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World Out of BalanceJune 11 PBoC raised RRR hike by 100bps to control inflation and hot moneyOn June 7, 2008, PBoC announced that the reserve requirement ratio (RRR) will be raised by 100 bps to 17.5%. The 100 bps RRR hike will be implemented in two stages. The first 50 bps hike will be effective on June 15 to 17%, and the second 50 bps rate hike will be effective on June 25 to 17.5%. In my view, this shows PBoC is concerning the excessive liquidity in China, and still relies on RRR hike as the primary tool to control liquidity and money supply. Considering the timing of the RRR hike this time, I believe the May CPI, which is due tomorrow, is higher than market consensus and will be higher than 8.0%. In addition, M2 growth and forex reserve accumulation growth may have been accelerated in May, resulting authorities applying the tightening measure more frequently to control inflation and hot money inflow at acceptable level. While I still believe RRR hike in an ineffective policy tool to control inflation and hot money, because 100 RRR hike will only lock up RMB420 billion liquidity, indeed the authorities don’t have much other measures to choose. As international investors still expect RMB appreciation will accelerate in 2H08, hot money is continuously flowing into China. A higher interest rate would likely attract more hot money into the country. I see this RRR hike a strong signal that PBoC remains highly sensitive and committed to control inflation and hot money, but PBoC is unlikely to increase interest rate in the short-term. Going forward, I believe inflation pressure will sustain in 2008 and I expect PBoC will have at least two additional RRR hikes in 2H08 which will drive the RRR to 18.5%. May 06 Rebound but not recoveryAfter a very strong rebound of Hong Kong market recently, I believe the market needs to take a break, especially as the FED is not likely to continue US rate cut and inflation pressure remains. We have recently already seen some rotational buying into blue chip names. However, given this round of China buying is more driven by global funds, I believe large market cap names will continue to dominate and outperform.
Several negative signals remain intact for China shares, in my view:
1) Earnings are not likely to maintain high growth
2) US economy is not likely to get rid of slowdown until 3Q09 3) RMB revaluation is likely to decelerate 4) Commodity prices are likely to remain high 5) Inflation pressure will persist in the long-term The investment strategy is based on financials remaining the key holding structure for China investments in 2008, and thus I continue to overweight banking and insurance. I prefer telecoms, conglomerates and utilities as they are more defensive in a downturn market. I underweight industrials, chemicals, energy and properties. I still like the consumer story and agricultural products in China, and favor various names such as Mengniu Dairy and Yurun Food. April 11 Is China's A share market bottoming?The recent rebound of China’s A share market, is mainly driven by a rebound in US equity market, and a perceived relaxation in macroeconomic tightening. In my view, the peak has been reached and excesses are being unwound. I remain cautious on the A-shares market and believe any rebounds will be the opportunities to sell. The fact that earnings downgrades have not yet happened does not mean that they will not happen. Pre-tax profits of industrial enterprises grew 16.5% yoy in January and February 2008, substantially decreasing from 31% and 37% in 2006 and 2007 respectively, and this is expected to challenge the sustainability of the high industrial profits growth, without RMB appreciation and commodities price hike problems in China. A decline in upstream product prices is likely to trigger a major earnings downgrade of China stocks. In my view, this will be the key determining factor in the market’s performance, as the overall China market has been over valued, the slowdown of earnings growth is an alarming sign showing repricing of A-shares is necessary and unavoidable. Interestingly, the government allowed appreciation of RMB to 6.9923 versus USD yesterday, but is keeping the interest rates unchanged in 1Q, despite the high inflation pressure. While I still believe the government’s top priority is to reduce inflation pressure and avoid economic slow down, I expect RMB exchange rate will continue raising, and the central bank will raise interest rates by 27 bps in 2Q, given March CPI is likely to remain above 8%. Raising interest rates and appreciating the RMB exchange rate have the effect of raising the cost of capital, which in turn will drag down long-term economic growth, as well as reduce the importance of investment as a growth driver. I maintain a defensive and consumption-oriented bias in China’s A shares market, particularly when some energy stocks’ valuations are very stretched now. Indeed, an appreciating RMB would hurt energy, as their RMB-denominated price would decline if the US-dollar denominated price remains high. In contrast, an appreciating RMB would benefit those companies with large domestic sales (with prices not internationalized) but with a high forex-denominated cost structure. I overweight banking, industrials, consumer staples, and underweight energy, auto, materials and utilities. February 21 China's January CPI inflation continues the upside trendAs expected, consumer price index rose 7.1% y-o-y in January, up from December’s 6.5% and the previous 10-year record of 6.9% in November 2007. The pickup in food inflation (18.2% YoY in January 2008 vs. 16.7% in December 2007) was the key driver behind the rebound in overall CPI in January. Grain prices rose 5.7% YoY in January versus 5.5% in December. Meat price further acclerated to 41.2% in January versus 38.8% in December, price of aquatic products rebounded to 8.7% from 6.1% and vegetables price increased to 13.7% from 9.5%.
