Has China's monetary policy reached its limit?

(By Caixin journalists Peng Qinqin, Wang Shiyu and Kelsey Cheng)

China's companies and households are shrugging off the central bank's efforts to get them to borrow and spend more amid a crisis of confidence in the economy fuelled by slowing growth and the impact of stringent Covid-19 controls.

The lack of appetite for debt is complicating the government's efforts to kick-start stalled growth in an economy battered by the effects of the "zero-Covid" policy, a property slump, an investment funk, along with growing financial distress among companies and local governments.

The People's Bank of China (PBOC) has used nearly every instrument in its toolbox to try to increase demand for borrowing - interest rate cuts; subsidised loans; targeted lending facilities, such as the medium-term lending facility (MLF) and relending programmes; and liquidity injections into the banking system through cuts in banks' reserve requirement ratios and open market operations.

But the impact so far has been limited, partly because of structural changes in the economy that have turned what used to be tailwinds to growth into headwinds. Property and infrastructure investment, the main drivers of debt and economic growth over the past two decades, have stalled and no other sectors, including household consumption, are strong enough to fill the void.

"We have now entered uncharted waters," Lu Zhengwei, chief economist at Industrial Bank Co. Ltd., told Caixin. "This is a situation unseen since the reform and opening up. The property sector can no longer absorb as much investment, and its role as an accelerator for credit expansion has been weakened."

Debate is growing over how much policy room the central bank has left for further easing given its other responsibilities such as keeping inflation in check and ensuring currency stability.

These factors are imposing constraints on monetary policy and limiting how much further the PBOC can cut interest rates - the main tool used by central banks to influence borrowing. Chinese interest rates have been higher than those in the US and other major economies for several years. That's now changing as other central banks increase rates to control inflation, which has contributed to capital outflows from China as investors take advantage of better returns elsewhere.

In April, for the first time in more than a decade, the yield on benchmark 10-year US Treasury bonds exceeded that on Chinese government bonds, fuelling fears of further capital outflows and more depreciation pressure on the RMB.

Some analysts and officials are questioning whether monetary policy will be able to do all the heavy lifting, especially as the problem now is lack of demand for credit rather than a lack of supply. In addition, the economy is going through structural changes that require more coordination across government and policy areas, including fiscal policy.

"The current economic problems go far beyond the scope of monetary policy," a senior regulator who declined to be identified told Caixin. "[But] we should still have monetary policy carry on operating under the existing framework with an emphasis on continuity."

The PBOC has been in easing mode for almost three years - the one-year MLF rate and the seven-day reverse repo rate, a key short-term policy rate, have been falling since November 2019. But measures have been cautious and accretive as the central bank tries to avoid a repeat of the debt hangover that followed the massive financial stimulus during the global financial crisis.

The central bank has stepped up its actions over the past year or so as GDP growth has continued to slide, expanding relending programmes to boost credit to some sectors in addition to cutting rates.

The PBOC has made significant efforts this year to support the property sector given its importance to the economy. To help revive flagging new-home sales, banks were told in May to cut the minimum mortgage rate for first-time homebuyers, and they have been urged to offer reasonable credit to property developers.

In August, China Bond Insurance Co. Ltd., a state-owned financing guarantee company, was told to provide direct guarantees for bonds or asset securitisation products issued by qualified developers, a programme that aims to ensure they have money to complete unfinished projects.

Following an alarming set of economic data for July, released during the first half of August, the PBOC on 15 August unexpectedly lowered the interest rate on its one-year MLF by ten basis points to 2.75%. The central bank uses the MLF to provide funds to the financial system via loans to large banks. The interest rate it charges guides the interest rates that the banks charge their customers through their own loan prime rates (LPRs).

The PBOC also cut the interest rate on seven-day reverse repos, an important money-market tool to manage liquidity in the financial system, to 2% from 2.1% on the same day.

A week later, Chinese banks followed, trimming the benchmark five-year-plus LPR, the reference rate for mortgages, to 4.3% from 4.45%, following a record 15 basis-point cut in May. The one-year LPR also fell to 3.65% from 3.7%, the first reduction since January.

Taken together, these cuts mean the mortgage rate for first-time homeowners has fallen to as low as 4.1% - among the lowest seen in the past 30 years, China Real Estate Information Corp. (CRIC) wrote in a report on 24 August.

"The significance of the LPR cuts may go beyond the attempt to improve demand and could be more about boosting confidence in policies and economic expectations," Lin Yuanyuan, an analyst at BOC International (China) Co. Ltd., wrote in a report on 22 August.

While August's economic indicators showed some signs of recovery, it's still too early to gauge the effectiveness of lower interest rates as they can take several months to affect business and household decisions. The PBOC, along with other government departments and agencies, faces an uphill task to revive business investment and the property market.

Sales of new properties by floor space tumbled 23% year-on-year in the first eight months of 2022, continuing a slide that started at the beginning of the year, according to the latest data from the National Bureau of Statistics. The slump has been exacerbated by a wave of mortgage boycotts by homeowners across the country who are angry that the properties they've paid for have not been completed on time.

Net new RMB loans issued by financial institutions in July and August dropped to 1.74 trillion RMB (US$243 billion) from 2.11 trillion RMB in the same period last year and were up just 1.8% year-on-year in the first eight months of 2022.

Interest rates in China's money markets, where financial institutions lend to each other, have fallen below the central bank's own policy rates, which should be the lowest cost of borrowing.

This phenomenon, known as inversion, points to weak credit demand from companies and households and indicates the PBOC's ability to influence market interest rates has been weakened. With too much spare cash, some banks are prepared to lend it to other financial institutions at a lower cost than the central bank is charging.

