Is China’s mounting trade surplus forcing the central bank to tighten up money supply?

Expectations of renminbi appreciation seen driving liquidity expansion and low interest rates.

The Chinese central bank (PBOC) has sought to tighten liquidity conditions over the past several months, despite the economic headwinds created by the War in Iran as well as Beijing’s explicit commitment to loose monetary policy.

Domestic analysts say the move comes in response to interbank interest rates sliding to worryingly low levels. Some point more specifically to the impact of China’s mounting trade surplus, which they say has driven heavy inflows of forex that have left the financial system awash with liquidity.

Other analysts point out, however, that a rising trade surplus is unlikely to be the culprit for excess liquidity or low interest rates, as PBOC is no longer heavily obligated to buy forex under China’s current exchange rate regime.

They instead impute persistently low interest rates to lacklustre demand for credit, as households and businesses continue to grapple with balance sheet recession conditions in the wake of China’s 2021 property slump.

Chinese central bank tightens since March

PBOC has pursued applied contractionary measures to the money supply since March of this year, despite the stance of “moderately loose monetary policy” it enunciated at the end of 2024, in tandem with a push for fiscal expenditures to reach new record highs.

Guoxin Securities notes that the central bank made net withdrawals of liquidity via open market operations for the three consecutive months running from March to May, as well as refrained from making injections via 7-day reverse repo operations in the opening week of June.

Guan Tao (管涛), chief economist at Bank of China’s securities wing, further points out that PBOC’s withdrawals of liquidity since March caused its net liquidity injections to plunge from 2.06 trillion yuan for the first two months of 2026 to just 648 billion yuan for the four-month period from January to April.

The shift arrives just as pressure to tighten monetary policy also hits the world’s other central banks, with unresolved conflict around the Strait of Hormuz contributing to global inflationary pressure.

In China, however, inflation remains tepid as a result of long-standing “involutionary” competition in its industrial sector, helping to keep a lid on price gains despite the oil shock created by the War in Iran.

Domestic analysts instead believe the driver for the central bank’s decision to tighten the money supply is concern over excessively low interest rates, with some further imputing the issue to inflows of liquidity created by China’s mounting trade surplus.

The framers of China’s monetary policy have designed its interest rate system so that the DR001 and the DR007 (the rates for overnight and seven-day repo loans on the interbank market respectively) hover around the central bank’s policy rate, which is the seven-day reverse repo rate.

Since June 2025, the DR001 has consistently sat beneath the policy rate. In April and May of this year, however, the DR001 sank to over 10 basis points beneath the policy rate, as compared to five basis points previously.

Guoxin analysts believe this deviation is too much for Chinese central bank officials to accept, serving as the motivation for its latest spate of tightening.

“The DR001 interest rate is still lower than the central bank’s desired target,” write Guoxin analysts.

“The central bank is currently using contraction of liquidity in an attempt to raise the overnight rate.

“A median deviation of approximately five basis points, which prevailed from June 2025 to March 2026, is likely the central bank’s desired reference range.”

The performance of the DR007 may have also raised hackles amongst central bank officials over China’s interest rates being excessively low.

Since April of this year, the average monthly DR007 has also been lower than PBOC’s policy rate - the first time this has occurred since August 2023.

Analysts from Guolian Minsheng Securities point out that interest rates in China have all fallen near historic lows, after the Chinese central bank cut the policy rate to 1.4% in May last year.

Why the trade surplus could swell liquidity

Some domestic analysts believe that the drop in interbank interest rates is the product of the expansion in liquidity driven by China’s mounting trade surplus, in tandem with expectations of renminbi appreciation.

China’s trade surplus continues to rise in 2026, widening to 723.98 billion yuan in May from 618.4 billion the previous month. Exports rose 7.6% year-on-year in US dollar terms, driven by exports of hi-tech goods that stand to benefit from higher oil prices - chief amongst them electric vehicles and solar PV panels.

This rising trade surplus expands the forex earnings of Chinese exporters. Because these export companies now expect the renminbi to appreciate, they exchange forex for renminbi from Chinese commercial banks, leaving the banks holding forex on their balance sheets.

