MARKET UPDATE: China Tightens Monetary Policy

Before we discuss the changes in China’s Monetary policy, summarised in the latest blog by Mitul Kotecha, Head of Global Currency Strategy at Calyon, we thought it valuable to outline the differences in the way the People’s Bank of China (PBoC) operate monetary policy relative to major central banks in the West...

 Western central banks set a benchmark “prime rate”, which is a reference interest rate at which banks can borrow, usually with an applied margin. Consumer mortgage rates are usually expressed as some formula of this rate. In the UK this is termed the Base Rate, in the US it is the Federal Funds Rate and in the Eurozone this rate is referred to as the Refinancing Rate. In China, there is no “prime rate” because China’s currency is pegged against a basket of other currencies. As a result, there must be flexibility in their short term “prime rate” in order to allow for the peg to be effective. Therefore the PBoC do not set a benchmark “prime rate”
 Instead, the PBoC have a number of other monetary policy instruments, including a Reserve Requirement Ratio that commercial banks must adhere to. On Tuesday of this week, the PBoC increased this ratio by 0.5% which is seen as a move to manage inflationary expectations and avoid a recurrence of the lending boom. The Reserve Ratio is the percentage of cash commercial banks must keep on their balance sheet in relation to the amount of deposits they take from their customers. By increasing this ratio, the PBoC are reducing the amount of capital available to commercial banks in China for lending to consumers and businesses
 This is also seen as the first of many moves to be made by the PBoC to tighten monetary policy

The effects on the markets have been summarised by Mitul Kotecha’s article;

 Risk appetite has soured due to a combination of the rise in China’s reserve requirements, disappointing earnings including Alcoa and a profit warning by Chevron, setting the scene for a day in the red for Asian markets
 All eyes are on China and markets will now look to the implications for CNY policy
 Increasingly it seems that data and policy in China is driving global markets and aside from the hike in reserve requirements this was also evident in the fact that stronger trade data over the weekend helped to counter the impact of the soft US December payrolls report

To view the full article, please click here to visit The Econometer website