China raised rates and cut interest income tax

China raised rates by 27 bps and cut interest income tax to 5%
As we have expected, China's Ministry of Finance announced on Friday, 20 July,
that the interest income tax will be cut from 20% to 5%, effective 15 August, shortly
after the People's Bank of China (PBoC) announced the benchmark one-year
lending and deposit rates would be raised by 27 basis points (bps), effective 21 July.
The demand deposit rate, unchanged at 0.72% throughout the current tightening
cycle, was raised 9 bps to 0.81%. After the latest hike, one-year lending rate will
rise to 6.84% from 6.57% while one-year deposit rate will rise to 3.33% from
3.06%. The two-pronged tightening action reflected the serious effort of the central
bank to rectify the negative real interest rate environment after the sharp spike of
June CPI inflation to 4.4% YoY. At the new one-year deposit rate of 3.33%, the
interest income tax cut is equivalent to a 50 bps hike in the deposit rate. Combining
the effects of the rate hike and tax cut, the government has raised effective oneyear
deposit rate by 77 bps in an attempt to curb the diversion of bank deposits to
stock market investments.
We believe the latest monetary actions should not bring major surprise to investors,
as the market has largely anticipated an imminent tightening after China announced
the much stronger-than-expected Q2 2007 real GDP growth at 11.9% YoY. The
PBoC's statement emphasizes that the interest rates hike is aimed to keep credit
expansion and investment growth in check, to stabilize inflation expectations and to
maintain stability in general price levels. Driven by continued rapid credit expansion,
fixed asset investment growth accelerated to 28.4% YoY in June from 26.9% YoY
in May. Industrial production growth also strengthened to 19.4% YoY in June, upfrom 18.1% YoY in May. Private consumption remained buoyant, with retail sales growth sustaining at the high level of 16% YoY
in June.
After the strong rebound of the HSCEI (+2.1%) and the Shanghai Composite Index (+3.7%) on Friday, the China equity markets
are expected to see near-term correction pressure next week as the simultaneous announcements of the rates hike and interest
income tax cut will be perceived by investors as negative news for China shares. However, we expect the austerity measures will
remain moderate and gradual, as the downtrend of the Purchasing Manager Index (PMI) in May and June suggested that the
Chinese economy would likely see a moderation going into Q3 2007. This should reduce the urgency for the government to
introduce aggressive tightening measures and therefore we see limited risk of a policy-induced major economic downturn. The
next major policy move to watch out is the upcoming CNY 1.55 trn special bond issue to establish the China Investment
Company (CIC). We advise investors to take any tightening-induced correction in the Hong Kong-listed H shares and red chips
as good buying opportunities ahead of the upcoming interim reporting season