China's Interest Rate Gap with the USA at Record High: Challenges for the Central Bank

China's yield differential with the United States has reached a new record level, posing significant challenges for the central bank as it strives to support the yuan. A sustained rise in Chinese government bonds and selling pressure on US bonds have led to an unprecedented gap of 300 basis points between the yields of the two countries. This discrepancy could further increase pressure on the yuan as the risk of capital outflows rises, especially as the currency hit a record low in offshore trading. This development suggests that policymakers may be forced to allow the yuan to depreciate in order to support the fragile economy through monetary easing. Against this backdrop, the People's Bank of China has supported the currency market this week, while allowing the yuan to fall below an important threshold last Friday. In addition to the yield differential, the yuan is suffering from a bleak economic outlook characterized by a persistent real estate crisis, weak consumption, and deflationary concerns. Furthermore, the tariff threats from the designated US President Donald Trump and declining expectations of US interest rate cuts are adding pressure on the Chinese currency. Mitul Kotecha of Barclays commented that China's deflationary tendencies and weak economic growth are further depressing yields, while relatively strong economic activities keep US yields high. The widening interest rate gap will continue to drive up the dollar-yuan rate. On Monday, the yield on China's 10-year bonds reached less than 1.6% for the first time according to official data, widening the interest rate spread to US securities of the same maturity to 303 basis points. Signs of capital outflows were already evident, as China suffered the largest recorded capital outflow from its financial markets in November. On Tuesday, the People's Bank of China increased the daily reference rate, which was significantly above the average estimates of a Bloomberg survey, to improve market sentiment. The currency slipped below 7.3 per dollar on Friday, fueling speculation that China is open to further depreciations. The offshore yuan recently showed little change at a rate of 7.3439, while it stood at 7.3291 domestically. Lynn Song, Chief Economist for Greater China at ING Bank, emphasized that the market is closely watching whether the central bank will loosen the fixing further as depreciation pressure grows. However, the process is likely to be gradual, as the authorities appear to remain keen on currency stability.