Non-food inflation remains stable at 1.2%. Residence inflation edged up to 6.1% YoY in January from 5.9% in December, led by housing rent (4.7% vs. 4.4%), utility costs (5.5% vs. 5.2%), and building materials (5.7% vs. 5.5%). However, inflation from other categories has been moderately keeping at similar level, and inflation from communications, healthcare, garment, and education have been offsetting the inflation from other non-food categories. In fact, non-food inflation has been heading up steadily in recent months, consistent with my expectations.
Overcapacity and deceleration of exports has limited the pass-through of higher raw material, energy, and labor costs to the consumer over the past years. However, I believe that competitive price cuts are reaching their limits amid razor-thin margins, and manufacturers are now starting to raise product prices. PPI (ex-factory price) data for January released earlier this week suggested a pickup in consumer goods pricing (4.6% vs. 3.7% in December) is in line with raw material inflation (8.5% vs. 7.7% in December).
Looking ahead, I see further upward pressure in consumer inflation, and I believe the February and March CPI is very likely to accelerate because:
1) The winter storm started in mid-January has caused disruption of airports, railways, and highways, many cities are experiencing vegetables and meat shortages
2) Shortage of electricity and raw materials may bring negative influence over industrial production, these factors have not been fully reflected in the January CPI 3) Accelerating M2 supply (18.9% in January) brings more pressure to inflation in the next couple of months 4) China’s PPI was up 6.1% y-y in January, with domestic oil prices still below market and temporary price freezing of key industrial products to rise in 2008, non-food inflation pressures remain high To China’s policy makers, inflation control remains the top priority and tightening credit controls should not be eased. Although the negative real interest rate and sufficient liquidity still offers policy makers the room to further raises the interest rate, export and industrial production may suffer from interest rate hike, therefore the more appropriate way is increasing RRR other than interest rate in the short-term. In my view, Chinese government should continue the tightened credit policy by further increasing the RRR by 50 bps and control M2 supply, and allow faster CNY appreciation against USD. January 08 The dilemma faced by Chinese policy makersFor the first time Chinese policy makers face dilemmas when using interest rates to control inflation in the past five years. Chinese policy makers either continue the interest rate hike to reduce inflation pressure but attract more speculative hot money flow in; or stop raising interest rate and face greater inflation pressures. China’s surging CPI seems to be serving as immediate catalysts to further raise interest rate, in order to maintain the real effective one-year deposit rate positive. Although we haven't seen the meat price inflation spreading into other sectors yet, I believe this will happen in the coming years and China's inflation pressure will persist. The inflation is driven by: 1) Food price inflation will continue. In my view, the food price inflation cannot be simply explained as pork price hike due to the blue-ear disease. Other food prices are rising too, including edible oils, dairy food, vegetables, and grain. The hidden reasons are farmers didn't intend to maintain and invest in agricultural plantation due to the rising pesticide, fertilizers, and animal feeds prices, as well as sluggish bulk agricultural products prices in previous years. Lack of investment in such sectors results food price hikes due to supply shortage. 2) Oil price and commodity shocks. The oil supply shortage is likely to maintain in 1H08 as OPEC doesn't plan to increase production quotas. China and India remain hungry for commodities in the next decade given their huge investment on infrastructure and industrials capacity expansion. 3) China's wage increase and particularly rural migrates wages increase. For decades we have seen China's total wage increase slow behind GDP growth. This is primarily because China's huge labors pool in rural areas and tough competition among Chinese companies to win export orders. However, urban incomes have been growing at a steady pace and rural migrant wages accelerate growing across the country. The dilemma that Chinese manufactures face is they either close their plants and quit the game, or increase wages to retain production workers but gaining more bargaining power from their overseas clients by increasing efficiency or switch to more value-added products production. Currently China's real effective one-year deposit rate remains