Ashmore’s Jan Dehn: Four important developments in China

29th October 2015

Jan Dehn, head of research at Ashmore, examines how there have been four important developments in the world’s second largest economy…

Four important developments have taken place in China. Firstly, China completed the full liberalisation of bank interest rates by completely eliminating the ceiling on deposit rates.

This was a target for 2015 and has been achieved ahead of schedule. Commercial banks can now compete to attract deposits. China has cleverly timed interest rate liberalisation to take place in an environment of falling inflation, so that real rates have risen in the context of declining nominal yields.

As China’s economy becomes more consumption driven, interest rates will become the single most important tool of macroeconomic control.

This is also why China is developing its bond market, notably via the municipal bond market. With freely determined bank rates and bond yields, the People’s Bank of China (PBOC) will be able to transmit its interest rate changes to the broader economy along the entire term structure. By eliminating the ceiling on deposit rates, China has shown once again that it has no intention whatsoever of changing the pace or direction of reform.

The second important development in China was that the PBOC cut interest rates by 25bps and reserve requirements by 50bps. China’s economy is slowing on the back of deep reform efforts designed to rotate the economy from export to consumption led.

The reforms create transitory uncertainty resulting in postponement of investment and consumption decisions. China has plenty of means of easing policy in order to support growth during this transition. This is a good environment for bonds.

Five year government bond yields have fallen from 4.5% in early 2014 to 2.9%, but real rates remain significantly positive given China’s inflation rate of just 1.6%. In a positive sign, house prices in China rose 0.5% in September, a similar rise to that recorded in August, while the number of cities with declining home prices fell to 17 from 23 (out of 70).

The third important development was that Britain and China took the first steps to set up a stock-connect scheme that would link the Shanghai and London stock exchanges.

This is an extremely important and positive development. The UK government – far more so than the US government – appears to have understood China’s importance as it opens its economy and the Renminbi (RMB) becomes a global reserve currency. This may be because London is the world’s main hub for global currency trading. In a world flooded with QE money, exchange rate trading will only become more and more important.

China’s RMB has most to gain in this environment, because it is destined to become the next major global reserve currency. Unlike most of the existing reserve currencies, China is not printing money ad nauseum and it is certainly not shying away from reform. This guarantees the rise of the RMB and much of this rise will happen in London. China is therefore 100% right in focusing so strongly on the relationship with Britain in general and London in particular.

Finally, unidentified Chinese officials said last week that the IMF is close to final approval of the RMB’s inclusion in the Special Drawing Right (SDR) basket. The US government recently dropped its political objections, leaving only a small number of technical criteria to be satisfied.

This should not surprise too much. The value to China of becoming a global reserve currency is difficult to overstate. The plenum to adopt the 13th Five-Year Plan is likely to adopt 2020 as the target data for full dismantling of capital controls. This is not a pre-requisite for SDR inclusion.



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