PBOC Monetary Policy Reform

Transcription

1 Thomas Shik Acting Chief Economist PBOC Monetary Policy Reform The People s Bank of China (PBOC) cut its benchmark interest rates and the required reserve ratio (RRR) in October in response to mainland China s slower economic growth and the persistence of a weak inflation trend in mainland China. The PBOC also took a final step towards interest rate liberalisation by removing the deposit rate ceiling, suggesting that the benchmark deposit and lending rates are now merely for guidance only. Going forward, the PBOC may use short-term reverse repo rates to guide market interest rates. We expect that, over time, changes in reverse repo rates will provide a better indication of the PBOC s monetary policy stance than that provided by benchmark rates. Oct/Nov 2015

2 PBOC easing On October 23 this year, the People s Bank of China (PBOC) cut its benchmark interest rates by 25 basis points, bringing the official one-year deposit and lending rates down to 1.50% and 4.35% respectively (Exhibit 1) the lowest on record for both rates. This was the sixth such move since November 2014, reflecting the further slowing of economic growth and the persistence of the threat of disinflation in mainland China. The economy s gross domestic product (GDP) rose by an annual rate of 6.9% in the third quarter of this year, the slowest rate since the first quarter of 2009, after a growth of 7.3% in 2014 and 7% in the first half of 2015 (Exhibit 2). The traditional drivers of the Mainland economy have been particularly weak. Industrial output growth has remained at its lowest rate in recent history and the latest survey of purchasing managers has indicated contraction in the manufacturing sector. Exhibit 1: Benchmark Interest Rates Exhibit 2: GDP Growth October/November

3 With the slowdown on the Mainland, inflationary pressures are limited, if not entirely absent. Consumer price inflation is currently 1.3%, having stayed at or below 2% for more than a year, and is now less than one half of the Central Government s target rate of 3%. Producer prices have fallen for 44 consecutive months, along with sliding world commodity prices. In addition, the GDP deflator, a broad measure of inflation in the economy that, arguably, only reflects the prices of domestically produced goods and services, turned negative in the third quarter for the second time this year (Exhibit 3). As we pointed out early this year, economic deleveraging has been taking place on the Mainland. 1 Therefore, output growth may continue to slow and inflation may remain weak for some time. In these circumstances, the PBOC is likely to keep monetary policy accommodative and assess the merits of any further rate cuts on a month-by-month basis. In announcing its most recent interest rate reduction, the central bank also lowered the required reserve ratio (RRR) by 50 basis points for all commercial banks and by an extra 50 basis points for those engaged in lending to the agriculture sector and small enterprises. In June, we explained that slashing the RRR is a way to mitigate the adverse impact of capital outflows on domestic monetary conditions. 2 When there are outflows and, in response, the PBOC sells foreign exchange assets (FX assets) to maintain exchange rate stability, both the foreign exchange on the asset side of the PBOC s balance sheet and the deposits held by commercial banks at the PBOC on the liability side will be reduced. If the RRR, which specifies how much of a commercial bank s deposits must be set aside as a reserve at the PBOC, remains unchanged, commercial banks may then have to cut their lending to the private sector to add funds to their reserve at the PBOC to meet the RRR. Therefore, whether or not to adjust the RRR depends a lot on domestic monetary conditions. We see a chance for the PBOC to cut the RRR by a further 50 basis points to 17% by the end of the year (Exhibit 4). 1 Hang Seng Bank, China Economic Monthly, February Hang Seng Bank, China Economic Monthly, June October/November

4 Exhibit 3: GDP Deflator Exhibit 4: Required Reserve Ratio The PBOC s FX assets, a measure of cross-border capital flows, 3 have dropped by more than RMB1.2 trillion since January this year and now stand at about RMB25.8 trillion (Exhibit 5). With concerns about the vicious cycle of capital outflows, slowing economic growth and the weakness of the renminbi (RMB), some are questioning the adequacy of the Mainland s foreign exchange reserves (FX reserves). In theory, the PBOC s FX assets should be identical to the Mainland s FX reserves, for which figures can be separately obtained from the State Administration of Foreign Exchange (SAFE). But, in reality, there are discrepancies between the two as FX assets are valued at historical costs in RMB, while FX reserves are measured in USD and subject to valuation changes when exchange rates fluctuate. According to SAFE, FX reserves have fallen by 12% from a record high of USD4 trillion in June 2014 to the current USD3.5 trillion (Exhibit 6). Although the decline has been significant in amount, it is important to remember that the existence of FX reserves reflects a country s desire to maintain exchange rate stability and its value is to prevent the country s currency from falling when there are capital outflows. As the Mainland is now open to more two-way volatility in RMB trading, the importance of FX reserves has somewhat declined. This can be seen in the way that the Mainland has just prevented the RMB from falling significantly by making use of its FX reserves to meet outflows but, if it later implements a floating exchange rate system, the size of FX reserves should no longer be a major matter of concern. 3 Hang Seng Bank, China Economic Monthly, March October/November

5 Exhibit 5: FX Assets (monthly change) Exhibit 6: FX Assets & FX Reserves Policy reform In addition to reducing benchmark interest rates and the RRR, the PBOC took a final step towards full interest rate liberalisation on 23 October this year by lifting the deposit rate ceiling once and for all. Before this development, banks were free to set their own lending rates but were only allowed to set deposit rates that were up to 50% above the benchmark rate. The central bank has stated that the move to give banks more freedom has been driven partly by the fact that many financial institutions had already entered the market selling wealth management products that offer depositors higher interest rates than the deposit rate cap. 4 Following this move, the PBOC no longer controls the deposit and lending rates that are applicable to transactions between banks and their customers. This development will allow the market to play a decisive role in allocating capital, as pledged by the authorities following the Mainland s Third Plenum meeting in November With interest rate deregulation, banks should be able to charge different borrowers different interest rates, according to their credit risks. But, to facilitate information exchange, there would be a need for a reference rate indicating to the market what price banks are generally setting on their loans under prevailing monetary conditions. This reference rate is commonly called the prime rate. 4 October/November