negative, which in turn result capital flood to speculative investments in property and equity markets. The low interest rate also stimulates local government and companies to expand China's already high fixed assets investment. The question is: does China need to frequently raise interest rate in 2008 to calm down the CPI pressure and overheating? The answer is no. In order to answer this question we need to look at the US-China interest rate gap. While FED has cut the benchmark federal funds rate to 4.25%, and the market still expects FED to further cut the rate in order to overcome the fears of credit tightening and US economy recession. If China and FED continuously raise and cut the interest rates respectively, there will be a big gap between USD and RMB interest rate, speculative capital flow to China will be significantly increased due to following reasons: 1) The arbitrage opportunities between RMB lending rate and USD deposit rate 2) Expectation of overseas investors that RMB will accelerate appreciation against USD 3) Foreign investors will seek to buy China's assets due to the bearish outlook of US economy Historically the RRR hike was approved a blunt and ineffective tool for conducting monetary policy, given PBoC faces difficulties to conduct effective monetary policy with undervalued RMB. As a result, China needs to accelerate RMB appreciation against USD to rebalance its economy. China’s currency fundamentals remain compelling, including: 1) China enjoys record-high trade surpluses and complaints from its trading partners 2) The rapid export growth of Chinese manufacturers 3) The rapid accumulation of foreign exchange reserves and USD in particular 4) The real exchange rate depreciation Going forward, as Chinese policy makers try to tighten monetary policy, I believe that quantity-based measures such as RRR hikes and administrative controls over bank lending will feature more prominently than price-based measures, such as interest rate hikes in the authorities’ monetary policy management in 2008. I expect PBoC to continue interest rate hike only 1 or 2 times in 2008 but a 12% increase of RMB exchange rate against USD. December 10 RRR hike - beginning of a new round of tighteningOn November 8, 2007, PBoC increased the reserve requirement ratio (RRR) increased by 100 bps to 14.5% from 13.5%, effective from December 25, 2007. Although this is the tenth RRR rise in 2007, this is the first time that the PBoC has raised by 100 bps. Even more worrying, PBoC said the government would have more tightening measures on the annual economic conference in Beijing last week.
The RRR hike – although clearly seen as a part of the tightening measures, which started in July 2006 – is hardly likely to be effective to control China's liquidity boom and asset price bubble. I see it only as an indication of China's concern about overheating. Indeed, the past RRR hike has approved its market impact was limited.
Going forward, I expect PBoC to maintain the tightening stance, and reiterate my view that an interest rate hike would be a more effective tightening measure given the pressure from asset price bubble and inflation appear more challenging to China's central bank compared with over lending and fixed assets investment acceleration. December 06 Brace for further tighteningOn an annual economic conference in Beijing this week, China’s policymakers has shifted the monetary policy stance from “prudent” to “tightening”, in addition, the governors also shown concerns over inflation and fixed assets investment.
I believe this is the beginning of a series of significant tightening moves on the interest rate front. The decision of the policy move also means that a series of hiking interest rate and reserve requirement ratio in 2008 would likely to happen, but the GDP growth will remain at over 10% next year. The central bank may want to watch if fixed assets investment continue to rise at a fast pace in 1Q08, and whether CPI will decrease to acceptable level, before deciding on whether and when to raise the interest rate and reserve requirement ratio. In my view, while negative interest rates have clearly contributed to the overall loose monetary environment, hiking interest rates without simultaneously allowing more RMB appreciation would encourage more capital inflows into RMB assets, accelerating forex reserve accumulation and thus making domestic money supply expansion harder to curb. It also would contradict the goal of encouraging more consumption and discouraging saving. Fundamentally, China needs to address the root problem of excess liquidity by allowing the RMB to appreciate faster, and continuously hike the interest rate. Therefore, for the HK market and China listed shares in HK, the negative influence from this policy move is limited.
