North Asian equity markets face a stark choice: follow the Fed or follow China.
The Fed is expected to hike rates at least three times in 2018 while the economy experiences fiscal easing. In contrast, China is maintaining an easy monetary policy but is fiscally tightening.
Unusually, Hong Kong, which is tied to US policy through its exchange rate peg, has experienced a surprise loosening in monetary policy for the past year: HIBOR has traded much lower than US LIBOR. However, this is beginning to reverse.
While global markets have been fixated on the trade dispute between Donald Trump and Xi Jinping, the recent comments by the new People’s Bank of China governor Yi Gang bore more relevance for local stock markets. Coincidentally and almost unnoticed, China’s bond market has rallied since the start of the Year of the Dog – a pertinent lead indicator for equity investors.
There were plenty of news headlines to distract investors and although it was President Xi Jinping’s address that stole the limelight at the Boao Forum in Hainan, it was Yi Gang’s first “fireside chat” that was more relevant for equity investors.
Yi responded to questions on monetary policy by acknowledging that interest-rate differentials with the United States are in a “comfortable range”. In our mind, while investors believe that monetary policy is set independent of the external environment, the Chinese capital outflow scare of 2015 appears to be uppermost in the PBOC’s mind. The PBOC, like other emerging market central banks, remains tied to the US Federal Reserve rate cycle despite the domestic financial reforms made to date.
No sooner had the conference finished than the PBOC announced that it would cut the reserve ratio requirement (RRR) for banks by 1 percent for targeted lending (mainly to small enterprises). They have presumably acted as interbank rates began to climb as medium-term money instruments matured. The RRR was 17 percent for large banks and 15 percent for smaller banks before the cut.
Interestingly, the RRR move also came alongside muted changes to the deposit and lending rate setting which would see commercial banks with greater freedom to determine their own deposit and lending rates.
Coincidentally, the Hong Kong Monetary Authority finally intervened after quite a few months of Hong Kong dollar weakness. The HKMA finally intervened as the currency hit the weak side of its band, forcing the local central bank to act due to its currency undertaking.
The buying of the local currency will mop up domestic liquidity and gradually force local rates higher. Over the past year the difference between three-month HIBOR and US LIBOR widened by around 100 basis points. The anomaly appears to have been due to the perception of higher investment returns in Hong Kong.
The bottom line is that Hong Kong has a long way to go to bring its rates close to that of the US and keep the local currency from touching the weaker side of the band. In contrast, the PBOC is seeing a strong renminbi while easing policy to ensure that money rates remain benign.
Chinese equities are set for a period of outperformance versus Hong Kong.
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