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The Big Conversation

Episode 122: Does China change things for the FED?

This week Jamie McDonald looks at the dramatic move in the Chinese Yuan that has sparked a response from the People's Bank of China. Between Covid lockdowns, a deteriorating economy, and policymakers' attempts to support the economy, the recent developments in China have introduced a new set of factors to be considered by the US Federal Reserve. In the Chatter, Jonathan Ashworth of Fathom Consulting discusses the impact China's lockdowns may have on inflation and whether this will derail or accelerate the Fed's current tightening plans.

  • Jamie [00:00:00] It finally happened. Nope. Not Elon Musk buying Twitter, but arguably something more important for US investors. China's central bank, the PBOC, has taken steps to stabilise the Chinese Yuan, which could be yet another factor for the Fed to consider as they try to predict whether a material slowdown in China is on the cards. Well, that's today's Big Conversation.

    Jamie [00:00:55] Over the last few weeks, the Chinese Yuan has come under pressure as investors weigh COVID lockdowns and the potential negative impact on the country's economy. Now, for the most part, policymakers have remained relatively quiet on the matter until Monday, when they announced the forex RRR move. Now, initially, the Yuan strengthened against the dollar, but where we go from here remains to be seen. Now, careful here, as there are a lot of misconceptions about what this means. For starters, a lower forex RRR means that banks in China are required to hold fewer foreign exchange reserves. Now, this allows banks to sell foreign currencies such as the US dollar, which can help stabilise the falling value of the Chinese Yuan. But this is different from the policy rate RRR. This is not the reserve requirement ratio banks need to implement for lending activities. The policy rate RRR is typically viewed as a cyclical tool where the central bank can increase the lending capacity, pro-cyclical or reduce lending activity. Now the former is naturally aimed at increasing economic growth, whereas the latter is typically used to rein in excesses. In fact, China had been reducing its lending activity throughout 2021, focusing on sectors like real estate development. However, with its zero-tolerance policy, a rapid pick up in COVID cases is forcing many parts of China's economy back into strict lockdowns. And it's these lockdowns that act as a drag on economic activity and thus policymakers are responding with pro-cyclical measures such as increasing lending activity. To be clear, though, the PBOC has recently made a slight reduction in its bank lending rate from 11.5 to 11.25%. But the question remains is Monday's announcement of a full one percentage point decrease in the forex RRR another step from China to stimulate growth? On the surface, it doesn't appear so. If anything, a reduction in the forex RRR looks to be nothing other than an attempted currency intervention as policymakers aim to stem panicked outflows from the region. But make no mistake, this distinction has wide-ranging implications. A dramatic currency intervention, like the one we saw on Monday, might suggest the economic situation is far worse than investors currently believe. And if so, there are questions as to whether these recent developments would derail the US Federal Reserve's plans to keep raising interest rates this year, when a dramatic slowdown in China acts as a drag on demand and by extension, cause an easing of inflation. Or will the lockdowns in China exacerbate inflationary pressures due to supply chain disruptions that were at the heart of price pressures during the initial onset of COVID? Needless to say, there are many variables at play and these are questions that we don't have answers to yet. Fortunately, though, I had the chance to sit down with Jonathan Ashworth, senior economist at Fathom Consulting, and an expert on China and Central Bank response.

    Jamie [00:04:22] Hey, Jonathan, how are you? And welcome to The Big Conversation.

    Joanthan [00:04:24] I'm very well, Jamie thank you very much, and thanks for having me on your show.

    Jamie [00:04:28] Good, good. Well, today we're talking China. And a couple of things, we've been looking at the effect that the recent lockdowns have been having and whether that's an inflationary pressure as it relates to the US, but also we've been looking at the decision on Monday, which was from the Chinese Central Bank, looking to potentially stabilise the Chinese Yuan. So I know you're a bit of an expert on central banks and China. I'm wondering how significant you think those two factors are with the way in which it relates to the Fed and the way the Fed is going to think about it. It's its rate rate hiking?

    Joanthan [00:05:03] Well, I think what's going on in China at the moment is quite significant. The economy had already been very weak in China amid the problems in the real estate sector. And now China is experiencing the largest surge in COVID 19 cases since early 2020. This is clearly weakening the Chinese economy much further, and they're going to really struggle to hit their growth target for 2022. I think in the present time, the authorities are really worried about capital flows from China, renminbi weakening, given the fact that the Federal Reserve is tightening monetary policy at the same time as the PBOC is easing policy. So they're very worried about capital outflows and they're trying to stabilise the currency at the present time. All that being said, as you know, China's super important for the global economy and global financial markets, but it's not going to be that, its actions are going to be that important for the Fed at the present time. Absolutely key focus for the US Federal Reserve is domestic developments. As you know, inflation in the US at the present time is in the highest since the early 1980s. The labour market is absolutely red hot in the US, but monetary policy is still extraordinarily easy. So the Fed has got to quickly tighten policy to try and prevent further overheating of the economy. So events in China in the short term are not going to have a big impact on the Fed.

    Jamie [00:08:03] Well, Jonathan, thank you so much for your time. It's been really helpful to hear your point of view. Thanks for joining us.

    Joanthan [00:08:08] Thanks, Jamie.