News of the week summary - 19/01/2025

Argentina slows Peso devaluation 

Argentina's central bank announced plans to reduce the devaluation rate of the peso, known as the "crawling peg," to 1% per month starting in February, down from 2%. This decision follows recent data showing a deceleration in inflation and reflects the central bank’s optimism about continued progress in stabilizing prices. The move aligns with the pro-market policies of President Javier Milei, whose austerity measures have sparked a rally in financial markets and bolstered hopes for additional IMF support.

Argentina’s inflation rate has been a defining challenge for the economy, with annual inflation peaking at nearly 300% in April 2024. Since then, aggressive spending cuts under Milei's administration have slowed inflation significantly, with the December rate at 117.8%. Monthly inflation in December was 2.7%, a slight increase from November’s 2.4%, attributed to seasonal price pressures, particularly in housing and utilities.

Despite these improvements, many Argentines continue to face financial strain. Rising prices for essentials like food and housing underscore the uneven impact of disinflation. While some sectors are stabilizing, the perception of persistent price increases reflects the deep-rooted challenges of combating inflation in a highly dollarized economy.

The slower peso devaluation is seen as a signal of confidence in the ongoing disinflation process and could extend the market rally fueled by Milei’s reforms. Investors anticipate a reduction in interest rates, currently at 32%.

However, this strategy carries risks. Reducing the devaluation rate too quickly could put pressure on Argentina's trade balance by making exports less competitive, while slower peso depreciation might not align with inflation’s full trajectory. Additionally, while inflation is cooling, it remains alarmingly high by global standards, necessitating careful policy management to avoid a relapse.

President Milei's administration has focused on restoring fiscal discipline through austerity, a critical step to secure further IMF assistance and rebuild economic credibility. While these measures have curbed inflation, they have also increased poverty rates, highlighting the delicate balance between economic stabilization and social welfare.

Looking ahead, the central bank’s decision to slow the peso’s depreciation and likely interest rate cuts represent a calculated gamble. If inflation continues its downward trend, these moves could reinforce confidence in Argentina’s economic trajectory. However, sustained success will depend on consistent fiscal discipline, structural reforms, and effective coordination between monetary and fiscal policies.

Tight liquidity in China amid Lunar New Year

China's overnight borrowing costs spiked dramatically on Wednesday, with rates reaching as high as 16%, driven by tight cash supplies in the financial system ahead of the week-long Lunar New Year holiday. Seven-day borrowing costs also surged to 10%, while the average rate for overnight repurchase transactions (repos)—a key measure of liquidity in the interbank market—hit 3.5%, the highest since October 2023. This marks a significant deviation from its typical range near 1.5%.

The surge in borrowing costs is partly seasonal, as cash demand typically rises during the Lunar New Year due to increased consumer spending and corporate payouts. However, the People's Bank of China (PBOC) has been cautious in its liquidity injections, balancing short-term cash needs against broader economic concerns.

The central bank recently injected 959.5 billion yuan ($130.87 billion) through seven-day reverse repos. Still, this was offset by the maturity of earlier lending facilities, resulting in a net liquidity withdrawal of 36.6 billion yuan. Traders expected more aggressive interventions, but state banks refrained from significant injections, exacerbating the cash crunch.

The tight liquidity conditions have broader implications for China's financial system. Elevated borrowing costs discourage investment in government bonds, as the funding costs far outpace returns. For instance, the 10-year treasury yield stands at a modest 1.6%, making it unattractive compared to the higher short-term borrowing rates.

The PBOC has expressed concern about excessive investments in government bonds, which have pushed yields near record lows. A central bank official recently warned that such trends could create a bubble, leading to market turbulence if bond yields diverge significantly from economic fundamentals. This cautious stance suggests that the central bank is prioritizing long-term financial stability over short-term liquidity relief.

While the Lunar New Year liquidity squeeze is temporary, it highlights underlying challenges in China's financial system. The weak yuan and declining bond yields have made the PBOC wary of over-stimulating markets, as excessive easing could undermine currency stability and inflate asset bubbles.

The surge in borrowing costs underscores the trade-offs central banks face between supporting liquidity and maintaining financial discipline. For China, navigating these pressures is particularly critical, as it seeks to balance seasonal cash needs, stabilize the yuan, and prevent imbalances in bond markets. How the PBOC manages this liquidity crunch will be a litmus test for its ability to sustain market confidence while guarding against systemic risks.

IMF updates its growth forecasts 

The International Monetary Fund (IMF) has revised its global growth forecast for 2025 upward to 3.3%, citing stronger-than-expected economic performance in the U.S., while downgrading growth prospects in Europe and the Middle East. Despite this improvement, the projected growth remains below the historical average of 3.7% observed from 2000 to 2019. Global inflation is anticipated to continue easing, reaching 4.2% in 2025 and 3.5% in 2026, paving the way for further monetary policy normalization.

The IMF cautioned against protectionist policies, such as tariffs and subsidies, which could harm international trade and economic stability. These measures, it warned, often lead to retaliatory actions that depress investment, disrupt supply chains, and ultimately slow economic growth.

The IMF raised its 2025 U.S. growth forecast to 2.7%, driven by a resilient labor market and accelerating investment. However, the IMF expressed concerns about the potential for excessive deregulation under the incoming U.S. administration. While short-term economic gains could arise from looser financial regulations and tax cuts, such policies risk creating financial instability and "boom-bust" dynamics. Over time, this could weaken the role of U.S. Treasury bonds as a global safe asset and expose the economy to fiscal vulnerabilities.

