The firebreak between mounting economic threats and a continuation in the global recovery: an imposing concrete and glass structure in the heart of Beijing’s financial district, elephant statues guarding the door, the Chinese flag flying above.
That is the headquarters of the People’s Bank of China (PBOC), which, in contrast to the US Federal Reserve, has shifted to stimulus mode to shield the world’s biggest growth engine from the China Evergrande Group property slump, COVID-19 lockdowns and higher global borrowing costs, as the Fed tightens.
Tasked with staving off destabilizing unemployment and a debt implosion, the Chinese central bank, headed by PBOC Governor Yi Gang (易綱), has a newfound autonomy unthinkable a decade ago that might prove crucial in keeping the country’s expansion humming above 5 percent this year.
Illustration: Louise Ting
It is summed up in a new mantra heard from China’s economic policymakers, roughly translated: “We set our own agenda.”
Decades of stop-start reform have led to freer currency movements and more refined capital controls, meaning that even as the Fed speeds toward its first rate increase since 2018, China’s central bank has the autonomy to move in the other direction.
Having avoided the all-out stimulus of Western peers when COVID-19 first struck in early 2020, the PBOC finds itself with dormant consumer prices and room to “open the monetary policy toolbox.”
For China, that sets the stage for a triple dose of support from increased lending, lower borrowing costs and — potentially — a weaker yuan that would boost exports.
The PBOC has already made a down payment on rate cuts, and most economists expect more to come.
By China’s normal standards, the prize for successful stimulus would be small — more preventing a continued slide in growth than driving a fresh acceleration.
Past policy errors — allowing a debt bubble to expand to enormous size — add risk to the outlook and a constraint on the PBOC’s freedom of maneuver.
However, if Yi and his team can pull it off, the boost from PBOC stimulus should offset at least some of the drag on global growth from Fed tightening.
IMF projections showed that China is set to contribute more than one-quarter of the total increase in global GDP in the five years through 2026, exceeding the US’ estimated 19 percent share.
Those with most exposure to China’s economy — commodity exporters such as Australia and Asian neighbors such as South Korea — would breathe the biggest sigh of relief if efforts at stabilization succeed. Countries with weaker ties to China, but more exposure to risks as the Fed tightens — such as Mexico and Turkey — have less to gain.
Many investors are betting on a rebound in Chinese assets after the MSCI China Index of stocks lagged the S&P 500 by 49 percentage points last year, the biggest gap since 1998.
Strategists at Goldman Sachs, BlackRock and HSBC are among those to have turned bullish on the country’s stocks.
Diverging PBOC and Fed policies reflect diverging trajectories for the Chinese and US economies.
PRICE PRESSURE
In the US, a combination of high energy and food prices, supply shortages and rising rents has pushed the consumer price index to 7 percent year-on-year.
Markets now view a first Fed rate increase in March as close to a certainty, with the hawkish tone from Fed Chair Jerome Powell at this month’s US Federal Open Market Committee news conference confirming the view.
Bloomberg Economics forecasts four more over the course of the year, as well as a speedy start to running assets off the bloated balance sheet.
The PBOC is moving in the opposite direction. Its 10-basis point cut in borrowing costs and a pledge to use additional tools was a clear signal that the priority has shifted away from reining in financial risks and toward supporting growth.
The biggest drag comes from the sector that was once China’s most reliable growth driver — real estate.
A default by giant developer Evergrande has shaken market confidence, tightening financing conditions. Sales and new construction are now falling at a rapid clip. With property contributing — directly and indirectly — about one-fourth of GDP, that is set to weigh on everything from demand for iron ore to spending on home electronics.
Then there is the virus.
With an outbreak in Xian triggering more COVID-19 cases than any time since the initial wave at the start of 2020, and the arrival of global athletes for the Beijing Winter Olympics adding to the petri dish, there is the risk of further lockdowns.
As the experience of an outbreak in the summer of last year demonstrated, even short-lived and targeted measures to control the spread of the virus can take a severe toll on consumer spending.
Pull those pieces together, and China again faces the risk of a significant blow to growth.
However, a repeat of the massive contraction in output seen at the start of 2020 seems unlikely. Still, the combined impact of national property slump and local lockdowns could be severe.
In its recent financial stability report, the PBOC envisioned a worst case where growth this year drops close to 2 percent — way below the consensus forecast of 5.2 percent and below even the most pessimistic forecast in Bloomberg’s survey of economists.
For the central bank, the best chance of steering away from such dire scenarios lies in harvesting the fruits of past reforms.
