- In parallel to likely changes in trade barriers, China is in the midst of a policy shift…
- …that encompasses significantly looser monetary policy and a weaker exchange rate.
- CH10Y yield could trade in the range of 1.2%-1.5% over the next 6-12M; USDCNY at 7.50-7.80
China policy shift?
The last Politburo meeting (held on 9 Dec) – and broadly reiterated in the Central Economic Work Conference (CEWC) – illustrated shifts in policy reminiscent of those in 2009-2010. The authorities pledged to use “unconventional counter-cyclical policy adjustments” next year, changing the language on the aimed fiscal policy from “Pro-active” to “More pro-active” and aimed monetary policy from “Prudent” to “Appropriately loose”. These specific words were last used in the aftermath of the GFC.
In context, fiscal stimulus could end up being at least RMB 5tn (incl. bank recapitalization and refinancing of bonds) or 4% of 2024 GDP, over the next two years. This is clearly sizeable! Note however that this will likely be largely a supply/liquidity injection exercise; domestic consumption therefore should not be expected to rebound significantly. Concrete numbers will be released at the next National People’s Congress (NPC) in March 2025. Regardless, the incoming data on activity, investment and housing keep coming weak, underscoring the need for more urgency.
On the monetary policy front, more policy rate and RRR cuts are coming as well as the PBoC engaging in QE to supress yields from increased issuance.
In what follows I will explain why I think monetary policy will be eased more than expected, why Chinese yields will fall further and why USDCNY looks primed for new highs in 2025.
What does the shift in policy mean for yields/rates
The benchmark 7D repo rate (the policy rate tool) was cut 30bps in 2024 and stands at 1.5%, though the actual broad measure of 7D borrowing has been unchanged at about 1.9%; markets now price another c.30bps of cuts in 2025. However, this is likely to end up being considerably larger.
§ Persisting disinflation: at 0.2% YoY, headline CPI has undershot significantly the policy makers’ target of 3%; core is running even lower at 0.1% YoY; while import price growth is at -2.4% YoY. PPI has been consistently in deflation for the last two years.
§ As a result, the real policy rate has started rising again: it is now at 1.3% vs a pre-pandemic average of 0.8% (using actual inflation)
§ In the pre-pandemic period, real GDP growth run on average 600bps above the real policy rate (quite consistently); the gap has now almost halved to c.350bps, illustrative of a much tighter policy.
§ To loosen policy, authorities would have to steer the real policy rate (benchmark and market) towards the pre-pandemic average i.e. close to 0.8%, and maybe lower; with inflation running close to 0% that would imply lowering the policy rate (7D repo) by at least 50-70bps!
§ In parallel, increased issuance to fund the fiscal stimulus would need to be counteracted by QE: between Aug and Oct the PBoC purchased RMB 940bn of Chinese treasury bonds – the first time since 2011 that the central bank expanded its gov’t bond holdings (by c.50%…). This policy will likely be maintained/accelerate in 2025, otherwise increased issuance will push up short and long end yields – something that would defeat the purpose of easing.
§ Chinese 10Y yields (CH10Y) have fallen to new lows (below 1.8%) while the CH10Y-7D benchmark repo spread has dropped below 30bps (long term average of 62bps). To ensure loosening of monetary policies but also not allow the yield curve to flatten (significantly) it is reasonable to expect that the PBoC may opt for a spread of c.40-50bps, which would translate to a drop in CH10Y at 1.4-1.5%; lower if the repo rate is cut by more than 50bps.
On balance, a reasonable range for rate policy easing in 2025 is around 50bps-70bps (benchmark 7D repo rate) and CH10Y yields to drop in the range of 1.2%-1.5%.
USDCNY to new highs?
A quick prior on FX policy: China has been operating in a de facto USDCNY peg, in the range of 7.00 – 7.35. On a daily basis, it also calculates and publishes the RMB central parity against the USD, from which the currency is “allowed” to fluctuate in a (-2%, +2%) range.
In principle, China has been facing a choice between accepting lower growth in 2025 or shifting gear to more stimulus – so far it seems to have chosen the latter, without yet having clarity on the severity of US tariffs. This underscores one important aspect: irrespective of the size of trade barriers, China was slowing faster than policy makers anticipated and inflation showed barely any signs of a sustainable pickup.
Hence, the exact nature, scope and size of tariffs may result in a recalibration of the stimulus (to the upside) but the stimulus was needed regardless, to avoid a downward debt/deflation spiral.
Although it seems counterintuitive to engage in a policy of devaluation given China’s trade surplus, the confluence of export levies by the US and slow(er) growth/inflation suggest that currency weakness is almost inevitable. And the policy announcements/shift underscore the high likelihood of even lower rates and a consequential change in the FX peg-range.
§ When the RMB goes, it goes big; and depreciation is idiosyncratic, not just due to broader USD strength. Since 2015, policy shifts and/or shocks have led to USDCNY appreciations of 7%-15%; importantly, during these periods, USDCNY rose materially above levels that were implied by the broader dollar. For reference, USDCNY is now only 0.4% higher than its dollar-implied value.
§ Probably the most important metric to be watching going forward: the daily fixing + 2%. Since the US elections, this has hovered very close to the upper end of the de facto peg range (7.35). A sustained break above this would suggest an implicit change in the peg range.
§ Monetary policy easing by the PBoC should lead to a stronger USDCNY: pretty straightforward here and good to put some numbers in context:
- Since 2022, the US10Y-CHY yield differential has explained c.87% of USDCNY variation.
- Assuming unchanged US10Y and CH10Y at 1.45% (see discussion above) suggests USDCNY should rise above 7.50.
§ What about tariffs? The experience of 2018 suggests that a 10% tariff applied to $150bn worth of imports corresponds to roughly +1% move in USDCNY. If 60% tariffs are enforced on all currently tariffed products then this rule of thumb would suggest that USDCNY rises by about 6%; however, if 60% was applied to the entirety of goods imported by the US, the rule would suggest an impact of 15%. This is not to be taken literally but (1) it is a decent approximation of the impact on the RMB and (2) this impact would work on top of that due to monetary policy easing.
On balance, a target range for USDCNY would be 7.50-7.80.
China is a centralised economy with rates and FX heavily managed. So many of my assumptions above can turn out to be wrong. That said, the Politburo message is suggestive of a policy shift; historically, such shifts have produced material market moves. We shall see!
