Guanghua Report: The Outlook for China's monetary policy in 2019
Apr 16, 2019
Peking University, April 16, 2019: China began to see more relaxed monetary policy, heightened market expectations and stock market rebound at the start of this year. Our real economy also started to show signs of bottoming out. How relaxed will our monetary policy be in 2019? How will it work?
Our economic growth remains relatively weak, and the pressure to maintain stable growth is huge, which calls for monetary policy support. Meanwhile, overly relaxed monetary policy will lead to economy-wide extreme behaviors and cause house prices and debts to soar, while the real economy cannot fully benefit from an inefficient monetary transmission mechanism. Suffice to say, our current monetary policy still face a dilemma between stabilizing growth and moderate leveraging. Opinions vary concerning questions such as to what extent will the central bank inject liquidity and will it cut the reserve ratio and interest rates in near future.
It is our prediction that, as long as the economy doesn't slow beyond expectations, we will see reserve ratio cuts twice this year, but not in April. Meanwhile, the central bank will not adjust the benchmark interest rate, but will accelerate market-oriented rate reforms by unifying rates and phasing out the benchmark lending-rate. Monetary policy will remain steady, and the central bank will prefer targeted structural policy tools to address particular issues instead of pushing strong stimulus policies that would have an economy-wide impact. Consequently, the stock market should stay in consolidation mode without huge fluctuations. It will only begin to rise rapidly in the later half when our real economy really recovers.
1. Reserve ratio might go down twice this year, but not likely in April
a. With the real economy stabilizing and financial policies gaining traction, monetary policy has less pressure to stabilize growth. Producer price index (PPI) in Jan. rose 0.1 percent from a year before, a smaller percentage gain. The index in Feb. remained the same, showing signs of stabilizing. Since this year, our power generation and cargo volume have also seen faster rise. March saw rebound growth in coal consumption of six major power producers. Both official and Caixin (a private business survey) PMI expanded far beyond expectations in March, strongly indicating that the economy was bottoming out. Different from last year, financial policies are exerting notable effect this year as the 2-trillion cuts of tax and fees and expansion of local government bond quotas are under way, and infrastructure investments are warming up again. Active financial policies have, to some extent, relieved the burden of monetary policy to stabilize growth.
b. Inter-bank liquidity is currently ample, and reserve ratio cut is not urgently needed as far as funds are concerned. Since last year, the central bank cut banks' required reserve ratios five times by an accumulated 3.5 percentage points, including a cut of 0.5 percentage points after the announcement of RRR cut this Jan. Market liquidity is ample. Broad M2 money supply at the end of Feb. rose 8 percent, and our outstanding total social financing (TSF) was up 10.1 percent from a year earlier. In particular, off-balance sheet forms of financing showed signs of stabilizing, overall credit conditions loosening, and credit availability ample. In Jan. and Feb., China's new yuan-denominated loans increased by 374.8 billion yuan year on year to hit 4.11 trillion yuan. Considering factors such as policy influence, improved enterprises' demand of loans, energetic house sales in big cities, the TSF is expected to rise further, and the money multiplier will get larger. Reserve ratio cut is not urgently needed to boost liquidity in the short run.
c. The reserve ratio for Chinese banks is already at a reasonable level compared with international standards, and there is not much room for cuts. Due to a combination of factors in recent years such as the central bank's policy changes, the adoption of new monetary policy tools and innovations in bank businesses, banks' excess reserve ratio has been decreasing and is now below 2 percent. With years of cutting the reserve requirement ratio (RRR), banks' current reserve ratio is not very high compared with other countries. Although the RRR in some developed countries is lower than ours, their excess reserve ratio is relatively high. For example, excess reserve ratio in the U.S. and the euro zone both top 10 percent, making their overall reserve ratio hit around 12 percent. Both figures in Japan reach around 30 percent. In comparison, the RRR for China's big banks and medium- and small-size banks both have fallen to 13.5 percent and 11.5 percent respectively. Taking into account less than 2 percent of excess reserve ratio, our overall reserve ratio is not much higher than the U.S. or European countries. Therefore, we do not have much room for cuts, and the central bank will be cautious in doing that.
2. We forecast that the benchmark interest rate will not decrease, while progress will be accelerated concerning the market-based interest rate reform. Unifying interest rates will be a key target, with the benchmark lending-rate likely to be abolished.
a. By lowering actual interest rates, the central bank aims to accelerate the rate reform and unification. With the reform under way for a while, main lending rates have already been marketized, and market rates have strayed increasingly from the benchmark interest rates in recent years. Since the end of 2015, the benchmark rate remained largely unchanged while market rates fluctuated notably. Since the benchmark rate is mainly correlated with mortgage rates and lending rates for large state-owned enterprises, lowering the benchmark interest rate will hardly have any effect on the financing cost for private and medium, small and micro businesses, and it goes against the effort of monetary policy. Since the later half of 2018, the central bank started to mention unifying rates as one of its key working aspects. It is expected to make further effort to achieve that and better link the money market to the credit market. Reforms are expect to first target lending rates and then deposit rates, and the benchmark lending rate is likely to be abolished in the later half of this year.
