In the wake of the 2008 financial crisis, the People’s Bank of China came out all guns blazing and kept firing for far too long. The legacy of that barrage was a massive step up in the country’s debt to gross domestic product ratio. In the current crisis, the central bank has been eager to avoid the same mistake. It has not disappointed, though fiscal stimulus has compensated somewhat.

The PBoC’s actions during the pandemic are not well understood, with their primary tools remaining largely hidden from public view. In fact, stage one tightening began in May last year. Since then, the PBoC has guided sovereign bonds higher. This gradual tightening helps to explain why the country’s sovereign bond market has been spared the worst of the ructions so far.

The Bank’s policy toolkit has changed beyond recognition in recent years, with its primary instrument being open market operations. The PBoC cut its interest rate corridor by 0.3 percentage points when the crisis hit last year. But it drove down interbank rates by about 1.2 percentage points through open market injections. It began retreating from this accommodative stance in May and market interest rates duly followed.

The Bank moved onto stage one-and-a-half of its tightening in January. Again, through open market operations, it spiked interbank rates, sending a clear message that rates are set to support the real economy, not to finance speculation. It temporarily crushed the carry trade from interbank markets into sovereign bonds and shook out some of the leverage in equity markets. In case the message wasn’t clear, prominent officials talked openly about bubbles.

Understandably equity market participants have decided that they don’t want to face such a formidable foe. At the same time, stage one tightening began to feed through to monetary conditions, right on cue; the PBoC has had some difficulty in pushing on a string in recent years but pulling tends to work well. It normally takes two or three quarters for changes in short-term rates to feed through to M1 growth, which is likely to have peaked in January.

Stage one, however, will take longer to slow the real economy. Official real GDP data lack volatility, save, of course, for the hole carved by the impact of the virus last year. But official real GDP figures shouldn’t be taken at face value just yet. A believable real GDP index can be formed from nominal GDP and an array of official price data, compiled into a deflator. M1 is a useful leading indicator both of nominal GDP growth and commodity prices, so its peak in the first quarter is highly significant. Previous M1 developments, however, imply a reacceleration of quarterly real GDP through this year.

It’s not all about the PBoC. The household saving rate also spiked during the pandemic. People ploughed their money into the corporate sector, through vehicles such as money market mutual funds, with businesses issuing fresh bonds in droves. Corporate borrowing from banks also rose in the early phase of the crisis, creating fresh money. Much of these funds still sit in non-financial corporate time and other deposits, waiting for the all clear. We estimate the excess is around Rmb2.9bn, or nearly 3% of GDP. As this money rolls back down the curve and the household savings rate normalises, the cycle is likely to be prolonged.

Quarterly real GDP growth could peak at the end of the year, but, despite the PBoC’s tightening, it will take a while to come down. The chart below assumes that 60% of the excess in non-financial corporate time deposits rolls back into M1 next year. In China’s case, it’s unreasonable to expect all of the excess to be spent in the real economy; a lot will be used to pay down debt, in the quest for deleveraging. Liquidity waiting to be spent will keep the economy going even as the effects of the PBoC’s tightening feed through to the real economy. In short, liquidity will become more plentiful, despite becoming more expensive.

The likelihood of a continued upswing in real GDP growth this year, combined with the prospect that above-trend growth will continue for a sustained period, means the second stage of tightening — a hike to the interest rate corridor — is probably not too far away. Of course, there are the now normal disclaimers here. The vaccine rollout is painfully slow and worries over safety persist. But the PBoC may pursue an early hike, possibly as soon as this year. PBoC tightening normally would ripple through Asian economies, through its impact on commodities’ and goods’ prices. This time, however, the reservoir of liquidity should help to blunt that.

Freya Beamish is Chief Asia Economist at Pantheon Macroeconomics.