Just how different China‘s monetary policy is run compared to the West?
Perhaps not much. They cut and raise interest rates just as everyone else does.
China is not different from the rest of the world in a sense that Newton’s three laws of motion and law of universal gravitation work in China just as everywhere else and basic principles of economics hold in China just as in everywhere else. Chinese central bank, just as every other central bank around the world, would like to see better growth in credit when they want to stimulate growth, and tighten monetary policy when they need to fight inflation. In that sense, they are the same.
The difference is just how monetary policy is run.
1. Interest rates
Just like other central banks, the People’s Bank of China (PBOC) changes target interest rates. But unlike most central banks in the developed world, which tend to control only the short-end of the curve (like the Federal funds rate), the PBOC control all rates across maturities and type of rates, i.e. both lending and deposit rates.
The absolute control on all rates have been relaxed somewhat in recent years, and particularly in the recent months, where banks are free to set lending and deposit rates with wider deviations from the benchmark rates.
2. Open market operation
This tends to get somewhat less attention among major tools, but PBOC does perform open market operation in the forms of bill selling, reverse repo, etc., which regulate liquidity in the banking system
3. Reserve requirement ratio (RRR)
This is a tool that tends to be used much less in the developed world, but the PBOC actively manipulate reserve requirement ratio. One of the big reasons why the PBOC uses this tool extensively is related to how foreign exchange mechanism for Chinese Yuan is arranged.
Chinese Yuan (CNY) has a soft peg mainly with the US dollar. The PBOC announces the daily exchange rate fixes of CNY against other currencies every day, and the market price of CNY is allowed to deviate within a tight range (currently ±1% from the daily fix). Massive trade surplus and capital inflow for the most part of the last decade meant that demand for CNY was strong. But because the authorities did not want CNY to appreciate too quickly, they have to intervene in order to keep CNY within a tight range, and the movements of daily fixes are usually small. That means creating more CNY to meet the demand.
But here comes the problem: with current and capital account in surplus (excluding the reserve account), the intervention is so massive that the Chinese banking system almost permanently had too much liquidity. There are ways to lock up the excess liquidity: either by selling bills to absorb, or increasing RRR.
4. Loan targets
This is perhaps lesser known tools of China’s monetary policy, because most developed countries do not use it. The fact is that the Chinese banking system is dominated by state-owned and policy banks, which makes it possible for the government to direct specific amount of lending to where it sees necessary.
China vs. the rest of the world
When a central bank wants to stimulate growth, it cuts interest rates in hope that demand for credit would rise as cost of funding would fall. This works until interest rates hit zero (or in liquidity trap situation). Demand for credit will remain weak even though there is no room to cut interest rates further. Central banks then engage in quantitative easing, which does nothing except creating massive amount of excess reserve, which has very little to do with stimulating credit.
China, however, can at least theoretically direct banks to lend anyway (or as we have been saying for a while: forcing banks to lend), whether there is demand or not for credit in the private sector. How can they do it? Well, there are local governments and state-owned enterprises ready to perform the tasks of investing into ever more useless projects. To finance those useless things, they go to the banks to borrow. And the banks lend.
We are not suggesting that this will happen, nor are we endorsing such actions from the government or the central bank. But that is, at least, something which is possible. More importantly, the fact that China can force banks to lend means that interest rate cuts are not even relevant in a sense that it is not the most powerful tool for stimulating credit growth, although lower interest rates do help debtors at a margin.
A lot of rooms to ease policy and stimulate credit growth, surely?
There are a lot of people out there saying that there is a lot of room for China to ease monetary policy. Presumably because the benchmark lending rate remains at 6% for 1 year, the impression most people get is that there is a lot more room for monetary easing before hitting zero bound. Not to mention that the reserve requirement ratio for large banks are currently standing at 20.5%, so surely there is much room to reduce that.
The problem is this is not really important. Or to put it in another way: whether there are rooms to cut interest rates and reserve requirement ratio ultimately may have very little to do with whether monetary condition can be eased in a meaningful way.
Remember we wrote above that China creates massive amount of money simply because they need to intervene in the foreign exchange market?
Now because trade surplus trends lower in the long term, capital inflow slows (with occasional outflows), demand for Chinese Yuan weakens, thus there is less need for foreign exchange intervention. That means less money created. If China ever runs a trade deficits, if foreign investment dries up, if everyone in China tries to buy US dollar while dumping CNY, liquidity tightens because the PBOC will have to do something completely opposite to what they have been doing: to prop up the Chinese Yuan, which means selling US dollar assets and buy back CNY, effectively removing liquidity.
That is, of course, an extreme situation. But we can by no means imagine something milder, and China would no longer need to intervene at all, so there is no need to print or destroy any base money. As a result of that, the PBOC will not be as much as a huge creator of liquidity as it was in the past.
There is one important implication here. We believe there is very little need going forward for the central bank to keep RRR at a high level as it is. Looking back into history, the reserve requirement ratio was at historical low of 6% in 2003. Going forward, we will not be surprised if RRR goes back all the way to 6% or lower. It will probably take at least a year or two to get there, in our view, but it is certainly a possibility. However, that is not equivalent to easier monetary condition because RRR was partly used as a tool to sterilise inflow, thus lower RRR only reflects less need for sterilisation in the future.
Another problem is debt deflation. We have probably been the most early in calling outright debt deflation in China, and we are obviously heading there right now. If we just forget for a moment that China can force banks into lending, then debt deflation would be a very dreadful situation as debtors have to sell assets to pay down debt, or else they risk default. When loans are being repaid or defaulted, wider money supply shrinks in the absence of central bank intervention. When debtors are all doing the same things, i.e. selling assets and repaying/defaulting on loans, it will result in deflation, i.e. a generalised fall in price level. In that scenario, as we have seen in most of developed world now, interest rates will ultimately be cut to close to or at the lower bound, i.e. zero, and yet because the private sector deleverages, zero interest rates have no meaningful impact on credit growth. We suspect that lending rates in China could be cut to very close to the lower-bound in the future (which again may take at least a year or two), but that does not mean that credit is becoming very easy.
At the end, only forced lending to finance pointless projects by local governments and state-owned enterprises will matter in determining whether credit growth will be strong, not interest rates nor RRR. Thus whether credit growth will be strong ultimately depends on whether the government has the determination to continue with the policies mix that has been widely regarded as wrong. Even though the country has run out of obviously meaningful things to invest in, the country can still force state-related entities to build more for the sake of maintaining GDP growth while running up even more debt through forced lending, and hope that the extra productive capacity will be utilised eventually.
This article originally appeared here: The ultimate guide to China’s monetary policy
Also sprach Analyst – World & China Economy, Global Finance, Real Estate
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