China’s Monetary Policy and the RRR
Goldman Sachs analyst Hui Shan predicts that China’s central bank will reduce the reserve requirement ratio (RRR) in the third and fourth quarters. The RRR represents the amount of money banks must hold in reserve. This action is intended to address the risks associated with recent increases in bond prices. Shan stresses that the People’s Bank of China (PBOC) aims to manage, rather than reverse, the decrease in long-term yields.
Recent economic data and anticipated PBOC actions suggest a need for further stimulus to meet yearly targets. The central bank plans to continue lowering financing costs for businesses and individuals. Goldman Sachs forecasts a 25 basis point RRR cut in Q3 and a 10 basis point policy rate cut in Q4, contingent on a US Federal Reserve rate cut in September.
The PBOC is wary of a potential bond market bubble, particularly the risk of financial institutions accumulating excessive government debt. The central bank faces a challenge: managing the pace of falling long-term yields while maintaining bank profitability through a rising yield curve.
The Yuan Carry Trade
Investors closely watch yuan carry trades after the turmoil caused by unwinding yen carry trades. The yuan’s 2% appreciation against the dollar this month reflects increased investor caution. However, experts believe risks are manageable until domestic demand strengthens.
The yuan carry trade resembles classic carry trades, where investors borrow low-yielding currencies to invest in higher-yielding assets. China’s capital controls limit yuan carry trade compared to more open currencies like the yen. Chinese exporters often engage in yuan carry trades to accumulate dollar liquidity, while foreign investors may borrow yuan for mainland investments. Another variation involves using cheap offshore yuan to buy dollar-denominated bonds.
Before 2022, China’s interest rates exceeded US rates. However, the Federal Reserve’s aggressive rate hikes and China’s easing reversed this. Chinese exporters shifted earnings to dollars for higher returns, contributing to the yuan’s depreciation since April 2022.
Estimating the yuan carry trade’s size is difficult, but it’s smaller than the yen-funded market. Chinese exporters and multinationals hold over $500 billion in foreign currency since 2022. In June, foreign holdings of yuan-denominated onshore bonds reached a record $128.12 billion.
The yen carry trade’s unwinding raises concerns about the yuan carry trade’s viability. Short offshore yuan positions have declined due to the yuan’s correlation with the yen. Onshore carry trades could reverse if Chinese yields rise and interest rate differentials narrow, requiring stronger domestic demand. Currently, yields are falling as investors seek Chinese bonds.
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