Trade and immigration policies proposed by the U.S. also pose risks. Tariffs could increase input costs for businesses, while restrictions on immigration might constrain labor supply, both of which could fuel inflation. Higher inflation, in turn, might force the Federal Reserve to delay planned interest rate cuts, tightening financial conditions worldwide.

While U.S. growth is accelerating, Europe’s economic outlook remains subdued. The euro area’s growth forecast for 2025 was lowered to 1.0%, reflecting weak manufacturing momentum and political uncertainty. The divergence between the U.S. and Europe is attributed to stronger U.S. productivity growth, particularly in technology, and structural issues in Europe, such as less dynamic business environments and shallower capital markets.

In China, the IMF slightly raised its growth projections for 2025 and 2026 following fiscal stimulus measures. However, the IMF emphasized that China must focus on boosting domestic demand instead of relying heavily on exports. The Middle East and Central Asia faced growth downgrades due to oil production cuts in Saudi Arabia, a key regional player.

The organization highlighted continued progress in reducing global inflation, aided by cooling labor markets and declining energy prices. However, it warned of potential inflationary pressures from heightened trade tensions or supply chain disruptions, which could lead to a stronger dollar and higher interest rates.

IMF Chief Economist Pierre-Olivier Gourinchas stressed that central banks must remain vigilant and agile. While they have so far succeeded in controlling inflation, any resurgence in price pressures could erode public confidence and demand a more proactive monetary policy stance.

China holds lending rates steady 

China's central bank kept its benchmark lending rates unchanged for the third consecutive month at January's monthly fixing. The one-year loan prime rate (LPR), which influences most loans, remains at 3.1%, while the five-year LPR, key to mortgage pricing, stays at 3.6%. These decisions reflect Beijing's cautious approach to monetary easing as it grapples with a weakening yuan and narrowing bank profit margins.

China's economy met its 2024 growth target of 5%, reducing the urgency for aggressive monetary stimulus. However, the yuan has faced depreciation pressure, prompting policymakers to avoid measures that could weaken the currency further. A weaker yuan makes imports more expensive and can deter foreign investment, both of which would strain the economy.

Additionally, Chinese banks are constrained by narrowing interest rate margins, which limit their ability to absorb further rate cuts. This underscores a broader balancing act: stimulating economic growth while maintaining financial stability and preventing capital outflows.

    The Broader Context

In late 2024, Chinese lenders significantly cut lending benchmarks to boost economic activity. Yet, the absence of further rate reductions signals a strategic pivot. Policymakers are instead deploying other measures, such as verbal interventions and issuing offshore yuan bills, to stabilize the currency.

The Politburo’s recent announcement of an "appropriately loose" monetary policy for 2025, alongside proactive fiscal measures, signals a shift in economic strategy. This marks the first time in over a decade that China plans to ease its monetary stance, reflecting the need for coordinated fiscal and monetary efforts to address slowing growth.

Investor sentiment has adjusted to reflect expectations of a pause in monetary easing. The derivatives market shows reduced bets on near-term rate cuts, indicating confidence that authorities will prioritize stabilizing the yuan before considering additional stimulus.

While holding rates steady avoids exacerbating yuan weakness, it also highlights China’s limited monetary options amid external and domestic pressures. The government’s challenge lies in balancing short-term growth ambitions with the long-term need to safeguard financial and currency stability.

Bank of Japan poised for rate hike 

The Bank of Japan (BOJ) is expected to raise its short-term policy interest rate from 0.25% to 0.5% on Friday, barring market turbulence linked to U.S. President-elect Donald Trump’s inauguration. This move, signaling the BOJ’s determination to normalize monetary policy, would bring Japan’s borrowing costs to levels unseen since the 2008 global financial crisis.

       Why Raise Rates Now?

Japan’s inflation rate has consistently exceeded the BOJ’s 2% target for nearly three years, driven by broad-based wage gains and a weaker yen that has elevated import costs. This persistent inflation suggests Japan may finally be overcoming decades of deflationary pressures. By gradually lifting rates, the BOJ aims to stabilize the economy at a neutral interest rate—around 1%—that neither stokes excessive inflation nor dampens growth.

Market expectations for a rate hike have been high, bolstered by hawkish signals from BOJ Governor Kazuo Ueda and other policymakers. The yen has already appreciated as investors priced in an 80% likelihood of a rate increase.

External risks also loom large. The global economic outlook, while recently revised upward by the IMF, remains uncertain due to potential disruptions from Trump’s policies and their impact on Japan’s export-dependent economy. Additionally, political instability within Japan, including challenges facing Prime Minister Shigeru Ishiba’s government, could complicate economic management.

This anticipated hike, the first since July 2024, marks the BOJ’s shift from ultra-accommodative policies that have defined its strategy since the global financial crisis. However, the pace and timing of further increases remain uncertain. Market participants will closely scrutinize Governor Ueda’s statements for signals about the BOJ’s future trajectory.

By carefully navigating its policy adjustments, the BOJ seeks to reassure investors and the public that Japan is moving beyond its prolonged deflationary era, even as it balances domestic and global economic uncertainties.