On Monday, April 11, 2022 – for the first time in twelve years – the spread between Chinese 10-year bonds and the comparable US Treasury didn’t just close but turned negative. Last occurring in June 2010, our experts explore what this means for U.S. vs China Interest Rate Parity.
For years, Chinese government bonds had paid significantly higher yields than US Treasuries. This has been a major attraction for international investors. However, that advantage has since disappeared. The yield on the 10-year US Treasury closed at 2.779% on Monday, April 11, 2022, while the yield on China’s 10-year government debt closed at 2.767%.
Fundamentally, we know the economic relationship between risk assumption and return generation; the more risk assumed, the greater the return. This then brings up a key question: what may we (potentially frighteningly) deduce from this current global assessment of essential parity between the US and China’s ability to borrow 10-year funding?
The Reasoning Behind Rates
Personally, I wouldn’t read a tremendous amount into what some may see as cause for concern, and this is for a couple of reasons:
First, when we’re talking about the return on U.S. Treasuries, the general assumption is that they are the risk-free rate. Here we’re talking about the nominal rate as opposed to the real Treasury Inflation-Protected Securities (TIPS) rate. So, the first implication is actually a good one. China’s debt would appear to be risk-free as well, assuming all other things are equal.
Now, the other question here is whether the Chinese rate is quoted in dollar-denominated bonds or in Yuan. If the latter, then we need to worry about expected changes in the exchange rate. If there was no expected change in the exchange rate, then the expected rates would be equal and we could conclude that there’s no risk premium in either rate.
Japanese Bonds as a Case Study
However, Japanese bonds come in at 0.25%. That suggests that all the rates quoted are in nominal terms and are in the domestic currency – the standard way that rates are generally quoted. But then we need to return to Interest Rate Parity (IRP). That is, we should expect interest rates across countries to be equal if two conditions hold:
- Both are risk-free so there is no risk premium involved in the comparison,
- And, both countries have the same rate of expected inflation.
At the moment, it’s likely that we are expected to have more inflation whereas Japan is expected to have less. And that should impact the interest rates.
From an equation perspective,
r(US)=r(J)+RP+e (change in ER)
is the basic interest rate parity equation where RP is the risk premium and e (change in ER) is the expected change in the exchange rate over the length of the rate.
If RP=0 for Japan, then we can take
r(US)-r(J)=e(change in ER)
Bottom line: from that spread, we can calculate the expected change in the exchange rate. Interest rate parity indicates that at the moment markets expect the value of the Dollar to decline by about 2.5% relative to the Japanese Yen. (It’s a bit more complicated looking at 10 years vs. 1 year but the key takeaway is fundamentally the same.)
The Truth in the Timing
We can now turn and ask what determines whether we should expect the exchange rate to rise or fall. In the short term, there’s a lot of focus on short-term GDP growth, but fundamentally that’s mistaken. In any one quarter or year, maybe we’ll have growth of 4% or 1%, but realistically over any longer-term period in the U.S., we should expect about 2.5%. (Actually, under Democratic presidents we should expect about 3% and under Republicans, we should expect closer to 2%, but let’s ignore that twist.)
Similarly, Japan and China are going to have a base growth rate that may fluctuate. However, all those growth rates are pretty much locked in by long-term factors, like the size of the capital stock, labor force, and training and productivity.
The implication? Return to the interest rate parity condition. What drives the expected change in the exchange rate? In the short term, changes in GDP growth may play a role, but over longer periods, those are locked in and the only thing left is inflation. (Generally, when we talk about GDP it’s real GDP, but what matters in this case, is nominal GDP and the inflation component in particular.)
So why do we see the 0.25% rate for Japan and the 2.75% rate for the U.S. and thus expect to see a 2.5% decline in the Dollar relative to the Yen? In a word; 2.5% higher expected inflation in the U.S. That shouldn’t be a surprise at this point.
Now, if we take that analysis to China, the rates are the same but there are two things that could differ: RP or the expected change in the ER. I expect that there’s still some positive RP associated with Chinese bonds. Say, for example, it’s 2%. The interest rate parity equation would then indicate
2.75=2.75+2+e(change in ER)
That would suggest that the Chinese Yuan was expected to depreciate by 2%.
The Bottom Line…?
My perspective is that China has had a higher interest rate, in part, because of a risk premium. And that risk premium likely hasn’t declined over the past year. If we’re looking at a change in the relative nominal interest rates, presumably that is due to a change in the expected ER, with an expectation of a declining Yuan.
Here is where the above Japan/China comparison fails. Japan, like the U.S., has a freely floating exchange rate. Those rates are set by market forces. China’s exchange rate was fixed, set by the government, until 2005. Since then, it has moved in the direction of floating ER yet it is still carefully managed, and the liquidity in that market is substantially less than that of the Dollar or the Yen. Nevertheless, even with a fixed exchange rate, maintaining an exchange rate that differs substantially from what would be the equilibrium or market rate will lead to “issues.” (In China’s case, China kept its ER well below the market rate and accumulated a very large amount of dollars.)
A strict long-term interpretation of Interest Rate Parity would argue that the expected appreciation or depreciation of a currency will depend on the differential between the two countries’ expected rates of inflation. If China’s expected inflation rate exceeds the U.S.’s expected inflation rate, then China’s currency would decline by that difference. In the short term, however, differences in GDP growth may also play a role as well as differences in monetary policy – or in China’s case exchange rate policy.
As China continues to struggle to contain COVID-19, one might reasonably expect more expansionary monetary policy there – or a more expansionary exchange rate policymaking their products less expensive. And this would be occurring at the same time that the Federal Reserve is pursuing a less expansive monetary policy here. Chinese actions would be driving down their nominal interest rates, although possibly generating additional future inflation, while Fed actions would be driving up our interest rates, in an effort to reduce current inflation. Those two actions together have moved U.S. and Chinese interest rates into a relationship that we are unaccustomed to. But in terms of managing the economy, I would rather be facing the problem the Fed faces than the problem the Chinese face.
Written by Richard Sheehan, Ph.D.
About the Author
Dr. Sheehan has published in some of the leading journals in economics, including American Economic Review, Review of Economics and Statistics, Journal of Business and Economic Statistics, European Economic Review, Journal of Money, Credit and Banking, Economic Inquiry, and International Journal of Forecasting.
At MVRA his responsibility is to ensure that the analytical background of every deposit and loan study follows best practices both in terms of statistical analysis and economic theory. He also works in model validation services analyzing financial and statistical models for financial risk.