China-US monetary policy divergence – Implications for Asia

China’s growth momentum has been falling since early 2021 amid a flurry of regulatory tightening. Shifting to a policy easing bias, the People’s Bank of China cut banks’ reserve requirement ratio.
Chi Lo

Senior Economist Greater China

BNP Paribas

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Diverging macroeconomic policies in China and the US have created market volatility recently amid concerns that China’s growth slowdown could spill over into Asia and a less generous US central bank could mean tighter US dollar liquidity for the region.

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How do policies diverge?

China’s growth momentum has been falling since early 2021 amid a flurry of regulatory tightening. Shifting to a policy easing bias, the People’s Bank of China cut banks’ reserve requirement ratio (RRR) in July 2021 by 50bp, marking the first cut since April 2020. This released an estimated RMB 1 trillion into the Chinese system.

China’s monetary policy matters for Asia as it affects China’s growth which, in turn, has an impact on Asia through the trade and supply-chain channels. It also affects the commodity market via China’s investment demand.

Meanwhile, the US Federal Reserve went in the opposite direction in July with its ‘dot plot’ of policymaker expectations pointing to interest rate increases sooner than thought and by extension to the Fed tapering its pandemic-era aid for the economy in the run-up to a rate rise.

The Fed’s policy matters for Asia as it impacts US growth, which in turn curbs Asian exports. It also has an influence on global liquidity conditions and, thus, Asia’s sources of external funding.

There are reasons to believe that this divergence in policy between the US and China may not be bearish for Asia. The PBoC is expected to continue easing liquidity selectively. This should mitigate the downside risk of a growth slowdown in China and, hence, Asia.

Meanwhile, Asia may benefit from a gradual policy normalisation by the US Fed since this would reflect stronger US growth, even if US interest rates were to rise.

China’s policy impact

Despite market worries that China’s regulatory tightening might have gone too far and may result in policy overkill that would crush GDP growth, there is evidence that China has great policy flexibility to manage macroeconomic risks and balance its policy goals.

When Covid-19 hit at the end of 2019, Beijing shelved all deleveraging and structural reform initiatives and switched to a prudent expansionary policy to protect GDP growth.

However, it did not enter into large-scale quantitative easing (QE) as many developed market central banks did. It shifted to a tighter policy bias in late 2020 after the economy recovered from the Covid shock and refocused on deleveraging and regulatory reforms.

As headwinds to growth have intensified again since Q2 2021 due to Covid flare-ups and the regulatory tightening effects, policy has returned to an easing bias.

Against almost all analysts’ expectations (except ours) of a tiered (or selective) cut in the RRR in July, the central bank delivered a blanket cut, signalling a clear policy shift. As growth momentum slows and regulatory tightening intensifies, there will likely be more moves to ease liquidity. This should help stabilise economic growth.

Measures may include an acceleration in government bond issuance and the PBoC injecting more liquidity via the RRR, its open market operations and its lending facilities.

There may not be any cuts in official interest rates since that could be too strong a policy signal. It would go against Beijing’s debt reduction and structural reform initiatives.

With an increasing share going to China, exports have led Asia’s post-Covid growth recovery. Granted, some exports concern components destined for third markets via China, but other exports cater for domestic demand.

Slower, though sustained, growth in China should help support external demand in Asia. More infrastructure investment in China, funded by increased local government bond issuance, should also benefit Asia and the commodity market in general in H2 2021 since capital spending typically involves more imports than consumer spending.

The Fed’s policy impact

The potential for Fed policy to disrupt markets will depend on the pace and magnitude of the rise in US real (inflation-adjusted) rates. There are reasons to believe that the pace will be slower and the magnitude smaller this time.

Learning from the 2013 experience, when US real rates rose by 150bp in four months, the Fed now appears to prefer a longer lead time between communicating its tapering intentions and the actual tapering, and between the actual tapering and policy rate rises. The Fed’s new inflation targeting framework is also more dovish than before.

Asia’s macroeconomic fundamentals are also crucial for determining whether regional economies would be hurt by rising US rates or benefit from the stronger US growth that would prompt the rate rises. For example, Asian growth benefited from strong US demand between 2003 and 2006 without being hurt by rising US rates and without being forced into a disruptive rate rise cycle itself.

However, in the 2013 ‘taper tantrum’, Asian growth suffered due to weak macroeconomic fundamentals. These included high inflation and large external deficits. This put downward pressure on regional currencies and forced some Asian central banks to tighten monetary policy.

This time, Asia’s macroeconomic fundamentals look mostly better: inflation is lower, current account deficits are smaller and currency reserves have grown.

The risks

Of course, if Beijing’s policy shift crushes China’s GDP growth unexpectedly or US inflation turns out to be higher and more persistent than expected, Asia would suffer a double whammy from the world’s two largest economies through both trade and global liquidity linkages.

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China-US monetary policy divergence – Implications for Asia