FX implications of China's rate hike

The Background
The People's Bank of China (PBoC) raised interest rates in a surprise move on Thursday. The 1-year deposit rate was raised from 1.98% to 2.25% and the 1-year lending rate was raised from 5.31% to
5.58%. In addition, the PBoC lifted all limits on commercial bank lending at rates above the prescribed ones. The wisdom of such a move on rates has been much debated in policy circles in Beijing during the last year. Many within the PBoC argued for such a move, but those who worried about the effect of high borrowing costs for state firms and the government had previously won out, arguing against a rate hike.

As our economists Stephen Green and Tai Hui note in their research piece 'On the ground: China moves from targeted to market-oriented measures', the interest rate hike suggests three things:

1) The government wants to move to "phase two" of its macro-economic management plan as a more effective way to moderate investment .
2) This is a continuation of a market-based reform plan.
3) The USD's initial rally on the news is likely to be short-lived.

Implications for the CNY
In the wake of yesterday's rate hike in China, the market appears to have divided itself into two camps: those who think that the PBoC's move is a substitute for an adjustment to the Chinese yuan (CNY) peg, and those who see the move as representative of a continuation of market-based reforms and likely to attract further capital inflows, which will in turn lead to greater pressure for the CNY to revalue. Standard Chartered holds to the second of these two views. The rate hike marks a further step along the path of market-based reforms and as such increases the chance of a CNY band widening/de facto revaluation. In particular, we note the scrapping of the upper limit on lending rates as reflecting a desire on the part of the authorities to adopt a more market-based approach. The view that a rate hike might be instead of a CNY revaluation or at least delay it appears to focus on the idea that a CNY exchange rate adjustment was aimed at slowing down the economy. However, in our view this is not the case. A CNY band widening would firstly reflect a continuation of the efforts by the authorities to move towards greater market flexibility. Secondly, it would reflect the prevailing macroeconomic reality, which is that the CNY is undervalued and should be adjusted accordingly. Such an adjustment, together with the recent rate hike, should help temper inflationary pressures.

We continue to expect the CNY regime to change. It could happen at any time. Certainly, it was on the agenda after recent comments from the State Administration of Foreign Exchange (SAFE) and PBoC and following this rate hike it is now even more so. Even then, we are expecting a move to a band of +/-2.5% around the current centre. Recently, the SAFE ruled out a one-off shift in the exchange rate, favouring instead greater flexibility with no timetable. Earlier today, the PBoC repeated this line, stressing that it was still studying the issue of an exchange rate adjustment, but that there was no timetable for this and until that adjustment occurred it would maintain CNY stability. Yesterday's rate hike means the following for the CNY:

•It is a further step in market-based reforms and increases the chance of a CNY band widening
•CNY band widening would primarily be a continuation of market-based reforms, as well as reflecting fundamentals
•The PBoC confirmed that they are still looking at the issue of exchange rate adjustment
•USD-CNY NDFs' discount declined initially on the news, but have since stabilised; expect choppy range trading near term
•Further out, renewed expectations for a CNY revaluation should keep NDFs firmly at a discount, though the 1 year is pricing in more than we expect
•USD-CNY NDF implied vol curve should steepen further as expectations for a 2005 revaluation increase

Implications for the dollar
Clearly, our view that the China rate hike is a further step in market-based reforms and is a precursor to an eventual CNY band widening/ revaluation is key to the potential implications for the global exchange rates. 7To repeat, we have three big calls for 2005 - a weaker dollar, changes to the CNY and MYR pegs and a sharp pickup in FX implied volatility. Recently, much of the dollar's necessary adjustment to reflect the widening U.S. current account deficit has taken place against European currencies. Asia is starting to play catch up but we expect this to accelerate in 2005, albeit after a modest dollar bounce in Q1.

In the immediate aftermath of the China rate hike, the market's initial reaction was to take both the dollar and global bond yields sharply higher. Since then, both have retraced lower as investors reassess the implications for global markets. We remain of the view that current global economic imbalances will necessitate a further dollar depreciation in 2005. Our call that the rate hike increases rather than decreases the prospect of a CNY band widening/revaluation is very much in line with this view. To date, the dollar adjustment has not happened against the CNY, but it will (to a modest extent). Rising expectations for this will add to upside pressure in Asian currencies. Note that overnight U.S. Treasury Secretary John Snow said the rate hike was "consistent with moves toward more sophisticated management of their financial institutions and macroeconomic objectives. This is a clear advance to use interest rate mechanisms to play a larger role in achieving macroeconomic objectives."

Implications for Asian currencies are mixed overall. Renewed speculation about a CNY revaluation in 2005 should boost capital inflows, to the benefit of these currencies. In the medium term China's strategy of simply stopping investment is not sustainable. Thus, we believe that policy makers want to use this rate rise as a more effective way to moderate investment. We still believe GDP growth in 2005 will be 8.5% y/y. However, other analysts view this rate rise as an additional means of cooling the economy. We disagree: we see this as a shift from targeted to more broad based measures. Expect global markets to continue to debate the issues over the next few days and weeks, which may lead to choppy range trading. In sum, our thoughts on how China's rate hike impacts the dollar and other exchange rates - both developed and emerging -are as follows:

•Dollar weakness remains the bias despite the market's initial reaction
•Our expectation of a CNY band widening/revaluation in 2005 further supports our call for dollar weakness
•USD set to weaken further against Asian currencies on expectations for a CNY revaluation
•China's demand for Asian exports and commodities will remain strong near term, though it may slow modestly...
•...but a series of rate hikes could trigger portfolio outflows from those countries very dependent on exporting to China

In terms of specific implications for each client type:

Leveraged funds:
· Maintain core short USD-CNY NDF outright positions, but trim trading positions
· Add to short USD-MYR positions
· Consider long EUR-AUD call spreads or long EUR-CLP call spreads as a way to express global slowdown in 2005

Real money:
•Maintain core USD underweight positions given macro outlook, but trim trading positions on increased volatility
•Outside of the USD, continue to focus on downside value in EURCHF and EURSEK
•Stay broadly long ASEAN currencies, but these would be vulnerable if this is the first of a series of rate hikes...
•...As would AUD, NZD, BRL and CLP
•Long EUR-CLP may be a good way to express a bearish view on China-related commodities

Corporates:
•EUR-based corporates should raise hedging ratios against CLP, BRL, AUD from the end of
the year
•USD-based corporates with Asian currency earnings should reduce hedging ratios for next 6
months
•Asian-based corporates should increase hedging ratios against the USD for the next 6
months