China’s currency move suggests optimism on growth and inflation
China’s announcement that it will allow more exchange-rate flexibility suggests growing confidence in the sustainability of domestic economic growth prospects, as a stronger currency would erode export competitiveness. We also believe renminbi (RMB) appreciation will combine with a slowing in key indicators to allow Chinese officials to relax their tightening bias going into the year end.
Following the 2008 global crisis, China adopted a policy that prevented meaningful RMB appreciation. This latest shift suggests increased confidence that its economy can cope with an erosion of export competitiveness from a stronger currency, and also China’s need to aggressively tighten interest rates has declined. While more moderate administrative tightening in the real estate market is likely, aggressive tightening on either front is unlikely.
The prospect of a hike in real estate taxes does remain. However, such moves are now widely expected in the market. Moreover, while interest rates could rise from here, we believe China’s strategy of moderate and broad-based tightening, which began in late 2009, decreases the likelihood of rapid, large-scale tightening going forward. This latest move supports our view that a pause in China’s policy tightening may emerge by the year end as the upward momentum in CPI begins to fade.
UK commercial property yields, in common with those provided by Investment Grade and High Yield corporate bonds, appear attractive in the current environment. Good yields provide an element of stability to returns. They are not dependent on capital appreciation, and offer favourable rates of return to investors in an environment of constrained growth. The prospect that fiscal tightening will prolong the era of low interest rates will only enhance the attractiveness of these yields.
Slower money growth to ease price pressure
Historically, China hasn’t been proactive in the easing process. Since China moved to a ‘managed float’ exchange rate regime in 2004, China’s preferred policy of making changes in reserve requirements has been concurrent with, rather than in anticipation of, peaks in headline CPI. So the case for overt easing in China rests, at least partially, with prospects for a deceleration in CPI.
Growth in the money supply (M2), which has recently been decelerating, has historically been a good leading indicator of CPI momentum in China. This suggests that inflation momentum should slow going into the fourth quarter (Q4) and an outright decline in month-on-month (MoM) CPI should emerge by the year end.
The arguments against this case and for continued aggressive tightening focus on the acceleration in PPI and recent rises in wage growth. PPI has continued its upward trend, rising to 7.1% in May from 6.8% in April. However, M2 trends are an even better leading indicator of PPI trends than CPI. M2 trends suggest a peak in PPI momentum in Q3, though an outright MoM decline in PPI may not emerge until early 2011. We believe PPI will remain elevated on a secular basis, rather than for cyclical reasons, as China encourages wage growth in particular in order to rebalance the economy towards household consumption and away from corporate investment.
The question is whether these wage rises will make it difficult for China to contain CPI inflation. So far, while the increases are substantial, the impact on unit labour cost seems to be minimal. Historically, unit labour costs have consistently fallen as wage growth has lagged overall growth in production. Going forward, we suspect that China will be amenable to wage growth that is in-line with production growth, so as not to undermine export profitability too much. A moderate RMB appreciation trend would support this view.
Tightening peak could trigger equity rally
Although Chinese equities have fared poorly in both absolute terms and relative to Asian peers so far this year, a peak in policy tightening should signify a turning point. China A-shares look to be more of a direct beneficiary of an end/pause in China’s tightening bias. However, should concerns surrounding Europe ease, China H-shares should also perform well. For the region as a whole, China’s announcement should favour export-driven sectors and economies, such as Taiwan and Korea.
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