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The long-awaited rate hike announcement by the People's Bank of China (PBoC) has finally arrived. The move was not exactly a surprise but still caused some damage to the stock market. However, the move should be considered a positive one from a long-term perspective and similar moves should be expected in the coming months.

The PBoC announced a 25 basis point hike in the one-year lending and deposit rates on Christmas Eve, raising them to 5.81 percent and 2.75 percent from 5.56 percent and 2.5 perent, respectively. Meanwhile, rates for all other deposits (except demand deposits) and loans were also raised to varying degrees. It was the second rate hike in 2010. Intensifying inflationary pressure indicates that it was quite necessary for the PBoC to make the move. Although the consumer price index (CPI) should see some mitigation in growth in December due to the lack of a tail-raising effect and price control measures taken by the authorities in the past few weeks, inflationary pressure nevertheless remains - especially considering the rising pressure on grains and other commodity prices. One noticeable characteristic of the rate hike this time is that longer-term deposit rates were again raised by more basis points than shorter-term ones, while the demand deposit rate was kept unchanged. On the one hand, this may indicate there will be sustained inflationary pressure over the next few years. On the other hand, it also shows the authorities still prefers maintaining current interest-rate margins for commercial banks.

The long-term lending rate was raised by more basis points this time than during the last move, indicating the intention of the authorities to further tighten its grip on the property market. Although the 26 basis point hike in the long-term lending rate does not seem to be excessive, the tightening signal will have a marked negative impact on the property market. The lending rate hike indicates the government's firm decision to rein in soaring property prices, which have actually become a hot topic in the country. Further tightening policies such as a pilot program for property taxes are expected to be launched in a few cities.

The consecutive hikes in the reserve requirement ratio (RRR) and the latest interest rate hike have actually pointed to a relatively tightening monetary policy in the first half of 2011. According to some reports, the monetary authority will not give a specific full-year lending quota for year 2011. Some market participants might consider this as a signal of a relatively loosening lending policy. But I believe this might be a misunderstanding. In addition, the rate hike this time could also indicate the firm determination of authorities to push forward the transition of the economic development model as the rate hike will exert more pressure on the country to become more flexible in terms of the yuan exchange rate. The fluctuation band for the yuan exchange rate could be further enlarged in the future.

Compared to the October move, the latest hike saw the PBoC maintaining the same percentage increase in the one-year deposit/lending rates while raising the percentage increase in long-term lending rates and flattening the rise in the deposit rate curve. Though asymmetrical, this is already better than market expectations. The hike is estimated to raise the net interest margin (NIM) of banks by 10 basis points. For the listed banks, given the rise in bond and inter-bank capital, we anticipate the NIM will go up 2-3 basis points and their 2011 net profit up 1.1 percent.

Looking forward, I believe that if the PBoC maintains the current mode of asymmetrical interest-rate hikes, given the unchanged demand deposit rate, the banks should be more capable of widening their NIM. The NIM growth will become more significant on the book this year. Therefore, given the limited impact on economic growth and asset quality risk, the rate hike will benefit the banks.

The impact on the stock market aside, insurance companies' fixed-income investments will post higher returns. The increase in bond yields will even induce a lower assessment rate. Despite the pressure from the rising cost of capital, the revaluation of the cost of capital will outpace that of investment returns from insurance funds. Thus, the effects of the interest-rate hike are clearly positive.

Peter Pak is executive director of BOCI Research Limited. The opinions expressed here are entirely his own and do not represent BOCI or any other affiliated companies within the group. Nothing in this article constitutes an investment recommendation.

(HK Edition 01/06/2011 page2)