Rate rises signal PBOC’s risk management shifting to a higher gear
The central bank has repeatedly warned of rising financial risks in recent months – the latest action suggests the tolerance for further bubble buildup is wearing thin
The recent increases of interbank interest rates by the People’s Bank of China came as a surprise to the market. Not only was the adjustment to the 7-day repo rate (a key money market rate for banks) the first since Oct-2015, the PBOC also lifted the long-dated repo rates – effectively raising the entire repo curve by 10bps – and the interest rates on other liquidity provision facilities, such as the medium lending facility (MLF) and standing lending facility (SLF).
Despite the scale of the move, we do not agree with some market interpretations that the PBOC has changed its policy stance by entering into a tightening cycle. To the contrary, we think that these actions are consistent with the central bank’s “neutral” stance on the real economy,
but “prudence” towards the financial system, particularly mindful of rising leverage and buildup of asset bubbles. The only surprise to us is that the authorities have decided to act so swiftly and decisively to manage these financial risks.
For the market, particularly onshore bonds and property, such a gear shift by the central bank (on risk management) foreshadows a tough time ahead. For the real economy, we expect a muted impact, as the intention was not to derail the recovery especially before the 19th Party Congress. Should there be negative spillovers, we think that more fiscal stimulus will be applied to mitigate the collateral damage.
Delving more into the central bank actions, we see the following implications:
Our first and foremost interpretation is that the PBOC is not trying to slow the economy, but to control financial risks. If the target was the real economy, the central bank would have used the deposit/lending rates and the Reserve Requirement Ratio (RRR), which have a much more direct impact on the economy.
Instead, the use of interbank rates suggests that the focus is on the financial system, especially the bond market, which has seen rising leverage used by investors, and the shadow banking system, where non-bank financial institutions source part of their liquidity via repos.
The PBOC and senior leaders have repeatedly warned of rising financial risks in recent months, and the latest action suggests that the tolerance for further bubble buildup is wearing thin.
However, the fight against financial instability is likely to be a drawn-out and complex battle that requires further actions from the authorities. We expect the interbank market rates and bond yields to trend higher, with more volatility, along with potentially more failures in the financial system.
Second, although not the prime intention of the PBOC, higher onshore rates could also help to ease the pressure on the RMB and capital outflows. The narrowing of US-Chinese interest rate differentials since Trump’s election victory has contributed to the RMB sell-off and accelerated capital exodus from China. To maintain the “soft peg” dollar peg, interest rates in China need to go up in tandem with the US’, either by market forces (capital outflows) or central bank rate rises.
The former has taken place, but too much and too fast outflows will risk destabilising the financial system. Hence, the PBOC is taking a pragmatic step to both curb domestic financial risks and ease external pressure, effectively killing two birds with one stone.
Whether this strategy proves effective will depend on many things. One of which is how the real economy copes with higher interest rates. As mentioned above, slowing growth is not the intention of these operations, but higher bond yields and tighter funding conditions for financial institutions will bound to have a real economic impact.
We think that the current steady growth environment is giving the PBOC confidence to pursue these financial tightening. The action will continue only if growth stability is assured. Should the recovery be derailed by these measures, we think the authorities will budge, by enacting a new round of fiscal stimulus to offset. Overall, maintaining macro stability is an absolute priority ahead of the 19th Party Congress, in our view.
Lastly, we think that the use of interbank instruments (e.g. repo rates) is part of the PBOC’s monetary policy reform – to move away from setting deposit/lending rates to more market-based operations.
In recent years, the PBOC has broadened its liquidity provisioning toolkit and operated the instruments with more transparency. The frequent use of open market operations has led to speculation that short-term repo rates may eventually become the anchor of monetary policy. What is holding the PBOC back in this transition is the concern about policy transmission (i.e. how moves in the short-rate get transmitted across the yield curve and to the real economy). This transition will take time, and require efforts from the central bank to guide the market towards the new framework. If this reading is correct, more policy signals could be then gathered by reading the PBOC’s interbank operations going forward.
Aidan Yao is senior emerging Asia economist of AXA Investment Managers