If PBOC then purchases the forex from commercial banks - as it has done in the past with the goal of putting downward pressure on the renminbi exchange rate, then this will increase liquidity, because the purchases are made with the central bank’s base money in the form of reserve balances.

“From a policy perspective, there is currently no significant indication of proactive easing by the central bank domestically,” ”write Tao Chuan (陶川)and Wu Shuo (武朔) from Guolian Minsheng Securities.

“Therefore, the reasons for the current round of ample liquidity needs to be explored by looking at external factors.

“A high trade surplus coupled with increased willingness to settle forex implies an expansion of the forex settlement surplus, potentially driving a resurgence in foreign exchange reserves.”

Tao and Wu point out that these conditions were absent last year, because Chinese export businesses did not expect the renminbi to rise, and as a consequence were unwilling to sell their forex to the banks.

“With the continued expansion of the trade surplus, enterprises accumulated huge amounts of foreign exchange earnings in 2025,” they write.

“However, due to the lack of a consistent expectations of renminbi appreciation, the willingness of market participants to settle foreign exchange was not strong.

“But once the rapid fermentation of renminbi appreciation started at the end of last year, the willingness of enterprises to settle foreign exchange began to rebound sharply - the settlement ratio of the trade in goods in the first quarter reached a near ten-year high.”

Tao and Wu further point out that expectations of renminbi appreciation also make China’s commercial banks more inclined to sell forex to PBOC in exchange for reserve balances - the critical mechanism that drives an increase in liquidity.

“Although the forex settlement surplus briefly turned positive in 2025, the lack of sustained appreciation expectations meant that banks, after absorbing forex settlement funds from market participants, remained reluctant to further settle forex with the central bank, making it difficult to inject base money.

“However, with renminbi appreciation gradually becoming the consensus and the settlement volume increasing, the willingness of banks to settle forex with the central bank is expected to continue to rise.”

Why the trade surplus need not contribute to liquidity

Bank of China’s Guan Tao does not believe low interest rates to be the result of an expansion in liquidity created by a mounting trade surplus and rising forex settlement.

He argues that the critical issue is whether the Chinese central bank is willing to purchase forex held by commercial banks - as opposed to whether the commercial banks are willing to on-sell forex to the central bank.

If PBOC does not make such purchases of forex using base money, then liquidity levels in the Chinese banking system will not increase, even if the volume of forex in the system as a whole expands.

Guan notes that under China’s current exchange rate system, PBOC is no longer obligated to purchase forex in large amounts to prevent excessively rapid appreciation of the renminbi as it did in the past.

“The idea that a forex settlement surplus leads to excess imported liquidity is outdated,” Guan writes, highlighting changes in China’s exchange rate regime since the Global Financial Crisis (GFC).

“Before the Federal Reserve exited quantitative easing in 2014, the Chinese central bank continuously intervened in the market to buy and sell foreign exchange to prevent the renminbi exchange rate from appreciating too rapidly.

“It accumulated forex reserves, resulting in a sustained large-scale injection of [base money] via forex purchases.

“PBOC then used methods such as issuing central bank bills or raising the required reserve ratio to offset these measures and withdraw liquidity.”

Guan argues that since 2018, however, PBOC has returned to a “neutral exchange rate policy,” and “essentially withdrawn from routine intervention in the foreign exchange market” - at least via direct purchases.

“Since then, the increase or decrease in the PBOC’s forex purchases has become largely disconnected from the difference between bank forex settlement and sales,” he writes.

To substantiate his point, Guan notes that PBOC’s purchases of forex have been very modest compared to bank forex settlement since the start of the year.

“In the first four months of this year, the cumulative surplus in bank forex settlement reached US$240.9 billion, equivalent to approximately RMB 1.67 trillion based on the average monthly onshore spot rate.

“During the same period, PBOC’s cumulative increase of RMB 299 billion in forex purchases was merely a drop in the ocean.

“Clearly, the fact that the central bank’s foreign exchange reserves have increased for four consecutive months does not indicate that the central bank has re-entered the market to intervene in the appreciation of the renminbi.

