Macro Outlook: Raising Rates- Momentum from Interest Margins and Regulatory Forces

Recent market discussions surrounding interest rate hikes have been heavily focused on inflation and the current state of the economy. GF Securities' Chief Macro Strategist, Lei Guo, thinks that momentum from interest margins and regulatory forces for raising interest rates in China are both experiencing a significant period of divergence. Policy makers need to observe carefully, as traditional policy tools (MLF, SLF, Reverse Repos) under current market conditions are a sure compromise. On one hand, raising rates would increase the real cost of capital, and inhibit further credit expansion; simultaneously, this would play more of a role in the financial sectors, and avoiding a rate hike would protect consumer spending and brick and mortar investments.

The logic behind pressure from interest margins pushing rates up is to stabilize exchange rates through stabilizing interest rate spreads. Maintaining interest margins are simply managed by passively following the global policy cycles. If you take the relative economic growth between the US and China as a latent purchasing power parity index, in the last thirty years, the RMB is facing its third pressure period from exchange rates. Lei Guo, the chief macro strategist at GF Securities believes that this pressure period for foreign currency assets is more market based, and policy needs to focus on exchange rate stability. In terms of market driven exchange rate decisions, if the purchasing power parity's expected contribution is generally negative, then certain assets will experience bilateral flows, resulting in the need to stabilize interest margins.

If the Federal Reserve raises interest rates 2-3 times throughout both 2017 and 2018 (mainstream expectations have this round of rates hikes going until 2019), then the benchmark US-China rate spreads are significantly negative. Under these conditions, interest margins as a driving force are extremely plausible, otherwise domestic assets will face a greater temptation of risk free returns from abroad. This in turn will result in a greater destabilization of exchange rates. At the policy level, emphasis has repeatedly been put on 'risk prevention' for 2017; however, in terms of risk prevention, other areas of the economy are relatively easy to control. An important risk to be wary of is the impact on the potential squeezing of asset bubbles and trigger effects from emerging market rates in relation to a period of strengthening US rates.

Secondly, with interest rates as one of the main tools of monetary policy, rate increases will prevent the economy from over heating and curb inflation. The third main function being to hold back asset bubbles, which all belong to the category of regulatory forces. Under current market conditions, there are visible signs showing from all three of these scenarios. At the same time, weak economic growth is also quite obvious. From trends in real corporate capital expenditures, internal demand for capital expenditures is just starting to recover, and still weak. Lei Guo believes that overall, the actual economy is still in a recovery phase and does not support rate hikes driven by regulatory forces.

Lei Guo strongly believes that there is still a large element of future uncertainty. By understanding interest rate policies through a balanced framework with internal and external considerations, several logical scenarios remain: 1. US interest rate increases will not happen as expected, leaving no basis for an increase driven by interest margins; 2. The Chinese economy is basically stable, but will experience greater downward pressure during the second and third quarters, resulting in no basis for a rate hike driven by regulatory forces; 3. The pace of US rate hikes will carry on as expected, with 2-3 increases through 2017 and 2018, resulting in increased pressure from interest margins, and overvalued assets facing a bumpy ride; 4. Investment in fixed assets from China will become overheated with inflation exceeding expectations, or assets approach bubble territory, with a rate hike based on regulatory forces initiated.

Analyst：

Lei Guo,

guolei@gf.com.cn

Translated by：

Luke Dimopoulos,

luke@gf.com.cn