The Chinese government no longer fears the Fed.
In early 2016, turmoil on China’s equity and currency markets dented confidence in the country’s economic policymakers. Foreign currency reserves were falling at an unprecedented rate and Beijing worried that any increase in US rates would further accelerate capital flight from China.
But the US Federal Reserve did not follow through on expected rate rises, in part because of the situation in China. The reprieve gave the People’s Bank of China time to implement capital controls, which slowed capital flight, while a credit surge in early 2016 stabilised economic growth. As Jeremy Stevens, China economist for Standard Bank, puts it: “Last year the PBoC got an assist from the Fed.”
This year the PBoC needs no such help. At its meeting on Wednesday, the Federal Open Market Committee is expected to raise its benchmark rate for the second time since March — and third since December — further narrowing interest rate and bond yield differentials between the world’s two largest economies.
Most analysts expect the PBoC and State Council, which must approve adjustments in China’s benchmark rate, to stand firm. “For now China needs to keep rates stable,” says Yu Yongding, a prominent Chinese economist and former PBoC adviser. “There is no need to follow the Fed.”
The PBoC’s one-year deposit rate was cut six times in 2014 and 2015, from 3 per cent to 1.5 per cent, and has not been adjusted since. The US Fed Funds Rate, meanwhile, has been raised from 0.25 per cent to 1 per cent since December 2015, with a further quarter-point increase expected this week. The spread on Chinese 10-year sovereign bonds over their US counterparts fell from 150 basis points in December 2014 to less than 80bp after the Fed’s March rate rise, although it has since widened.
In addition to the effectiveness of China’s capital controls and strong year-on-year gross domestic product growth — up 6.9 per cent in the first quarter — the PBoC has proved that it can tighten monetary conditions through short-term open-market operations.
A day after the Fed’s March rate increase, the PBoC raised rates on short-term reverse repurchase agreements, or repos, and loans from its medium-term lending facility by 10bp.
In announcing the reasons for its moves at the time, the PBoC cited lower real interest rates, improved corporate profitability and the Fed rate rise. Surging producer prices, which only turned positive in September after years of deflation, have made it easier for companies to service their debts.
“China has been able to use other tools,” says Mr Yu, who adds that the expected Fed rate rise has been well telegraphed. “It won’t have much of a market impact.”
Repo and MLF rates have proven more effective than expected in the eyes of PBoC officials, as the yield curve on five and 10-year Chinese government bonds inverted in April for the first time and corporate bond issuance fell to a record low in May. Net corporate bond financing was negative Rmb217bn last month, as the amount of maturing debt dwarfed new issuances.
“PBoC officials are very concerned that the fall-off in bond issuance will affect economic growth,” says one person familiar with internal PBoC deliberations.
“Short-term interest rates have already come up a lot in China and [tougher] financial regulation has meant a de facto tightening of financial conditions,” Andrew Batson, head of China research at Gavekal Dragonomics, wrote in a recent note. “The central bank is unlikely to desire to see rates rise further.”
The effectiveness of China’s capital controls, which tightened checks on foreign exchange purchases and overseas remittances by companies and individuals, has given the PBoC another reason to worry less about rising US interest rates. After holding at about 6.9 to the dollar for most of the year, the renminbi has risen 1.4 per cent since late last month — an unusual surge for the carefully managed currency.
As a result, says Andrew Polk at Trivium, a Beijing consultancy, “the PBoC has blown up expectations around the renminbi”. Late last year, many analysts were expecting the renminbi to fall to 7.3 against the dollar if not lower.
Renminbi strength has had the added benefit of lowering trade frictions with the US. Presidents Donald Trump and Xi Jinping agreed at their first meeting in April to a 100-day timetable for a series of trade and economic negotiations.
A weaker renminbi would have added to bilateral trade tensions. Renminbi strength has also been bolstered by Mr Trump’s turbulent first months in office. Lower expectations about his administration’s ability to deliver on tax reform and infrastructure stimulus have weakened the dollar, which has fallen almost 8 per cent against the euro since January.
Additional reporting by Xinning Liu