit
reserves constitute the upper and lower bounds of the corridor, respectively.
The central bank will align the policy rate target with their desired levels via
open-market operations.
     Policymakers are still discussing which rates should be permanently
employed, the official said.
     Meantime, the source said, economic growth next year will likely slow to
6.5% given that weakness in investment has not been matched by gains in
consumption. China is also not ready to rebound from the so-called "L-shaped"
stalled growth, he said.
     China has ways to prop up growth via investment, but has to weigh deploying
that strategy against certain consequences, such as prolonging financial risks
and compromising its goal of cleaning up the environment, the source said. 
     The widening gap between the consumer price index and producer price index
means that downstream demand remains sluggish and that the service sector has
yet to catch up, he said. 
     The Chinese government, with strong control over virtually every aspect of
the country, is powerful enough to prevent a so-called Minsky moment, or a
sudden major collapse of asset values sparked by debt or capital flight risks
posed by local government borrowing and rising household debt, according to the
source.
     "China will never allow widespread bankruptcy that can lead to
instability," the official said. "That said, we still need to take heed of the
risks and address financial bubbles in case they damage the real economy," he
said.
--MNI Beijing Bureau; +86 (10) 8532 5998; email: marissa.wang@marketnews.com
--MNI Beijing Bureau; +86 10 8532 5998; email: william.bi@mni-news.com
--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com
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