How Should China Ease Monetary Policy?
There is increasing inconsistency between China’s economic fundamentals and the monetary policy, which appears to be too tight. There has been no major monetary policy change in China since 18 May 2012 when the People’s Bank of China (PBoC) cut the required reserve ratio (RRR) by 50 basis points on 18 May 2012. However, the Chinese economy and financial markets have experienced significant changes over the past two years.
While the economy has slowed from 7.7 percent in 2012 to 7.4 percent in Q1 2014 and the risk of deflation has risen, the funding costs facing the enterprises have stayed at an elevated level. The short-term money market rates have risen sharply, and on average, 7-day repo rates have moved up by 84 basis points in the past two years from 3.49 percent in 2012. While the weighted average one-year benchmark rate remains at 7.2 percent in Q1 2014, corporate profit margins have dropped from 5.7 percent on average in 2012 to only 5.3 percent in 2013.
Admittedly, China has been fine-tuning its monetary policy since the credit crunch in last June. From January this year, the PBoC also has intervened both FX and money markets to push down the rates. However, the low short-term rates have not been successfully translated into the low lending rates so far, given the accelerating interest rate liberalization. The elevated funding costs, on one hand, have added the risks to the de-leveraging, especially for the highly-indebted industries; on the other hand, the high interest rates onshore have brought in strong capital inflows to arbitrage large interest rate differentials, which have significantly eroded China’s monetary policy effectiveness.
So, it’s time for China to ease now, as China cannot solely relying open market operations to conduct monetary policy and reduce the high interest rates facing overall economy. Now the question is: how should China ease the monetary policy?
Lowering the reserve requirement ratio is a feasible option, as the interest rates facing the savers and borrowers have been increasingly influenced by the market interest rates. Notably, while the PBoC conducts the open market operations frequently to lower the market interest rates, the short-term liquidity operations appear to be difficult to anchor the market expectations. From this perspective, the importance of a RRR cut cannot be ignored as it will permanently inject liquidity and deliver a clear policy easing signal.
However, because China’s lending rates are now market driven, the cost curve of the lending rates is still determined by the deposit ceiling rates, as the deposit ceiling rates are still an important binding constraint. To some extent, the existing deposit rate liberalisation measures have in fact pushed deposit rates to rise further. For example, in order to compete for deposits, the commercial banks are offering high-yielding wealth management products to evade the deposit ceiling control.
Thus, reducing RRR alone is not sufficient to bring down China’s lending rates. We believe that, in addition to a RRR cut, the PBoC will also have to address the deposit rates by setting the prime lending rates lower and cutting the binding deposit ceiling rate. Only by doing so can China fundamentally reduces the overall funding costs of the economy.
When gradually moving towards a fully liberalized interest rate setting regime, China should accelerate market reform by encouraging large and listed companies to enter capital markets, especially the bond market to raise long-term capital. By doing so, Chinese state-dominated commercial banks will then have to look for new customers. Small and medium enterprises will then get more credits and their funding costs will start to fall. The capital market liberalization will not only leads the funding costs to decline, but also help offset the rising interest rates which are often associated with interest rate liberalization.
Last but not least, it is worth noting that the monetary policy cannot be used as a structural policy to address the structural issues facing China’s economy. China has many structural imbalances such as overcapacity in the heavy industry, rising income disparity and diminishing return in investment. These structural imbalances should be addressed by structural policies and reforms. A tight monetary policy also can not be relied upon to solve the structural imbalances in China.