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Riccardo Matteotti

How the Chinese central bank responds to war and COVID restrictions

The People’s Bank of China has the main goals of maintaining financial stability and fostering economic growth in the country. The tools can be the conventional changes in interest rates, issuing Renminbi currency (Yuan), regulating interbank lending and interbank bond market, and finally, managing foreign exchange and currency transactions.

Inflation in China has followed a different path from that of Europe and the United States. After a long period of low and stable inflation (2012-2019), at the end of 2019, a spike in inflation occurred, then COVID negatively impacted the level of prices, but the PBOC has been able to keep the inflation rate not far from its historical levels (as shown in the graph above).

China was not impacted as the US by inflation, as the country’s growth was severely affected by COVID-related restrictions, and not even exogenously impacted as the EU, thanks to the preferential treatment granted by Russia in the supply of oil.

The two issues the PBOC had and will have to face soon are: keeping exchange rates competitive against the American and European increase of interest rates and favoring the economic restart after the long period of restrictions.

The Chinese economy gave positive signals at the beginning of the year and the Central Bank did not want to lose the “economic momentum”. Therefore, on March 27th the PBOC applied a 25 basis points cut in the reserve requirement ratio, bringing it to a value of around 7.6%. The goal is to apply macro policies that improve liquidity and access to credit, favoring lending by banks and so encouraging economic recovery. This choice was unexpected by the markets, especially after the failure of regional American banks and the hundreds of billions of yuan already injected into the system mainly through medium-term lending facilities.

China has set a target of around 5% for economic growth in 2023, taking into account the lower-than-anticipated growth rate in 2022 (the target was 5.5%, which turned out to be 3%).

Moreover, in the past weeks, the governor of the PBOC, Yi Gang, announced: “The current level of real interest rates is relatively appropriate” driving investors’ expectations, he also said that priority will be given to maintaining currency value and financial stability, as this promotes full employment and economic growth.

Regarding exchange rate policies, it's important to note that the Chinese Yuan has been pegged to the US dollar since 1994 (it can float around 1% every day), which is different from what most of the advanced economies have, which is floating exchange rates (as the dollar itself). The goal is to keep the exchange rate low and favor Chinese export, meaning that the Chinese currency is undervalued and buying goods in Chinese currency is attractive to the rest of the world. To achieve this goal, the PBOC needs to buy dollars and sell yuan (China Foreign Exchange Reserves are projected to trend around 3180000.00 USD Million in 2024).,according%20to%20our%20econometric%20models.

Currently, China’s policy of pushing export, after the strong decrease during the COVID years, is favored by the growing American and European interest rates, which are strengthening the respective currencies. The graph above shows Chinese exports through the years.

What will the PBOC do in the near future?

Similarly, as before COVID, also before the 2008 world crisis the PBOC was cautiously appreciating the Chinese currency; however, during the 2008 crisis, Chinese exports sharply dropped (as shown in the graph), and to stimulate them, the Chinese authorities halted the yuan’s appreciation, the appreciating policy was later resumed in 2010.

So, the Chinese authorities may follow a similar approach to stimulate their demand again. It should, nevertheless, be considered that in the early 2010s, the US and Europe were decreasing interest rates, as a stimulus to the economy was needed at that time, following an opposite trend compared to today’s situation.

Therefore, it's difficult to predict the PBOC's future moves. However, given the cut in the reserve requirement ratio and the large amounts of money already injected into the financial system until December, it seems likely that monetary policies will continue to be expansionary, which will favor China's economic recovery.

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