China Money Policy easing may allow higher rates

SHANGHAI - China is loosening some areas of monetary policy as economic growth slows. But that isn't a signal to buy fixed-rate bonds -- the policy shift could eventually mean higher interest rates.

By (Reuters)

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Published: Wed 6 Aug 2008, 2:26 PM

Last updated: Sun 5 Apr 2015, 11:49 AM

As China slows appreciation of the yuan and expands commercial banks' corporate lending quotas, it may gain room to bring real rates closer to positive territory.

‘Slower yuan appreciation and the relaxation of loan controls could actually be a prelude for the central bank to shift monetary tightening towards interest rate policy later this year,’ says Felix Sun, fixed income analyst at UBS in China.

In most economies, higher interest rates would be unlikely to accompany monetary easing. But in China's complex but highly regulated money markets, where the central bank still resorts to elements of central planning to control loan growth, they are a distinct possibility.

The benchmark one-year bank deposit rate is at 4.14 percent and July consumer price inflation is estimated at around 6.5 percent. That means real interest rates are sharply negative, threatening over the long run to fuel inflation and encourage excessive investment in the stock and property markets.

But with continuous appreciation of the yuan luring billions of dollars of speculative money into China every month, the central bank has not dared to raise interest rates this year, for fear of attracting more inflows.


A changing policy environment, however, may give the central bank room to act in coming months. In the past 10 days, China's leadership has responded to an economic slowdown by signalling a shift towards sustaining growth from fighting inflation.

One element of the shift appears to be slowing appreciation of the yuan. The foreign exchange market is scrambling to cut back its expectations for long-term yuan appreciation -- on Tuesday, non-deliverable forwards implied as little as 3.15 percent appreciation of the yuan against the dollar over the next 12 months, down from a peak of 13.79 percent in March.

Many traders are talking of the possibility of continuous yuan appreciation ending around the end of this year. That could halt or even reverse net financial fund inflows into China, giving the central bank room to raise interest rates.

Meanwhile, officials said last week that they were expanding quotas for banks' corporate lending to aid smaller companies, and the central bank has adopted a slightly more generous stance in its money market operations over the last few weeks.

As it eases monetary policy quantitatively in those ways, the central bank may seek to balance that with modestly higher interest rates. Difficulty in obtaining loans has already been forcing smaller companies to pay well above benchmark rates, so a rise in the benchmarks would not necessarily hurt them.

In a monetary policy report late last month, the central bank stressed the need to be flexible, which the market took as a reference to its quantitative easing. But it added a sentence implying interest rate rises were quite possible.

‘We should let interest rate leverage play a reasonable role and steadily push forward interest rate reform,’ it said.


The possibility that interest rates could rise may be one reason that bond yields have not dropped much since it became clear in July that China was set to ease quantitative policy.

After a two-month uptrend, the indicative five-year government bond yield peaked at 4.2636 percent bid in early July, but it stood not far below that level at 4.2234 percent on Wednesday, Reuters Reference Rates show.

If it does decide to raise interest rates, the central bank could lift benchmark one-year deposit and lending rates, perhaps by roughly a quarter of a percentage point.

It might also allow yields at its weekly three-month and one-year bill auctions to rise, after keeping them flat for six months apparently because it did not want to widen the spread of Chinese yields above US yields.

The prospect of higher rates could increase demand for floating-rate bonds, especially since history suggests they are now attractively priced.

The spread of three-year, floating-rate policy bank bonds to the one-year deposit rate has been near 50 basis points in the last few weeks. Over the past year it has moved around 35 bps, hitting this year's low of 24 bps in March.

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