Market Economics | Interest Rate Strategy - BNP PARIBAS ...

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notice construction activity as far as the eye can see. In downtown Hong Kong, real estate is selling for EUR 5000 per square foot, driving house prices relative to income to unrealistic levels. However, lending restrictions have been introduced that limit the leverage relative to the cost of the real estate project to 75%; this will provide the housing market with a good cushion. Hence we do not envisage the Hong Kong real estate market undergoing a Dubaistyle crash. However, we wish to highlight the impact of a booming real estate market on consumer price inflation. Unlike Dubai, Hong Kong’s real estate boom is only moderately leveraged and is funded by Chinese real money. Nonetheless, real estate prices rising out of all proportion to income will squeeze low-income groups out of the cities. As low-income groups tend to be service providers, it should not be a surprise to see Hong Kong’s real estate boom leading to a period where inflation is an issue. Rising bills Each time I go to Asia, my bills are higher than on previous visits. There is a lot of anecdotal evidence suggesting Asia is inflating its relative competitiveness away. Official data may understate real inflation by a substantial margin and the Chinese administration’s endorsement of 20% wage increases may be viewed as a move to calm the population’s anger as real incomes are eroded by rising prices. The motivation behind the PBoC’s current policy mix Last Friday, the PBoC again increased its minimum reserve requirements with the aim of reducing the velocity of money and credit in the Chinese economy. This policy has become known as quantitative tightening. There has been a lively discussion on why China has largely been refraining from using the traditional interest rate tool to fight inflation. An argument often deployed is that higher RMB money market rates could trigger an inflow of unwanted hot money, pushing currency reserves up even up rapidly. Indeed, absorbing incoming reserves by selling sterilization bonds has become an increasingly costly business for the PBoC given the negative spread between the yield from foreign currency reserves and the yield offered by the sterilisation bonds. Nonetheless, the main reason why China is using the interest rate tool only reluctantly is the highly leveraged “state-owned” corporate sector. Here, higher interest rates could burst the leverage bubble. China’s households have on average saved 35% of their income on average over the past decade. As authorities run a closed capital account and 50.0 49.0 48.0 47.0 46.0 45.0 44.0 43.0 Chart 3: US Wages Relative Output have Declined 42.0 Sep-75Jun-79 Mar-83 Dec-86Sep-90Jun-94 Mar-98Dec-01Sep-05Jun-09 Source: Bloomberg, BNP Paribas Percent 6 5 4 3 2 1 -1 US Wages are a proportion of GDI US CPI (y/y, RHS) Chart 4: USD Vs CNY 3m Bill Rates USD 3m bill yield households have saved for pension and rainy-day purposes, savings were accumulated into bank deposits. Domestic banks have only been allowed to lend domestically, which in a booming economy is relatively unproblematic. However, Chinese bankers (as everywhere else in the world) are paid to ride the yield curve and convert deposits into vast amounts of credit. China’s household savings relative to GDP have reached 100% but state-owned corporate liabilities are now a multiple of that. China’s national accounts data are not yet as comprehensive enough as those provided by Western statistics offices. However, given the closed capital account and huge private household savings, either the corporate or sovereign sector must be deeply in the red. In China, it is the state-owned corporate sector which is highly leveraged and thus sensitive to changing funding costs. The Chinese authorities know that, explaining why they have been reluctant to use the interest rate tool. 12.0 10.0 Nov May Aug Nov Feb May Aug Nov Feb May Aug Nov Feb May Aug Nov Feb 06 07 08 09 10 11 Source: Reuters Ecowin Pro, BNP Paribas CNY 3m bill yield 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 Hans Redeker 20 January 2011 Market Mover, Non-Objective Research Section 60 www.GlobalMarkets.bnpparibas.com
Capitalism requires business cycles There has been much admiration for the Chinese state-controlled economic model. We predicted that China in 2009 would be the anchor of stability for the global economy and so it turned out. However, we are not sure that the same can be said for the next 12 months. Yugoslavia showed that a statecontrolled market economy cannot ignore the need for business cycles to correct wasteful investment. The business cycle works in the capitalist economy as a quality control for the efficient use of resources. Business cycles are necessary and useful. In its 2006 stability report, the IMF illustrated that delaying cyclical downturns only makes the following recession deeper and more painful. In this sense, the absence of a Chinese business cycle is worrying and implicitly suggests that there must be a