Fed inaction broadens China options

The US Federal Reserve held its benchmark interest rate steady at 3.75 percent to 4 percent on Wednesday, in line with market expectations. The move gives China greater room to maintain a moderately accommodative monetary stance, while balancing support for domestic demand with the need to safeguard renminbi stability and contain financial risks.

Cheng Shi, chief economist at ICBC International, said although the Fed has paused its rate hikes, its continued commitment to a relatively tight monetary policy means external financial constraints on China remain in place.

"However, the impact of these constraints on China's exchange rate, interest rates and financial markets has weakened, giving Beijing greater room to maneuver in managing its economy," said Cheng.

China's growing monetary policy autonomy is becoming increasingly evident. While long-term real interest rates in the United States remain elevated and external financial conditions are unlikely to ease significantly in the near term, Chinese government bond yields have become progressively less sensitive to movements in US Treasury yields. This suggests that changes in interest rates abroad are having a diminishing direct impact on domestic financial conditions, he said.

"The trend gives Chinese policymakers greater flexibility to maintain the principle of 'putting domestic priorities first', allowing monetary policy to focus more fully on supporting economic growth, stabilizing prices and meeting financing needs," Cheng added.

The renminbi — also known as the yuan — has also become less vulnerable to external interest rate pressures. Since the beginning of the year, the Chinese currency and the US dollar have strengthened simultaneously, while the renminbi's sensitivity to changes in the China-US interest rate differential and the US Dollar Index has declined significantly.

This suggests that the Fed's decision to keep rates high does not necessarily translate into sustained depreciation pressure on the renminbi. The currency is expected to remain broadly stable at a reasonable and equilibrium level, Cheng said.

Liu Tao, a senior researcher at the international finance research institute of the China Chief Economist Forum, said, "The Fed's decision to hold rates steady will ease external liquidity pressures on China in the near term, but it amounts to a 'hawkish pause' rather than a definitive easing of external constraints."

Liu said pressure on the renminbi is likely to ease in the near term, adding that its performance is underpinned by China's trade surplus, the conversion of export earnings into renminbi and seasonal factors, rather than being driven solely by the China-US interest rate differential.

For policymakers in Beijing, the latest decision by the US central bank provides a more favorable window to manage domestic liquidity, but it does not fundamentally change China's monetary policy priorities.

"China has long adhered to the principle of putting domestic priorities first and will not passively follow the Fed's lead," Liu said.

Nevertheless, the substantial inversion of the China-US interest rate differential and market expectations of a possible Fed rate hike in December could constrain Beijing's room to cut policy rates.

"Going forward, China is likely to rely more heavily on structural monetary policy tools, government bond purchases and sales, and potentially cuts to the reserve requirement ratio, rather than rushing into broad-based interest rate reductions," he said.

Liu Chunsheng, an associate professor of international economics at the Central University of Finance and Economics, said pressure from the China-US interest rate differential could make cuts to the RRR preferable to interest rate reductions, as they inject longer-term liquidity into banks while exerting less pressure on the renminbi.

He expects the Chinese currency to remain relatively strong in the near term, although two-way fluctuations will remain the norm even if the Fed resumes rate hikes.

Alongside a moderately accommodative monetary stance, the People's Bank of China — the country's central bank — may make greater use of its exchange rate management tools to reinforce expectations of two-way movements of the renminbi. Monitoring cross-border capital flows and guarding against excessive exchange rate movements driven by one-sided market expectations will also be important to prevent abrupt inflows and outflows of short-term capital from destabilizing domestic financial markets, Liu Chunsheng said.

Contact the writers at jiangxueqing@chinadaily.com.cn