Rio de Janeiro Seminar: Thursday, March 9 — a conversation with Arthur Kroeber

Seminars Close
Gavekal Dragonomics

When Will Monetary Policy Get Interesting Again?

Chinese monetary policy is much less exciting than it used to be: the People’s Bank of China has not moved benchmark interest rates since October 2015, and the last change in the reserve requirement ratio was in March. After the substantial rate cuts last year, the central bank’s top priority this year has been maintaining stability in rates. This stability offsets some of the downward pressure on the renminbi, and also helps the PBOC build a new monetary policy system centered on money-market rates. The desire for stability has also driven a shift in the tools of monetary policy, with the PBOC now completely relying on reverse repos and lending facilities to manage liquidity, sidelining the old favorite of the RRR. All this may sound a bit boring, but as Mervyn King once said, a successful central bank should be boring. The quiet can last for a bit longer: the PBOC is unlikely to push rates down much until next year, when growth will be under more pressure from the downturn in the housing cycle.

China’s interbank market rates have never been so stable. After years of huge volatility—which peaked in the interbank crunch of June 2013—the overnight repo rate has traded at 2% for the past six months, and the 7-day repo rate has also stayed in a narrow range of 2.3-2.5% over the past year. The central bank has been very proactive at injecting liquidity, which not only prevents market crunches but has even eliminated the usual seasonal volatility. To achieve such stable rates, the PBOC has injected more than RMB500bn via 7-day reverse repos at 2.25% every week since last October, and also injects 3-month money at 2.75% and 6-month money at 2.85% when needed via its medium-term lending facility. The combined monthly injection of funds from reverse repos and the MLF averaged more than RMB2trn in the first seven months of 2016, a big surge from previous years’ monthly average of RMB500bn-RMB1trn.

Why has the PBOC changed its policy tools so much? After all, open market operations, lending facilities and the reserve requirement ratio can all adjust interbank liquidity, and for a long time the RRR was preferred. One reason is that past changes in the RRR were mainly a response to changes in foreign exchange reserves: the PBOC had to raise or lower the RRR (which controls its liabilities to banks) when its assets surged or shrank (see Keeping Control Of The Interbank Market). But foreign reserves have been little changed since February thanks to the decline of capital outflows and a more stable outlook for the renminbi (both related to a weaker US dollar). So there was less need to move the RRR.

However, the more important difference between injecting liquidity through open market operations (and lending facilities) and doing so by cutting the RRR is that they create excess reserves at banks through different mechanisms and at different prices, so the effect on interbank rates is not the same. The PBOC can cause banks’ excess reserves to increase by RMB100bn either by cutting the RRR by the necessary amount or by injecting the sum through a reverse repo or a lending facility. If the PBOC cuts the RRR, required reserves fall by RMB100bn, giving the bank RMB100bn in new excess reserves—but total reserves at the central bank don’t change. This means almost free money for the banks: they should be willing to put the funds to work anywhere that offers a rate higher than 0.72% the PBOC pays on excess reserves. But if the PBOC injects RMB100bn to banks through a 7-day reverse repo, then excess reserves increase by RMB100bn, total reserves increase by the same amount, and the PBOC’s claims on banks also rise by RMB100bn. In this case the banks’ cost of funds for the new RMB100bn is the 2.25% 7-day repo rate, so they will be reluctant to lend it out for less than that rate.

Therefore, adding liquidity through open market operations and lending facilities means that interbank rates will not fall much below the rates on those instruments. So the central bank’s choice of policy tools is a sign of its policy goal: keep rates steady at their current low levels, rather than driving rates steadily lower. The heavy use of open market operations and lending facilities has made the PBOC’s claims on banks double from end-2015 to RMB5.6trn, with these claims for the first time substantially exceeding banks’ excess reserves held at the PBOC. By injecting this more expensive money, interbank rates have stayed at the upper end of the PBOC’s interest-rate “corridor”, around the reverse-repo rate, rather than approaching the theoretical floor of the 0.72% excess reserve rate.

Not everyone approves of this strategy: with private-sector investment declining, overall growth weakening, and weak demand for credit outside of real estate, there is now rising pressure within China for the PBOC to further ease policy. A research report from the National Development and Reform Commission called for more rate cuts, although it was quickly removed from the internet after it stirred concerns that the NDRC was trying to intervene in monetary policy.

Interactive chart
The PBOC of course has good reasons for not wanting to cut rates. Some of these are external: its most recent monetary policy report, the central bank said it did not want interbank rates to fall too much, as this would make it cheaper to short the renminbi. Since there is still a risk that the US dollar will rise as the Federal Reserve hikes interest rates, this factor remains a constraint. In an explanatory press release on Monday, the PBOC also noted that credit growth is still quite fast this year, and blamed various technical factors for July’s surprising decline in corporate lending. Based on these public statements, the central bank does not seem to be in a hurry to start lowering rates again.

Another important reason, not discussed publicly, is that the central bank wants to preserve some room for further policy easing when it is more needed. After all, China’s GDP growth is still above 6.5%, while the PBOC’s reverse-repo rate (now the de-facto policy rate) is already at 2.25%. This means there a limited supply of future rate cuts that can be made before the PBOC confronts the zero lower bound. The central bank cut the benchmark deposit rates by 150bps over 2014-15 (and the 7-day reverse repo by 185 bps), in response to a slowdown of only about 100bps in real GDP growth (though to be fair nominal GDP growth declined by about 400bps from 2013 to 2015). Further growth slowdowns in the future will thus have to be met by a more modest response in terms of rate cuts. For instance, even if real GDP growth falls by another 250bps to 4%, the central bank is unlikely to want to cut the reverse-repo rate by 250bps, as that would make rates negative. The PBOC has been very skeptical of the negative rate policies pursued by other economies, all of whom would be absolutely overjoyed if they could achieve growth of 4%.

These various arguments will hold less weight once the cyclical downturn in housing becomes more advanced, and growth and investment indicators take another step down, which is likely to happen around the end of 2016 or early 2017 (see Housing Takes A Breather; More Stress On The Way). The political desire for stability will also get more intense because of the sensitivity of the 19th Party Congress scheduled for fall 2017. With monetary policy in transition, the next rate-cut cycle will play out a bit differently: the rate to watch now is the interest rate the PBOC pays on its reverse repos, which is announced as part of its regular open market operations. But for communication purposes the PBOC is still likely to pair such a cut with the familiar announcement of a cut in benchmark deposit rates, even though this is technically meaningless now that deposit rates are formally deregulated. The bigger difference is that the speed and magnitude of rate cuts will be less than in the last cycle.


  • >Anonymous



    Just a point of clarification:

    "by the necessary amount or by injecting the sum through a reverse repo or a lending facility"

    "the rate to watch now is the interest rate the PBOC pays on its reverse repos"

    One assumes you mean "repos" and not "reverse repos" for injecting liquidity in the first quote?

    • >long.chen



      Dear reader, 

      There is indeed a terminology issue. What is called "repo" in the US as well as many other countries is called "reverse repo" in China...just from different angles...

      Best, Long