A-Share Market Feels Pain on Expansionary Policy Exit

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Entering February, China's A-share market has continued to drop. The expected "good start" to the year was cut short as the central bank announced the raising of the deposit reserve rate on January 12. In January, the Shanghai Composite Index fell 8.78%, ending a four consecutive month rising trend at the end of 2009.

 

The falling A-shares have analysts almost unanimously pointing to the tightening of policy. Banks, real estate, coal, nonferrous metals, and cyclical industries have taken the worst hits from capital flight, while the performance of defensive industries such as bio-medicine and agriculture have seen less change.

 

The raising of deposit reserve ratio has the market very sensitive to any economic data that may lead to changes in the previous loose policy control. 

 

Reports in January had bank credit reaching nearly 1.6 trillion yuan, which, if accurate, means that new data in January is almost flat with the same period of last year. This is clearly not in conformity with the stated aspirations of regulators to shrink bank lending. The deposit interest rate raise is related to inflation and loan delivery. In addition to concerns about the credit data, the market is becoming sensitive to inflation expectations.

 

Those expectations are strengthened by PMI data from January. January's PMI index was 55.8%, down 0.8 percentage points over the previous month, having remained at over 50% for 11 consecutive months. In January the purchase price index rose by 1.8 percentage points over the previous month, reaching 68.5%, rising for three consecutive months, the highest since August 2008. From an historical point of view, the purchase price index has risen ahead of PPI for 6 months, suggesting that the PPI index may face strong upward pressure in the coming months.

 

The biggest worries are that price increases may exceed expectations. Because of the base effect, oil was only $30 a barrel this time last year while it is now over $70, having fallen from over $80. The price has risen 130% year on year, while year on year prices for copper, aluminum, zinc and lead have also increased , and those of sugar, cotton, and rubber are twice what they were in the first quarter of last year. Many analysts estimate the year-on-year increase of CPI in January, February, and March at 2%, 3%, and 4% and PPI at 3%, 4%, and 5%. The real data may well top expectations.

 

Inflation expectations are increasing under the moderately loose monetary policy and pressure from resource prices, along with stronger and stronger economic recovery. Structural adjustment is an increasingly important aspect of China's sustainable development and inflation will be the major challenge in the coming year.

 

Expansive lending and increasing inflationary pressures raise the need for higher interest rates. The first window to raise rates comes in mid-February when January's CPI and credit data will be released, with a second window with the mid-March release of February's CPI and credit data.

 

While market unease over policy changes has not reached panic levels, as investors have realized that the loose policy would inevitably be withdrawn, they have been surprised that the policy correction has come so soon.