IMPOSSIBLE TRILEMMA
It is an idea from the academy that — from former PBOC governor Zhou Xiaochuan (周小川) to his successor, Yi — has held an enduring fascination for top central bank officials: the impossible trilemma. That is a theory that an economy cannot control its exchange rate, open to cross-border capital flows and set its own interest rates at the same time — it must pick two of the three.
China’s experience illustrates why.
In 2002, when Zhou took over at the helm of the central bank, the yuan was pegged to the US dollar. The capital account was closed in theory, but in practice it was easy to dodge controls and move funds in and out of the country.
As a result, the PBOC found itself on the horns of the trilemma, with limited monetary policy independence. Set interest rates too high relative to the Fed, and there would be massive capital inflows. Too low, and capital would flow out.
With the yuan undervalued, interest rates confined within a narrow range, and crude credit quotas were the main instrument for managing the ups and downs. The economy ran hot and asset prices soared. The seeds of later problems — like the Evergrande property bubble — were sown.
The move toward more market-driven exchange rates began in 2005, with a one-off 2 percent appreciation against the greenback.
The road ahead was far from smooth. Slow progress was a constant source of irritation for the US — which saw an undervalued yuan as an unfair source of competitive advantage for China’s exporters.
FAIR VALUE
Some reform steps misfired — as when a mini yuan devaluation in 2015 triggered a global market panic. Even so, in the years that followed — with stops, starts and major missteps along the way — the PBOC moved the yuan toward fair value, and all but eliminated day-to-day intervention in the market.
That painstaking process has shifted China to a new regime with a close-to-market exchange rate, targeted capital controls, and monetary policy that is now more autonomous from outside influence.
“Because China’s exchange rate policy has become more flexible, maintaining monetary policy independence has become much easier,” said Yu Yongding (余永定), a former PBOC adviser and long-time champion of yuan liberalization.
His old colleagues agree. In their monetary policy report at the end of last year, the PBOC cites yuan flexibility as one of the big reasons for resilience as the Fed tightens.
A refined set of capital controls also play a role. Even as China allows more two-way movement in its currency and more global investors in to snap up its assets, strict controls remain on individuals’ and companies’ ability to move money abroad.
A shift in economic wisdom in the West over the past decade has seen the IMF endorse capital controls it had once called for countries to abolish.
For China, the benefits of reforms cannot arrive soon enough. Lower borrowing costs and abundant liquidity would help prevent contagion from the Evergrande default spreading too far. They should also stoke investment — offsetting at least some of the drag as property construction slumps.
In the past, if lower rates drove yuan weakness, that would be a panic signal, requiring the PBOC to wade in to stabilize the market. Now, with acceptance that the yuan is a two-way bet, currency weakness would be an additional benefit by helping drive export earnings.
For the rest of the world, the looming threat of accelerated Fed tightening is a stumbling block on the path to recovery.
Never one to miss an opportunity to present his country as a force for stability, Chinese President Xi Jinping (習近平) used his speech to the World Economic Forum in Davos, Switzerland, this month to warn of “serious negative spillovers” when the Fed slams on the brakes.
The problem is especially severe for China’s fellow emerging markets, which face the prospect of capital outflows as US rates rise.
The prospect of PBOC stimulus stoking Chinese demand promises at least a partial offset, especially for countries such as Chile and Brazil that count China among their biggest export customers.
For Asia’s central banks and financial markets, divergence between the Fed and the PBOC would — over time — introduce a new dynamic to navigate.
As China’s financial system opens wider, PBOC policy would start to exercise an influence on Asian markets that collides with that of the Fed.
From Seoul to Jakarta, central bankers and foreign-exchange traders would have to decide whether it is US or Chinese policy that is the stronger anchor.
Already, some regional currencies are tracking the yuan more than they used to.
Success at stabilizing the economy is far from guaranteed. The PBOC’s progress on reforms came too late to prevent an explosion in debt, which now stands at close to 285 percent of China’s GDP.
The consequences of that are evident in the Evergrande debacle, and the need to deflate the bubble constrains capacity for stimulus.
In a worst-case scenario for COVID-19 — with widespread contagion triggering a new national lockdown — no amount of rate cuts or yuan depreciation would prevent a plummet in output.
Still, at a critical moment, the PBOC’s patiently pursued reforms have bought China at least a little more space for stimulus.
Will it be enough? China’s leaders, emerging markets warily eyeing Fed tightening and investors focused on the risk of debt crisis hope the answer is yes.
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