“The judgment that the central bank has withdrawn from routine intervention in the forex market remains valid.”

Tang Yuanmao (唐元懋), Du Runchen (杜润琛) from Guotai Haitong Securities Research concur with Guan Tao.

“Recently, a number of market view points argue that the rise in the value of the renminbi and the increase in enterprise forex settlement has led to an expansion of bank balance sheets, helping to loosen interbank liquidity,” they write.

“However, under current conditions, when there is huge surplus in the forex settlement of banks on behalf of their clients, forex can just remain on the balance sheets of banks, and does not necessarily shift to the central bank.”

Tang and Du point out that balance sheet data for the central bank from December 2025 indicates that its forex account fell 2.7 billion yuan on-quarter, and that its forex account posted negative growth for each quarter that year.

By contrast, the foreign-denominated assets on the balance sheet sof Chinese commercial banks rose 595 billion yuan, while at the same time their value in renminbi-terms contracted as a result of renminbi appreciation.

“This indicates that the excess foreign exchange positions resulting from the forex settlement surplus made on behalf of customers has remained on the balance sheets of commercial banks, and isn’t being converted into additional base money supply.”

Weak demand for funds seen as the culprit

When it comes to why China’s interest rates are so low, Guan Tao points the finger of blame at inadequate demand for credit from Chinese households and businesses, many of whom are still reeling from the impacts of the housing market slump in 2021.

This is consistent with the consensus opinion of Chinese economists, who point to insufficient domestic demand as being the chief macro-economic dilemma confronting Beijing’s policymakers at present.

“The ample market liquidity is not due to excessive money supply, but rather insufficient effective demand for financing,” Guan writes.

“As of the end of April this year, the outstanding balance of domestic renminbi loans, which accounts for about 60% of the total social financing, grew by 5.6% - 4.6 percentage points slower than the trend value over the past five years.

“This dragged down the overall year-on-year growth rate of total social financing significantly below trend.”

Guosheng Securities also highlights weak demand for credit - pointing to both ailing demand from households as well as the reduced issuance of government bonds at start of the year.

“Weak credit demand and insufficient issuance of government bonds have led to an under-allocation on the asset side of bank balance sheets, driving an easing in liquidity on the demand side,” Guosheng analysts write.

“Following a strong start to credit growth in January, February and March were both lackluster.

“New loans stood at 845.8 billion yuan and 3.15 trillion yuan respectively, both below the average for the same period over the past three years.

“New government bonds in January-March totaled 3.54 trillion yuan, still 330.2 billion yuan less than the same period last year.”

Chinese central bank set to further tighten

Irrespective of the cause behind China’s low interest rates, domestic observers believe the Chinese central bank has switched towards a more cautious stance for the time being, with no further major injections of liquidity or interest rates cuts likely in the near-term.

“Persistently low interbank rates below the policy rate are not conducive to the transmission of policy intentions,” write analysts from China Merchant Securities.

“Therefore, we expect the current very loose liquidity conditions to soon face marginal changes.”

“At present, market interest rates are near the lower edge of the interest rate corridor,” write analysts from Guosheng Securities.

“The central bank has no intention of maintaining excessively loose liquidity and has started to gradually withdraw liquidity, but the impact is currently limited.

“Subsequent medium- and long-term liquidity may continue to see net withdrawals, and liquidity may gradually shift from loose to neutral.

“Fiscal revenues and expenditures (including government bond issuance and fiscal spending), credit expansion, and foreign exchange reserves are key variables determining the pace of liquidity returning to neutral.”

Analysts from China International Capital Corporation (CICC) point out that pivotal changes to the phrasing used by the central bank’s Q2 monetary policy execution report also serve to signal further tightening of liquidity ahead.

‘Compared to the 2025 Q4 monetary policy implementation report, the phrase ‘reserve requirement ratio cuts and interest rate cuts’ has been removed,” they write.

“This suggests a reduced urgency for such cuts in the short-term,” while use of the phrase ‘precise and effective’ also implies a potential narrowing of the space for easing.”