Recently there have been signs of the Chinese economy decoupling from overseas economies. China’s December manufacturing PMI fell, while the manufacturing PMI remained high in the US and rose in the euro area, Japan and most emerging economies. This is mainly because China is at a different stage of the economic cycle from the US. The US has experienced several years of painful deleveraging and accommodative monetary conditions are now supporting the expansion of aggregate demand. In China, however, market interest rates at relatively high levels may become the new normal, as China’s monetary policy is constrained by the real estate bubble and potential financial risks. Although the risk of a hard landing is low, it is also unlikely that economic growth will rebound strongly in 2014.
 
Rising interbank market interest rates have led to higher financing costs for the non-financial sector. The cost of various types of debt financing in total social financing increased almost across the board in the past quarter. Real interest rates have risen along with nominal ones, considering inflation did not change significantly in the past quarter.
 
The negative impact of higher interest rates on aggregate demand takes time to be felt and may be insignificant in the short term. First, the rise of interest rates is in part a result of the expansion of aggregate demand since 2H13. Second, with real estate prices rising and local government financing vehicles being insensitive to interest rates, real estate and infrastructure investment which combined make up half of fixed asset investment are little affected by high interest rates. Third, higher interest rates help transfer income from the government and corporate sectors to the household sector, supporting private sector consumption. Fourth, the impact of rising interest rates on real estate prices – the most important component of household wealth in China – is still insignificant, so there is limited negative wealth effect.
 
Looking ahead, monetary policy will need to maintain a balance between supporting economic growth and controlling financial risk, and will likely be relatively tight overall. The median level of interest rates is unlikely to come down significantly until deep-seated imbalances in the economy are resolved and especially until the irrational rise in real estate prices and the related credit expansion are effectively curbed.