Short-term volatility seen for China markets

SHANGHAI (Reuters) - China's most aggressive monetary tightening this year may make its markets volatile next week, boosting the yuan and pulling down stocks, but is not expected to change their long-term outlook.

Analysts see steps announced by the central bank on Friday mainly as symbolic -- an effort to placate protectionists in the Congress, a warning to Chinese banks to restrain lending, and a reminder to the stock market not to rise too fast.

They do not expect yuan appreciation against the dollar to accelerate much if at all over the long run, or think the stock market's long-term uptrend will change.

And while money market yields are likely to jump, the market had already been expecting an interest rate hike, so yields may stabilize quickly.

The widening of the yuan's trading band "will have a short-term impact on yuan trade in the domestic foreign exchange market and cause sharper volatility," said Wang Qing, economist at Bank of America.

"But as the yuan never seriously tested its previous daily limit, the latest move should for now just be seen as symbolic."

The yuan, which hit a high of 7.6679 to the dollar on Friday, its highest level since it was freed from a dollar peg in July 2005, will be able to move 0.5 percent from its daily mid-point against the greenback, instead of 0.3 percent.

But the central bank will still be able to regulate the pace of appreciation simply by setting the mid-point before the start of trade.

By signaling China still intends eventually to liberalize the yuan, the band widening may slightly improve the atmosphere at next week's trade talks between Chinese Vice Premier Wu Yi and U.S. Treasury Secretary Henry Paulson.

Several Shanghai dealers said the yuan would rise on Monday as the market tested the central bank's intentions -- possibly reaching 7.6500 by the end of next week.

But analysts doubt that the central bank, which has been keen to avoid destabilizing China's export industries, will change its fundamental policy of permitting only gradual annual appreciation.

"This will of course trigger market expectations for more aggressive CNY appreciation, but we believe this is the wrong conclusion to draw," said Standard Chartered's Stephen Green.

Green said he was keeping his prediction that the yuan, which has gained 1.8 percent against the dollar so far this year, would rise only about 4 percent for the full year. Some Shanghai traders expect annual appreciation of 5 percent.

YIELDS MAY RISE 10 BPS

Analysts think the stock market, where the Shanghai index .SSEC is up 51 percent this year, may pull back 10 percent or more in the next month in response to the central bank's hikes in interest rates and bank reserve ratios.

"There should be no doubt that the stock market will tumble some 100 points (2.5 percent) at the opening on Monday," said Qian Qimin at Shenyin & Wanguo Securities.

"One apparent purpose of the steps is to cool the stock market. And if the market doesn't respond, that will surely prompt stronger steps directly targeting stocks."

But Qian and others said that while authorities wanted to prevent a dangerous bubble from building in stocks, they were not trying to reverse the market's long-term uptrend.

A strong stock market is key for many of Beijing's economic policy goals, from weaning companies off excessive reliance on bank lending to improving corporate governance and helping ordinary Chinese share the fruits of the economic boom.

The government plans to have more of China's biggest companies list in Shanghai by the end of this year. So many investors expect that after a stock market correction which could last a month or so, authorities will take steps if necessary to restore confidence in rising stock prices.

In the fixed income market, analysts said yields on bills and bonds could jump 10 basis points or more early next week, with rises particularly sharp at the short end of the curve.

The monetary tightening was unexpectedly harsh because a 0.5 percentage point reserve ratio rise was announced at the same time as interest rate hikes -- usually, the two steps are announced at intervals.

Another unusual aspect was that the one-year lending rate was raised only 18 bps, less than the 27 bps deposit rate hike. This will shrink banks' lending margins, and appeared to be a punitive measure directed at banks to warn them to curb lending growth.

"Deposit rates were raised by more than lending rates. The narrowing of this spread hits banks' bottom lines, which is negative for the whole fixed income market," said economist Wang Haoyu at First Capital Securities.

A trader at a U.S. bank said that while the market had previously believed the central bank wanted the seven-day bond repurchase rate, a key measure of short-term liquidity, to fluctuate around 2.5 percent, its aggressive steps suggested it might have raised the target to 2.7 percent.

"But this is not entirely a surprise -- expectations of an interest rate hike had been factored in. So rises in medium- and long-term bond yields may be limited to 10 bps next week."

(Additional reporting by Charlie Zhu and Karen Yeung)