The Chinese government no longer fears the Fed. In early 2016, turmoil on China's equity and currency

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The Chinese government no longer fears the Fed.

In early 2016, turmoil on China's equity and currency markets dented confidence in the country's economic policymakers. Foreign currency reserves were falling at an unprecedented rate and Beijing worried that any increase in US rates would further accelerate capital flight from China.

But the US Federal Reserve did not follow through on expected rate rises, in part because of the situation in China. The reprieve gave the People's Bank of China time to implement capital controls, which slowed capital flight, while a credit surge in early 2016 stabilised economic growth. As Jeremy Stevens, China economist for Standard Bank, puts it: "Last year the PBoC got an assist from the Fed."

This year the PBoC needs no such help. At its meeting on Wednesday, the Federal Open Market Committee is expected to raise its benchmark rate for the second time since March and third since December further narrowing interest rate and bond yield differentials between the world's two largest economies.

Most analysts expect the PBoC and State Council, which must approve adjustments in China's benchmark rate, to stand firm. "For now China needs to keep rates stable," says Yu Yongding, a prominent Chinese economist and former PBoC adviser. "There is no need to follow the Fed."

The PBoC's one-year deposit rate was cut six times in 2014 and 2015, from 3 per cent to 1.5 per cent, and has not been adjusted since. The US Fed Funds Rate, meanwhile, has been raised from 0.25 per cent to 1 per cent since December 2015, with a further quarter-point increase expected this week. The spread on Chinese 10-year sovereign bonds over their US counterparts fell from 150 basis points in December 2014 to less than 80bp after the Fed's March rate rise, although it has since widened.

In addition to the effectiveness of China's capital controls and strong year-on-year gross domestic product growth up 6.9 per cent in the first quarter the PBoC has proved that it can tighten monetary conditions through short-term open-market operations.

A day after the Fed's March rate increase, the PBoC raised rates on short-term reverse repurchase agreements, or repos, and loans from its medium-term lending facility by 10bp.

In announcing the reasons for its moves at the time, the PBoC cited lower real interest rates, improved corporate profitability and the Fed rate rise. Surging producer prices, which only turned positive in September after years of deflation, have made it easier for companies to service their debts.

"China has been able to use other tools," says Mr Yu, who adds that the expected Fed rate rise has been well telegraphed. "It won't have much of a market impact."

Repo and MLF rates have proven more effective than expected in the eyes of PBoC officials, as the yield curve on five and 10-year Chinese government bonds inverted in April for the first time and corporate bond issuance fell to a record low in May. Net corporate bond financing was negative Rmb217bn last month, as the amount of maturing debt dwarfed new issuances.

"PBoC officials are very concerned that the fall-off in bond issuance will affect economic growth," says one person familiar with internal PBoC deliberations.

"Short-term interest rates have already come up a lot in China and [tougher] financial regulation has meant a de facto tightening of financial conditions," Andrew Batson, head of China research at Gavekal Dragonomics, wrote in a recent note. "The central bank is unlikely to desire to see rates rise further."

The effectiveness of China's capital controls, which tightened checks on foreign exchange purchases and overseas remittances by companies and individuals, has given the PBoC another reason to worry less about rising US interest rates. After holding at about 6.9 to the dollar for most of the year, the renminbi has risen 1.4 per cent since late last month an unusual surge for the carefully managed currency.

As a result, says Andrew Polk at Trivium, a Beijing consultancy, "the PBoC has blown up expectations around the renminbi". Late last year, many analysts were expecting the renminbi to fall to 7.3 against the dollar if not lower.

Renminbi strength has had the added benefit of lowering trade frictions with the US. Presidents Donald Trump and Xi Jinping agreed at their first meeting in April to a 100-day timetable for a series of trade and economic negotiations.

A weaker renminbi would have added to bilateral trade tensions. Renminbi strength has also been bolstered by Mr Trump's turbulent first months in office. Lower expectations about his administration's ability to deliver on tax reform and infrastructure stimulus have weakened the dollar, which has fallen almost 8 per cent against the euro since January.

The European Central Bank has started to hold foreign exchange reserves in renminbi in what amounts to a seal of approval for Beijing's ambitions to internationalise its currency.

The ECB invested 500m of its reserves in renminbi-denominated assets during the first half of this year, reflecting China's importance as one of Europe's largest trading partners, the bank said on Tuesday.

While the 500m amount is just a sliver of the ECB's 68bn forex reserves, the purchase of renminbi assets reflects the growing acceptance in Europe of China's status as a global economic superpower along with a desire to build closer ties with one of the world's largest economies.

The ECB is the most powerful central bank to date to invest in renminbi.

"The ECB's investment is modest in size but has huge symbolic significance," said Eswar Prasad, a professor at Cornell University. "For the central bank behind the euro, the world's second most important reserve currency after the dollar, to hold renminbi assets in its own foreign exchange reserve portfolio speaks volumes about how far the Chinese economy and its currency have come."

The ECB's investment is modest in size but has huge symbolic significance

Eswar Prasad, Cornell University

The purchases follow a decision taken behind closed doors by the ECB's governing council in January but not announced until the purchases were completed.

Mr Prasad added: "Everybody wants to be friends with China. The ECB's actions can be seen as downpayment for establishing stronger trade and financial links."

The ECB also invests in dollars and yen as well as gold. It sold dollars to fund the renminbi purchases but still holds the majority of its foreign-exchange reserves in the US currency.

The popularity of the renminbi has risen since the International Monetary Fund in 2016 included it alongside the dollar, the euro, the yen and the pound in its "special drawing rights" basket of the most important global currencies.

Other central banks including the Swiss National Bank have also bought assets denominated in the Chinese currency. As low-risk investors, central banks have tended to purchase safer assets such as government bonds.

"It's an important signal that the ECB is not immune to the broader trend," said Ousmne Mandeng, a researcher at the London School of Economics. "Though the numbers are rather small it's a very modest start."

The ECB started to consider investing in renminbi as early as 2014, with a discussion in the governing council during the autumn of that year.

As well as setting interest rates and supervising lenders, central banks are responsible for investing trillions of dollars in of reserve assets, built up through interventions in currency markets and as a buffer to protect against liquidity shortages in foreign currencies.

According to IMF data, public officials manage reserves worth $10.8tn. Some of those investments are held in the form of gold, but more than $5tn is in dollar-denominated assets such as US Treasury bonds, reflecting the US's role as the sole global economic superpower during much of the latter half of the 20th century.

Some $1.5tn is held in euros and smaller amounts, in sterling and yen.

Purchases of China's currency by global central banks have lagged behind its rise as an economic power in part because of the restrictions Beijing places on foreign investments into China and the currency's fixed exchange rate. A greater share of reserves is still held in currencies of smaller economies such as the UK, Australia and Canada.

"It is remarkable that a currency that does not yet have a market-determined exchange rate has become a de facto as well as de jure reserve currency," said Mr Prasad. "[But] it is difficult to envision the renminbi making the leap to a major reserve currency in the absence of major reforms to China's financial markets, exchange rate regime and overall economic and institutional structure."

1. Why does the PBoC fell elss pressure to follow the Fed in raising short term interest rates now than it did 18 months ago?

2. What happened to the renminbi/dollar exchange rate between the beginning of 2014 and the beginning of 2017? http://www.xe.com/currencycharts/?from=USD&to=CNY&view=10Y

3. What effect did this have on the US-Chinese trade balance?

4. Why do you think that this change occured?.