China 7 Day Repo and Monetary Policy

The PBOC has tightened monetary policy recently by raising the level of the 7- day repo rate and increasing its volatility. These steps seem to be aimed at controlling asset inflation in housing in general and particularly that funded by small and medium-sized banks. We think it is too early to rule out the PBOC needing to tighten policy further. Some progress in slowing activity has occurred, but house prices are still rising and banks may find ways to work around the tightening so far. Crucially, we see these measures as aimed at containing specific risk factors – housing and SME bank lending – and believe they are not aimed at a more general slowing in credit and economic growth. We think the government remains committed to keeping GDP growth at 6.7-6.8% in 2017 and we estimate this will require broad credit growth to remain at least 13%. A key market implication is that monetary policy should prove incompatible with the recent effort to hold the CNY stable vs. its basket. We continue to expect the CNY to fall about 1% vs. the basket over the next several months and about 4-5% over the next year. Given our USD-G10 forecasts, this leads us to expect USDCNY to rise to 7.01 and 7.33 in 3 and 12 months respectively.