An Assessment of U.S.-China Interest Rate Differentials and RMB Exchange
The U.S. capital market has adjusted accordingly since the beginning of the year as the Federal Reserve said it would accelerate the pace of tapering, possibly raising interest rates earlier and pushing for a “sharp turn” in monetary policy. The 10-year Treasury yield, which has an influence on market interest rates, started to rise sharply in 2022, hitting 1.88% on January 18. By January 19, the 10-year Treasury yield had topped 1.90%, reaching its highest level since January 2020. The 10-year Treasury yield has risen 39 basis points in just two weeks. This change indicates that U.S. investors began to make corresponding adjustments to expectations that the Fed will raise interest rates by 50 basis points at the end of the first quarter. According to a Bloomberg survey, the benchmark 10-year Treasury yield is expected to rise to 2.13% by the end of this year.
By contrast, China’s 10-year bond yield has been falling since it began monetary easing in late 2021, dropping to a near 20-month low of 2.74% as of January 18. With the market continuing to expect “moderate monetary easing” in China, CITIC Securities’ chief economist expects 10-year bond yield to slide to 2.6% in the medium term. The spread between China’s 10-year bond yield and the U.S. 10-year Treasury yield has now narrowed to about 85 basis points, its lowest level since 2019. This drastic change has brought more and more pressure to the RMB exchange rate, and it is more worried that the U.S. interest rate hike will bring about the sharp fluctuation of the RMB exchange rate, thus affecting the stability of China’s economy. As a result, some market participants are also concerned about the “reverse course” of China’s and America’s monetary policies and the sustainability or even necessity of China’s loose policy.
There is no doubt that interest rate movements in the U.S. and China are driven by different monetary policies in the two countries. Market investors are adjusting their investment strategies based on their expectations, resulting in a widening of the interest rate differentials between the two countries. For ANBOUND, which advocates moderately accommodative monetary policy, there are legitimate reasons to worry about the resulting USD/RMB exchange rate volatility and economic stability. Researchers at ANBOUND also believe that China has both a window of time and a limited policy space to promote monetary easing at this time. However, from the overall point of view, economic stability is the basis of exchange rate stability, and only by achieving a “soft landing” and maintaining appropriate economic growth can the RMB exchange rate be fundamentally stabilized. Therefore, the focus of China’s monetary policy still needs to be placed on the “internal circulation”, and only with this basis can the internal and external balance be considered.
As the economy faces multiple pressures and its growth continues to slow down, the country still needs to seize the opportunity to further promote steady economic growth. Liu Guoqiang, deputy governor of the People’s Bank of China, also pointed to the need to “utilize the monetary policy toolbox to avoid a credit collapse”. “Judging from past experience and the current internal and external environment of the economy, China should strengthen counter-cyclical regulation, shorten the time for the economy to bottom out, improve market expectations, maintain the continuity and stability of policies, protect and stimulate the vitality and enthusiasm of market players,” said Dr. Sheng Songcheng, an ANBOUND cooperative scholar. Similarly, Dr. Sheng sees the Fed’s policy “sharp turn” as an inevitable move. With the U.S. economy growing less than expected, it has had to deal with rising inflation instead. In the case of the United States, the Fed will also face pressure to achieve economic growth both politically and in terms of its responsibilities. Therefore, the degree of tapering is still possible to change to some extent when inflation is considered by the Fed to be “transitory”.
Researchers at ANBOUND believe that future changes in the RMB exchange rate cannot be judged solely from the U.S.-China interest rate differentials. The recent appreciation of the RMB, in addition to the short-term factor of demand for foreign exchange settlement, is closely related to the Chinese and American economies. It should be noted that while the U.S.-China interest rate differential is narrowing, it is widening rather than narrowing if one takes into account changes in real interest rates in China and the U.S. as a result of their respective inflation levels. The U.S. consumer price index (CPI) has been rising since the second half of 2021 and reached a high of 7% in December. China’s CPI has already started to fall, falling to 1.5% in December from a high of 2.3% in November. On this basis, the change of RMB nominal exchange rate reflects more the change of price level between China and the U.S., and does not have much impact on the real exchange rate. With U.S. inflation remaining high and unlikely to be reversed in the short term, the basis of the USD/RMB exchange rate (nominal exchange rate) will not change too quickly. Of course, as the central bank said, the most important thing in the short term is to form a two-way fluctuation of the RMB market exchange rate, so as to avoid risk aggregation caused by unilateral appreciation and depreciation.
In this regard, the narrowing of interest rate differentials between the U.S. and China may not trigger a short-term basis for the RMB exchange rate. However, both China and the U.S. are changing their monetary policies in opposite directions based on their respective domestic economic situations. Excessive fluctuations in either the RMB or the USD are not beneficial to the two major economies. Therefore, the contrast between China and the U.S. monetary policies will not last for a long time. Both countries will make necessary adjustments according to the current situation. Nonetheless, the major task now is to resolve the contradiction of “stable growth”.
Final analysis conclusion:
On the whole, the current monetary policy should not dwell too much on the pressure on the RMB exchange rate due to the change in the interest rate differential between the U.S. and China, but should instead focus on the stability and development of the “internal circulation” in order to establish expectations of stable growth. In this case, the problem of RMB exchange rate risk will be solved.
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