b. Market rates are already at a low level, and lowering the benchmark interest rate will not effectively improve the inefficiency in our monetary transmission mechanism. Currently, banks' liquidity is ample. The seven-day reverse repurchase rate and the seven-day Shanghai Interbank Offered Rate (Shibor) are both below 2.5 percent. In particular, Shibor has been oscillating slightly at a low level since this year, indicating that the more important question is still how to effectively divert money from banks into the real economy. It is not necessarily related to the benchmark rate.
c. Borrowing costs in the real economy have already dropped, and interest rate cuts will only attract more funds to the fictitious economy. Following greater financing supports for private and medium- and small-sized companies, the average RMB lending rate in the 4th quarter last year dropped by 0.31 percentage point from the previous quarter. At the end of Feb., the yield on the 10-year treasury bond dropped by 70-plus basis points from the start of 2019. With rising house sales in major cities and stock market rebound recently, lowering the benchmark interest rate will cause the economy to overheat in parts and prices to soar, leading more money from the real economy to the fictitious economy. This goes against a steady monetary policy.
3. Our monetary policy will remain steady, and the central bank will prefer structural policy tools to address particular issues via an improved monetary transmission mechanism over extensive, direct stimulus.
First of all, it is not realistic to resort to old measures such as increased leveraging and large-scale investment stimulus to boost economic growth. Our country's marginal product of capital has been staying at a low level, and large-scale stimulus policies in infrastructure construction and property investment will only have very limited effect in boosting the economy while worsening development imbalance and other problems. Despite a year-on-year drop, China's macro-leverage ratio at the end of 2018 still neared 250 percent, a relatively high level. There are still some structural debt issues, the corporate leverage ratio and residents' debt-to-income ratio are at a high level compared with other countries, and public private partnerships (PPP) and other investment left local governments in huge implicit debts. As a result, there is not much room for more macro leverage. That current monetary policy remains relaxed is only to ease the stress in the money market following deleverages and stricter supervision in the financial system. It is out of the question that we will adopt strong stimulus policies that would have an economy-wide impact.
Second, the central bank will use more structural policy tools to address particular aspects and ensure a smooth and effective monetary transmission mechanism. Instead of tight liquidity, the current problem with our monetary policy is an ineffective monetary transmission mechanism that holds back funds from flowing into the real economy, and private, small- and micro-sized companies still have a hard time financing. Since last year, the central bank has used a lot of structural monetary policy tools, including the expansion of the scope of securities as collateral for the medium-term lending facility (MLF), an increase of relending and rediscount quotas, reducing the refinancing rates for medium and small-size businesses, and the introduction of targeted medium-term lending facility (TMLF) and the central bank bills swap (CBS). This year, it will continue to focus on structural monetary tools, utilize TMLF and CBS, and gradually switch to price-based monetary policy adjustments by accelerating the market-based interest rate reforms.
4. The stock market is unlikely to rise or fall sharply and will stay in consolidation mode. It will only soar in the later half when our real economy really recovers.
a. The rise of the stock market between last October and the two sessions this year was the result of positive expectations and revived confidence driven by the policy cycle. At the end last October, the country started to see rapid policy adjustments, and stabilizing economic growth became the key target. In Nov., President Xi Jinping vowed to unswervingly support the development of private enterprises and small and micro businesses. After targeted RRR cuts in Oct., the central bank reduced RRR again in Jan. During this year's two sessions, it was announced that fees and tax would be cut by 2 trillion yuan, the deficit-to-GDP ratio and local government bond quotas would increase. Meanwhile, China-U.S. trade talks have achieved positive results and will likely reach concrete agreement. As a result, market confidence revived and the stock market rose.
b. The stock market showed signs of consolidation after the two sessions, and is unlikely to rise or fall sharply. The real economy has already shown signs of recovery, and the stock market will not plummet in the near future. Our PPI began to see faster year-on-year growth, power generation and cargo volumes rapidly increasing. PMI also rose beyond expectations and surpassed 50, indicating expansion. With tax cuts under way, infrastructure investment recovering and government policy support, the real economy is expected to stabilize and rebound. However, policies need time to take effect, and the foundation for the real economy recovery is still weak, which means forces to push the stock market to soar will still be absent in the near future. Targeted policy measures will be preferred, financial policy remains largely unchanged, and tax and fee cuts will only affect the real economy after a while. As the economy is still consolidating, PMI's sub-index for new export orders is still below 50, and car sales remain low, the real economy will not rebound in the short run. As a result, the stock market will not see huge fluctuations any time soon, and it is highly unlikely to surpass 3,500 or fall below 2,800 before the 3rd quarter.
c. A new economic cycle might emerge mid-year, with a bull market coming after the 3rd quarter. It should be noted that the stimulus in this policy cycle is on a rare scale. According to our calculations, the actual deficit ratio will hit 6.5 percent this year, much higher than last year's 4.7 percent. The 2-trillion-yuan tax cuts will prominently boost companies' investment and productivity and raise GDP growth by about 0.6 percentage points. Currently, social financing and loans are also growing fast, and deleveraging is giving way to stabilizing. As various policies gradually take effect and China and the U.S. reach trade agreements, a new economic cycle will kick off mid-year when investors become more confident and the stock market cast off its shackles and soar.
Source: Guanghua research group on Macro-economic policy
