China gets tough on banks, supports dollar

China Micro- Manages Lending Control

China’s increase in the reserve requirements to 17% on its top six banks serves as a viable excuse for U.S. dollar shorts to stabilize selling and for markets to consider possible consolidation ahead of the release of U.S. earnings. We long said that in a world of inevitable QE2 (quantitative easing) from the U.S. central bank, the only viable means for a notable stabilization in the U.S. dollar are: i) unforeseen event risk from the Eurozone and; ii) an interest rate hike from the Peoples Bank of China (PBOC).

But will raising the reserve requirement for the fourth time be enough to contain overheating bank lending? Last month, China raised the down payment to 30% on third time home buyers. The measures clearly show China’s priority is aimed at stabilizing housing lending (to avoid a housing crash), than worried about containing overall consumer inflation, which is at 3.5%. Said differently, hiking the reserve requirements on select banks and adopting administrative loan controls is a more targeted approach to housing than rate hikes, which is more akin to cracking a nut with a sledge-hammer.

The fact that reserve requirements had been raised four times without touching lending interest rates highlights China’s preoccupation with slowing the broader economy as well as exacerbating the losses of the PBOC through its sterilized currency interventions (borrowing in higher rate local bills to store proceeds in lower U.S. Treasuries).

Meanwhile, S&P has already warned that home prices in major Chinese cities could drop 10% in the next six to12 months, if more aggressive tightening is adopted. The fact that rates have not been raised since December 2007 is also highlighting the negative real interest rate on China’s depositors during 3.5% inflation.

QE 2 to Enter New Normal

Today’s release of the September FOMC minutes will likely highlight the dissent as well as uncertainty among FOMC members regarding i) the need to purchase additional bonds (beyond maintaining the balance sheet intact) and; ii) the visibility towards the November 2-3 meeting. The FX impact of QE2 will primarily be in function of the quantity as well as the extent to which it keeps the door open for further purchases, Thus, an initial announcement of say, $150 billion may disappoint dollar bears who had been anticipating higher amounts, but not if the FOMC announces a monthly purchase program that is subject to revision.

Once U.S. QE2 becomes the new normal, selling pressure on the USD could well ease as traders begin anticipating the days of similar moves by the Bank of England (70% chance of occurring before January) and the ECB (50% chance of occurring before March 2011). In addition to these factors, the risk of China hitting the brakes too hard could well increase in its role of weighing on equities, commodities and risk currencies.

EUR/USD breaks below its four-week trend line support of $1.3850 (see chart below), a New York close below which would extend losses towards the next key support of $1.36. The stochastics validation for further decline is in place. Now that the 200-week moving average retracements at $1.3920 were both attained, this may be the time to take profits and extend losses towards possibly $1.36. Do not forget that EUR/USD had four consecutive weekly gains (longest winning streak since Jul/August) and a correction is overdue. UK September CPI held at 3.1% year over year, while the core slipped to 2.7% from 2.8%. Sterling being hit by escalating demands for additional QE from the business community. GBP/USD continues to look like a double top from the August high of $1.5997 and $1.57 appears a decent preliminary target (trendline from Sep 9). GBPCAD eyes 1.6020.

Ashraf Laidi
Chief Market Strategist CMC Markets
133 Houndsditch, London EC3A 7BX
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About the Author

Ashraf Laidi is chief global strategist at City Index-FX Solutions and author of “Currency Trading & Intermarket Analysis.” His Intermarket Insight appears daily on

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