6 In the US, the prime rate tends to move closely with the Federal Reserve s policy rate (Fed funds target) and the spread between the two has been fairly stable (Exhibit 7). It is typically uniform across major commercial banks, which use it as a base rate for many types of loans. On the Mainland, the PBOC officially introduced the loan prime rate (LPR) in October 2013 (Exhibit 8). It is set by asking nine commercial banks to submit their best lending rates which are then used to calculate a weighted average on a daily basis. By removing controls on market interest rates, the PBOC is now encouraging banks to actively use the LPR as a base rate for their loans to the private sector. 5 Exhibit 7: US Fed Funds Target vs Prime Rate Exhibit 8: Mainland s Loan Prime Rate Interest rate deregulation also means that the PBOC s benchmark deposit and lending rates are now merely for guidance only. The central bank may therefore have to set a new policy rate usually a target level for the short-term interest rate in the wholesale interbank market through which it can affect a range of other interest rates in the retail banking market and, ultimately, influence the state of the economy. This would formally mark a shift in approach for the PBOC - from setting the quantity of money by adjusting loan quotas and issuing window guidance, to setting the price of money by determining the policy rate through which it can influence market interest rates and hence economic activity. 5 October/November

7 But why is this change in the use of policy tools by the PBOC important? First, capital account opening is resulting in more cross-border capital flows, and it is getting increasingly difficult for the PBOC to control the quantity of money that it deems suitable for the domestic economy. Second, rising cross-border capital flows is also making it more difficult for the PBOC to continue to control interest rates at the retail banking level. Against this backdrop, there is a growing need for the central bank to shift its focus to targeting interbank interest rates instead of retail market interest rates. The PBOC has made it clear that it will make more use of short-term reverse repo rates to guide market interest rates going forward. 6 Its policy framework has also been taking shape and is increasingly more akin to the one in the US or the Eurozone (Exhibit 9). Exhibit 9: Interest Rate Corridor People s Bank of China US Federal Reserve European Central Bank Upper-end Standing lending facility Discount window Marginal lending facility (%) (2.75% overnight) (0.75%) (0.30%) Target rate (%) Reverse repo (not specified, currently about 1.8% overnight) Fed funds target rate (0-0.25%) Main refinancing operations (0.05%) Lower-end (%) Interest rate on excess reserves (0.72%) Interest rate on excess reserves (0.25%) Deposit facility (-0.20%) Source: PBOC, Federal Reserve, European Central Bank, Hang Seng Bank 6 Reverse repo transactions are usually at maturities of 7 days, 14 days, and 28 days. October/November

8 Specifically, the PBOC appears to be moving to adopt an interest rate corridor system, under which it brackets its desired level of short-term reverse repo rates with the interest rate on the Standing Lending Facility (SLF) above and the interest rate on excess reserves parked at the PBOC by commercial banks below. The central bank may use open market operations to adjust the supply of liquidity so as to keep reverse repo rates at its target level. And under this corridor system, the ability of banks to borrow from the PBOC at the interest rate on the SLF, which is designed for the purpose of meeting banks short-term liquidity needs, should put a cap on reverse repo rates, while the ability of banks to earn interest by parking money at the PBOC should set a floor on reverse repo rates. Concluding remarks Overall, the PBOC is shifting its focus from control of retail market interest rates to control of interbank interest rates. The benchmark deposit and lending rates are now guidance, not requirements. We believe that changes resulting from the PBOC s open-market operations in reverse repo rates should, over time, provide a better indication of the PBOC s monetary policy stance than that provided by benchmark deposit and lending rates. October/November

9 China Economic Monitor Statistics November 2015 GDP Industrial output Fixed asset investment Retail sales Nominal Real Real Nominal Nominal Foreign trade Consumer prices Exports Imports Trade balance Food Non-food RMB bn yoy (%) yoy (%) ytd (%) yoy (%) yoy (%) yoy (%) USD bn yoy (%) yoy (%) yoy (%) , , , , , F NA Q , Q2 15, Q3 16, Q4 17, Q , Q2 16, Q3 17, Jun 2015 NA NA Jul NA NA Aug NA NA Sep NA NA Oct NA NA YTD 48, Deposits (domestic currency) Loans (domestic currency) New loans Lending rate 1-year Money supply (M2) Forex reserves Foreign direct investment CNY per USD (period end) Total social financing RMB bn yoy (%) RMB bn yoy (%) RMB bn % yoy (%) USD bn ytd (%) RMB bn , , , , , , , , , , , , , , , , , , , , , , , , , F 122, , , , ,000 Q , , , , ,600 Q2 113, , , , ,920 Q3 112, , , , ,280 Q4 113, , , , ,503 Q , , , , ,644 Q2 131, , , , ,125 Q3 133, , , , ,131 Jun , , , , ,833 Jul 134, , , , Aug 134, , , ,086 Sep 133, , , , ,303 Oct 134, , , YTD 134, , , , ,376 NA: not available; (A)= actual; (F)= HASE forecast; yoy= year-on-year; ytd= year-to-date Source: State Statistical Bureau, China Statistical Yearbook, Macrobond, CEIC, Bloomberg, Hang Seng Bank October/November

10 GDP Growth Consumer Price Inflation Urban Fixed Asset Investment Retail Sales Loan & Deposit Money Supply (M2) Benchmark Interest Rates Exports & Imports October/November

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