The PBOC announced on Sunday that it would raise the 1-year deposit rate and 1-year lending rate by 25bps to 2.75% and 5.81% respectively, effective from 26 December 2010. Demand deposit rates will remain unchanged, but the deposit rates for 3 months, 6 months, and 2 to 5 years are raised by 30-35bps.

This rate hike is not a major surprise to us as we had expected 75bp rate hikes by the middle of next year (vs market consensus of about 50bps). However, the fact that the Pboc is hiking rates when December CPI inflation is poised to decelerate (to about 4%yoy) on softening vegetable prices and improved base effect shows the central bank's strong desire to address the negative interest rate issue. More aggressive rate hikes may also serve as a policy tool to offset the impact of stronger-than-expected net lending growth target for 2011. Note that the new lending target for next year is reportedly set at RMB7.5tn vs the previous expectation of RMB6.5-7.0tn, and may generate upside risk to the government's 4% CPI inflation target.

Given the relatively swift (vs market expectation) response from the Pboc's interest rate policy in the past two months to inflation pressure, and the fact that inflation is shifting from food driven towards a more broad-based one (driven also by rental, commodity and wage costs), we raised our expectation for next year's rate hikes to another 75bps after today's move. That is, we expect 1-year deposit rate to reach 3.5% by the end of next year (vs our previous expectation of 3.25%). We think the first half of next year will see rate hikes of at least 50bps.

As inflationary pressure will remain strong in H1 next year, and monetary tightening is still unfolding and will last at least for another six months, we will keep our cautious market outlook in the near term. In particular, we think investors should be fully aware of downside risks to sectors such as IPPs, highly leveraged developers, coal, and mid-sized banks as they tend to suffer more from rate hikes and price intervention. Developers will face the additional risk of a likely implementation of the property tax pilot program in the near future. We believe that insurance, large banks, tourism, IT, high-end manufacturing, and cement will be relatively immune from policy risks and should benefit from positive structural changes next year.

• [Editor:editor]