The DR007, the interest rate that reflects how much banks charge each other for collateralised loans made through seven-day repurchase contracts, dropped to 1.285% in early August, the lowest rate since May 2020 and well below the PBOC's seven-day reverse repo rate of 2.1% before the 15 August cut. The DR007 has since risen to around 1.5% in mid-September, data from the National Interbank Funding Center show.

Interest rates on interbank certificates of deposit (ICDs), which banks issue to one another on the interbank market with a maturity of less than a year, are also lower than the interest rate on money the PBOC lends to banks through the one-year MLF. The yield to maturity on ICDs fell to around 1.89% in early August from 2.63% at the beginning of the year, compared with the 2.85% cost of borrowing via the MLF, which is now 2.75% after the 15 August cut.

Some analysts said that the excess money sloshing around the formal banking system may be seeping into more-risky shadow banking activities and that institutions are likely using some of it to leverage up and bet on the bond market.

"The excess cash piling up in the interbank system is unable to be transmitted to the real economy, and could lead to a liquidity trap," analysts at Citic Securities Co. Ltd. wrote in a report on 12 August, referring to a situation where the expansion of credit becomes ineffective in stimulating investment and consumption.

"When market interest rates have fallen 50 or 60 basis points below policy interest rates, policy interest rates must be adjusted, otherwise the effectiveness of open market operations will be affected," a senior economic analyst who declined to be identified told Caixin.

The central bank has two main options to reverse the situation - cut its policy rates or withdraw liquidity from the market to reduce the supply of money. It has already pushed interest rates lower and has been draining cash from the money markets through daily open market operations and its monthly MLF activity, which usually takes place in the middle of the month before the monthly LPR announcement.

The PBOC reduced the daily injection of cash through seven-day reverse repo operations to 2 billion RMB from 10 billion RMB in July, and on the day of the rate cut on 15 August, it only partially rolled over 600 billion RMB of maturing MLF loans, which resulted in 200 billion RMB being sucked from the market.

Part of the problem facing the PBOC lies with monetary policy transmission, which refers to how financial institutions, financial markets, non-financial companies, and households respond to changes in policy such as interest rates and how these changes affect prices and economic activity such as investment and consumption.

From 2008 to the first half of 2021, the main channels of monetary policy transmission were the infrastructure and property sectors, Gao Shanwen, chief economist at Essence Securities Co. Ltd., said at a forum in late May. Whenever policymakers indicated they wanted to ramp up investment in infrastructure or real estate, there would be a sharp rise in bank loans and total social financing, China's broadest measure of credit and liquidity. But that's no longer the case, he said.

"If local governments, the real estate industry and the private sector are not borrowing, how can monetary policy be transmitted?" Gao said.

Even ignoring the impact of the pandemic, China's economic fundamentals have begun to change, which is affecting transmission, another senior regulator told Caixin.

"Several factors that drove China's growth in the past, such as globalisation, technology imports, the demographic dividend, as well as large-scale infrastructure and real estate investment, have almost all undergone fundamental changes," he said. "These used to be tailwinds to growth but now they seem to be turning into headwinds."

Household and business expectations have also changed, he said. "No one dares to assume that their income will continue to grow, so they dare not borrow money, dare not consume, and dare not invest."

Many economists point out that China's economy is becoming more dependent on high-end manufacturing and modern service industries to drive growth. But the intensity of demand for credit in these industries and their ability to provide eligible collateral for loans lag traditional industries, Gao said. It is widely believed that consumption - which accounted for 54.5% of China's GDP last year - doesn't require the same amount of credit as investment.

Some analysts are calling for more and steeper interest rate cuts, because they say this is still one of the best tools to revive the economy and create jobs, especially as the current core consumer inflation rate - which excludes more-volatile food and energy prices - is not high.

"Monetary policy is a tool and means, and its purpose is employment and economic growth," said Zhang Bin, a deputy director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. "Now that we are still facing downward pressure on the economy, especially on the job market, should we be more open to other options of monetary policy tools?"

Interest rate policy, as the most market-oriented policy tool, should be given priority, he told Caixin, adding that policy rates need to come down by another 100 to 150 basis points to "achieve the desired level of employment".

But other analysts say the PBOC has little room for more rate cuts because of growing inflationary pressure, rising interest rates in the US, and the risk of further RMB depreciation.

The offshore and onshore RMB weakened past the key 7 per dollar level for the first time since 2020 in mid-September, as worries about growth and a surge in US Treasury yields amid tightening US monetary policy left RMB-denominated assets less attractive than before. On 28 September, the onshore RMB fell to 7.2409, the weakest level against the dollar since 2008.

"The impact of sharp rate cuts on economic and financial stability could be catastrophic," said Sheng Songcheng, an adjunct professor of economics and finance at the China Europe International Business School and former head of the PBOC's Financial Survey and Statistics Department. He added, "China is different from the US and its monetary policy is subject to too many constraints."

"What we are facing now is not a problem with interest rates, but a problem with the supply side [of credit], which has not adapted to changes in the demand side," Sheng said.

Interest rates are only one aspect of monetary policy and in this new environment, the PBOC should consider how to relax monetary conditions overall, including the exchange rate and monetary aggregates, Lu from Industrial Bank said.

Both the central bank and the market need to constantly adapt to the new environment, he said. Everyone was nervous about the prospect of yields on benchmark US Treasurys moving higher than those on Chinese government bonds, but when it finally happened, the consequences were nowhere near as bad as people had feared, he added.

"No one has a crystal ball," said Lu. "We can only constantly put monetary policy to the test and have it adapt to new environments."

This article was first published by Caixin Global as "In Depth: Has China's Monetary Policy Reached Its Limit?". Caixin Global is one of the most respected sources for macroeconomic, financial and business news and information about China.

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