I believe China should stick to the course it started in July, 2005 to appreciate the RMB at a faster pace, as well as to try to channel the excess liquidity out of the domestic market through further liberalization of the capital account, given that the root cause of the fast pace of expansion in money supply, bank loans and fixed investment is the elevated external trade and overall balance of payments surpluses, and hence the rapid accumulation of forex reserves. Meanwhile, in addition to the stricter enforcement of the central bank's full-year loan growth target for individual commercial banks, there could be more targeted, area and sector specific administrative measures to address the overheating risks in the near term. November 30 Hong Kong equity market - uncertainty continuesDespite the recent weakness in global equity markets, the Hong Kong equity market has shown high volatility these days. While warrant accounted for over 30% of the total trading volume last week, I believe this signals investors remain cautious on HK market due to the uncertainty surrounding expected US slowdown and its impact on Hong Kong and mainland China. Market participants face four sources of uncertainty in the HK market. 1) The concerns over US subprime woes still continue and a recession of US economy becomes highly possible to happen in 2008; 2) High oil price is expected to maintain until 1Q08 and this will result earnings downward revisions; 3) Rapidly slowing growth of credit and consumers spending in US shows US economy is likely to have a soft landing next year; 4) Investors are concerning the market could divert its near to mid-term attention to potential further monetary tightening as China still faces inflation and liquidity pressure. The inflation and liquidity pressure is now clouded with more uncertainty than before and may thus pose a risk. Longer-term inflation expectations are drifting higher again, and I continue to think that commodities price pressures will rise to complete the circle of inflation. The flood of liquidity into HK market from mainland China is a result of the simulative policy allowing China's domestic financial institutions investing in overseas market and HK in particular. H-shares are still trading at a significant discount of A shares, and Chinese fund managers still think they can arbitrage from buying low of red-chip and blue-chips. Given higher uncertainties from the market, I suggest investors to focus on value plays to achieve the best risk and reward tradeoff in a potentially high volatility trading market. I recommended investors retain a market-neutral strategy with a near-term focus on the sectors with strong domestic consumption. November 28 Turning cash into valueAs investors re-assess risk tolerance to the crunching beat of the credit markets, credit constriction ups borrowing costs globally; therefore investors now turn to a more defensive strategy and prefer companies with strong cash positions.
While this rule does apply on the global basis, the impact on Hong Kong companies is far less pronounced than in US and Europe, because HK companies have cash-rich domestic balance sheets, strong EPS growth, as well as a combination of USD weakness, rising local inflation, and potential US interest rates cuts spells Hong Kong asset inflation.
To HK and China listed companies, cash is welcomed in some industries and companies only, but this does not apply to all. As Chinese companies usually don't spend cash for share buybacks, and only some companies pay dividends to shareholders, most of companies would still like to spend cash on capital expenditures for future growth, or cash M&A.
As a result, investors still favour companies with rich cash in property and banking sectors, but such companies in sectors like machinery, automotive, and building materials appear not attractive. Hong Kong market perspectivesI think if US enters recession, capital inflow to HK market is likely to increase. I think investors will still prefer resource-oriented markets such as South Africa, Canada, Russia, Indonesia and Australia, as well as several emerging markets (such as Hong Kong, Korea, Singapore, Malaysia, and Brazil). My thoughts are: - Investors still prefer compelling stories that currently exist in some of the emerging markets (China and India in particular) - Comparing with Eastern Europe, Latam, and SE Asia, HK market is more open and efficient to overseas investors - Although HKD's link with USD has negative influence over the HK market in the middle-long term, but investors are still able to share the high quality EPS growth of H share companies In conclusion, I expect volatility to continue to increase during 2008 because of increasing uncertainty about global monetary policies and credit conditions, but I am still bullish on emerging markets and commodities.
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