While the U.S. Federal Reserve tightens its monetary policy, China’s authorities have initiated extensive and rapid easing operations to bolster the economy this month, indicating a significant economic policy divergence between the two countries.

According to some analysts, the Chinese central bank takes advantage of the last open window before the Fed raises interest rates by relaxing the easing policy earlier than planned. Otherwise, the RMB exchange rate will be under pressure, and the market will face the possibility of capital outflow.

The RMB exchange rate and the flow of money in the Chinese market are in the spotlight as market expectations heat up and interest rate differentials between the United States and China fall rapidly.

The People’s Bank of China (PBOC) announced that the interest rate on one-year medium-term lending facility loans of about $110 billion in total was reduced to 2.85% to stimulate the economy. It was the first time such a cut had been made since April 2020.

The seven-day reverse repurchase rate, another PBOC lending measure, was also cut while the bank pushed an additional $31.6 billion of medium-term liquidity into the financial sector.

Then, on Jan. 20, the PBOC lowered the one-year loan prime rates by 10 basis points to 3.7% for the second time in two months. In addition, for the first time since April 2020, it cut the five-year loan prime rate by five basis points from 4.65% to 4.6%.

The central bank’s move came after its deputy governor, Liu Guoqiang, said at a press conference that the Chinese economy is facing triple pressures and the country needed rate cuts. 

According to Reuters, most new and outstanding loans in China are based on the one-year loan prime rates, whereas the five-year rate impacts home mortgage pricing.

According to Capital Economics, the rate decreases are part of the PBOC’s ongoing efforts to lower borrowing costs.

Sheana Yue, an economist at Capital Economics, predicts that China’s easing cycle is in full swing. China’s central bank will continue to cut interest rates to boost housing demand in the coming months.

Sheana Yue said in a note following the announcement.

“Mortgages will now be slightly cheaper which should help shore up housing demand. The PBOC has already pushed banks to increase the volume of mortgage lending.”

Yue added, “Targeted support for property buyers does appear to be limiting one of the more severe downside risks facing the economy.”

It has been anticipated that the United States Federal Reserve will raise interest rates in March before The PBOC accelerates its easing strategy.

Hong Hao, head of research at BOCOM International, said expectations of easing from the People’s Bank of China while bracing for tighter U.S. monetary policy “will spur traders to punt on rates-sensitive assets such as commodities and bonds.”

The Fed will be holding its first meeting of 2022 (from Jan. 25 to 26), and it is widely expected to set the stage for rate hikes at its March 15 to 16 meeting.

Last December, the Fed proposed three rate hikes in 2022. However, based on recent official speeches and interviews of officials from the bank, it appears more likely that the Fed is eyeing four rate hikes in 2022.

Mike Sun, a senior investment advisor in the U.S., suggested that the driver behind Beijing’s lowered loan prime rates is directly governed by the expected rise in the Fed’s interest rate hike. 

One of the main reasons is that Beijing wants to seize this small open window to stimulate the economy and prevent further decline; other purposes include reducing the pressure of mortgage repayment for borrowers, indirectly stimulating consumption.

Previously, the Chinese authorities have spoken of concerns over the impact on China’s capital market when the U.S. increases interest rates.

According to a commentary article published by the Financial Times on Jan. 5, 2022, led by the central bank, the RMB exchange rate will likely experience depreciation pressure in 2022 due to changes in the “four disparities.” 

The “four disparities” refer to the narrowing of the interest rate disparities between domestic and foreign currencies, the change in the economic growth disparity, the narrowing of the foreign trade disparity, and the reversal of the risk expectation disparity.

The commentary further explains that if the Fed raises interest rates more sharply than expected, it will push up U.S. bond yields and narrow the discrepancy between China and the U.S. Cross-border capital may flow out of emerging markets, including China. In addition, it will push the depreciation of emerging market currencies, including the RMB.

Furthermore, suppose the global financial markets become volatile due to interest rate hikes, resulting in a shift in investor expectations. In that case, external uncertainty may increase, and some risks may spill over to the Chinese market through capital flows in emerging economies.

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