Why the People’s Bank of China is unlikely to raise interest rates next year

With China’s economic recovery gaining more traction, the market has started to speculate that the central bank will raise interest rates next year. This expectation is already reflected in the interest rates derivatives market where we can see a steepening curve. Typically, this kind of steepening suggests that a tightening cycle is under way. Given that an interest rate rise is a typical way to tighten monetary policy, how likely is it that the People’s Bank of China will raise interest rates next year? My answer is “unlikely”. There are several reasons for this. First, while the Chinese economy has been leading the global post-Covid-19 recovery, China’s growth momentum is set to decelerate in the coming quarters. The Chinese economy has largely returned to its pre-virus level since the second quarter. Therefore, it makes more sense to expect a more organic growth trajectory going forward. In fact, China’s third quarter gross domestic product growth was already below market expectations, indicating that the market might have taken an overly optimistic view of China’s recovery. Somewhat alarmingly, the sectors benefiting from the global disruption of supply chains might witness a significant slowdown when the pandemic is under control. For example, China’s share of global exports has climbed in recent months as many countries were unable to produce at full capacity during lockdowns. As China has effectively contained the virus, Chinese manufacturers have been able to gain market share at this time, but this short-term gain is not sustainable. Moreover, there is the risk of disinflation, which will deter the central bank from raising rates. China’s consumer price index inflation has been below 1 per cent since October, and is likely to fall into negative territory at the beginning of next year. In addition, core inflation, which excludes food and energy components, has been sluggish for a few years. The soft inflation figures indicate that underlying demand is not on a solid footing yet. From this perspective, the central bank should think twice before engaging in an outright tightening cycle. It seems ridiculous to raise interest rates against a softening of underlying demand. From a global perspective, it is not in China’s interest to aggressively tighten its monetary policy, either. The US Federal Reserve has clearly signalled that interest rates will remain low for a considerable period. In addition, the Biden administration is likely to launch a huge fiscal stimulus package to support households hard hit by the pandemic. In Europe, the European Central Bank is prepared to increase the size of its pandemic emergency purchase programme as continued lockdowns across Europe have affected the economic outlook. Against a backdrop of global easing, any PBOC tightening of monetary policy could result in further appreciation of the Chinese currency. The yuan has experienced a relentless rally since May, which reflects an improving economic outlook. However, too rapid currency appreciation will have significant side-effects, including erosion of export competitiveness and asset price inflation, which the PBOC will take into consideration as well. By and large, China has been engaging in normalisation of its monetary policy. In the latest implementation report, the Chinese central bank said it would control the floodgates of money supply, which is widely being read by the market as meaning that the PBOC will pull back the extraordinary measures rolled out to help the coronavirus-hit economy. Nonetheless, the Chinese authorities have faced tough issues. For example, there have been a few debt default cases among local state-owned enterprises, which has not only challenged the prevailing market consensus that SOEs are very unlikely to go bust, but also served as a warning that the economic recovery is still fragile. Beijing should carefully calibrate policy normalisation; a tapering rather than a sudden halt would be more feasible, given the still-elevated post-Covid-19 uncertainties. Sun Dawu vs the state: a cautionary tale for China’s private sector? In fact, compared with a normal tightening process, China has one more task to achieve – to contain and reduce the high level of debt in the economy. China initiated a “deleveraging campaign” in 2017, which has flattened the macro-leverage ratio. Unfortunately, the debt ratio jumped again this year as the policy was eased aggressively to soften the blows to the economy from the coronavirus. As the economy is largely back on track, the Chinese authorities may again see the necessity of conducting a new round of deleveraging, which is critical for financial stability. In fact, a more effective way to contain the debt ratio is through quantitative measures, by controlling the money supply. Pricing instruments, such as an interest rate rise, are unlikely to have an immediate impact on controlling the money supply, if the risk appetite across the economy remains strong. In addition, a high interest rate could crowd out credit demand from the private sector, which is clearly not the central bank’s intended result. Thus, it appears that a rate rise is not feasible over the coming year, given the economic and market dynamics. China needs to calibrate its approach when designing policy in the coming year. While policy normalisation is clearly on the table, the PBOC is likely to prefer a gradual process. Hao Zhou is senior emerging markets economist at Commerzbank