Cover photo: Rate hikes of Fed could present a headache for the PBoC.
The Fed’s rate hike on 14 December and its projected three rate hikes in 2017 could present a headache for the PBoC’s monetary policy to balance China’s economic and policy needs. Rising US rates will narrow the interest rate differential between China and the US, thus putting pressure on capital outflows from China and the renminbi exchange rate.
This presents a policy dilemma for the PBoC. On one hand, it wants to keep interest rate low and liquidity ample to help sustain China’s growth rate at the official 6%-7% range during China’s structural transition. On the other hand, it wants to keep the renminbi stable, thus needs to intervene in the foreign exchange market to prevent the renminbi from falling too much. But this intervention will create a negative spillover effect on domestic liquidity and interest rates.
The Chinese authorities are not going into any contractionary policy mode anytime soon, in my view, as China’s economic growth momentum remains fragile. They now want stability at all cost, as opposed to growth at all cost, on the back of President Xi’s political transition from his first term to the second term, which will involve a lot of highly significant personnel changes in the coming year. Hence, they are doing a lot of fine-tuning, even policy flip-flops (back-peddling) especially in structural reform measures to ensure systemic stability.
The PBoC’s policy stance has turned neutral from expansionary earlier, as the economy starts to stabilise. There have been no moves in the benchmark interest rates and the bank reserve requirements ratio since March this year. Instead, the PBoC has been using open market operations (OMO) to manage liquidity (to prevent tightening) in the system and kept the 7-day repo rate and CHIBOR in a very tight range between 2.4-2.7% (Chart 1). There have been more injections via OMO than withdrawals (in fact there has been no withdrawals recently, Chart 2).
Indeed, the PBoC’s monetary stance has been held hostage by its foreign exchange management: It has been trying to prevent the RMB from falling as fast and as much as market forces would warrant (due to capital outflow pressure from the financial account). The cost of this foreign exchange stability is a passive tightening of liquidity which the PBoC’s OMO has not been able to totally offset.
The onshore bond market has sold off recently partly because of this liquidity pressure, and partly because of the fears about a return of inflation prompting the authorities to tighten up policy. Thus Chinese bond yields have risen sharply (Chart 3), increasing corporate funding cost. The US rate hikes will aggravate this undesirable impact on China.
If the USD continues to soar on the back of rising US yields, it will aggravate the PBoC’s policy headache as a rising dollar will put more downward pressure on the RMB, prompting more PBoC foreign exchange intervention. This will, in turn, create more passive liquidity contraction in the Chinese system!
However, the situation for China may not necessarily be all this bad. A lot depends on capital outflows. If Chinese capital outflows fade further, China’s current account surplus will come back to dominate the forces behind the renminbi exchange rate, giving China/the PBoC a breathing space in terms of liquidity flows and interest rate pressures. This will still be the case despite US rate hikes and USD strength, provided that the US forces are not excessive.
Beijing has recently tightened up regulations to prevent excessive capital outflows. These will take effect over the coming months. In the short-term, capital outflow pressures will continued to put downward pressure on the renminbi exchange rate and, hence, domestic liquidity.
Nevertheless, the resultant higher bond yields and money market rates in China may have limited impact on the economy, as more than 60% of China’s credit to the economy is priced off benchmark rates, which are unlikely to change in 2017. Furthermore, as PPI recovers, real yields and rates will fall and corporate profits will recover, providing an offset to the increase in nominal yields and rates.
Structurally, China needs lower interest rates in the medium-term due to the need for deleveraging and structural changes. But tactically, there is more upward pressure on Chinese rates and yields in the next quarter or two. We can also expect continued but controlled depreciation of the RMB in the coming months, and Beijing will continue to tighten up capital controls even at the expense of slowing down capital account liberalisation.