certain degree of wasteful investment in the economy which at one point will have to be cleared out. What should not be forgotten either is that wasteful investment reduces efficiency, turning a competitive and noninflationary economy slowly into a non-competitive and inflationary one. 130 120 110 100 90 80 70 Graph 5: USD – CNY REER gap has Widened by 30% Jan-94 Apr-95 J u l -96 O c t -97 Jan-99 Apr-00 Jul-01 Oct-02 Source: Reuters Ecowin Pro, BNP Paribas CNY Broad BIS REER Jan-04 A p r- 05 USD Broad BIS REER Chart 6: Chinese Shares have Underperformed Jul-06 Oct-07 Jan-09 Apr-10 Does that mean the consensus has started the year with a wrong distribution of risk preference? Most think that the main risk of economic underperformance should be associated with the US. They have allocated their currency portfolios accordingly, using the USD as a funding currency. Along with a better-than-expected performance by the US economy, Asia’s inflation rate could undermine this investment strategy. The meaning of inflation for currency markets Indeed, the economic outlook for China and by extension Asia depends on the seriousness of the current inflation wave. The consensus sees inflation as mainly driven by commodity-driven cost-push effects. If this assumption proved correct, current prices would stabilise within a year. What we find disturbing is that the rhetoric has taken the same angle as in the early 1970s when the Yom Kippur war triggered the first oil price shock. Then, It was argued that higher oil prices would reduce real disposable income and would in fact prove to be deflationary in the long run. Hence they did not require attention from monetary authorities. This view backfired in the 1970s, a decade when inflation proved a real problem. Interestingly, the 1960s had seen a sharp expansion of the monetary base, exceeding GDP by a multiple. Over the past couple of years, the same has happened on a global scale. That is good enough reason in our view to discuss what will happen on FX markets, should inflation become a theme. Changing the way we look at FX Source: Reuters Ecowin Pro, BNP Paribas First, we will have to change the way of analysing FX markets. During the time of the ‘Great Moderation’, central bank credibility advanced to ever-higher rates, allowing us to use nominal interest rate and yield differentials to predict currencies. At times of corporate-dominated cross-border flows, we used corporate bond market yields but, most of the time, sovereign flows dominated cross flows anyway, keeping the emphasis on sovereign yield differentials. When inflation comes back, it will be real yield differentials that tell us if currencies have upside or downside potential. The relative credibility of central banks will determine the value of FX Secondly, central banks will be differentiated according to their willingness to tackle inflation head on. In the case of Indonesia and India, markets have started expressing doubts, putting their asset markets under selling pressure. The selling pressure Hans Redeker 20 January 2011 Market Mover, Non-Objective Research Section 61 www.GlobalMarkets.bnpparibas.com
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Market Economics | Interest Rate St
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The obvious focal point is the Summ
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such shocks at the moment, such as
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US monetary conditions, because the
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Page 27 and 28: Japan: New Cabinet and Policy Outlo
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Page 31 and 32: US/EUR Spreads: Further Tightening
Page 33 and 34: US: Could the Short End Have a Puls
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Page 37 and 38: ange bound, as we expect, given tha
Page 39 and 40: EUR: Liquidity is No Stress • The
Page 41 and 42: EMU Debt Monitor: Trade Ideas • K
Page 43 and 44: EMU Debt Monitor: CDS Analysis Char
Page 45 and 46: EMU Debt Monitor: Redemptions • O
Page 47 and 48: EUR: Buy 3m5y Straddle vs 3m10y Str
Page 49 and 50: Global Inflation Watch Eurozone HIC
Page 51 and 52: Table 2: BNP Paribas' Inflation For
Page 53 and 54: Inflation: With Supply Comes Opport
Page 55 and 56: Pricing Date Repo Rate Sett. Date T
Page 57 and 58: Germany 10y: MT 61.8% (3.12) break
Page 59: Travelling Asia • Inflation has e
Page 63 and 64: EURUSD Rally Eyes 1.3750-1.3950 •
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Page 67 and 68: than an unrelenting rise in prices
Page 69 and 70: Economic Calendar: 21 - 28 January
Page 71 and 72: Key Data Preview 120 115 110 105 10
Page 73 and 74: Key Data Preview Chart 5: French Sa
Page 75 and 76: Key Data Preview 10 5 0 -5 -10 -15
Page 77 and 78: Key Data Preview 3 2 1 0 -1 Chart 1
Page 79 and 80: Economic Calendar: 31 Jan - 25 Feb
Page 81 and 82: Next Week's T-Bills Supply Date Cou
Page 83 and 84: Economic Forecasts GDP Year 2010 20
Page 85 and 86: Market Coverage Market Economics Pa
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