Chinese policymakers need to think a bit 'out of the box' to find ways to stimulate a stagnating economy. By Jonathan Rogers.
As China grapples with its most severe deflation in almost 30 years and the nominal rate of growth enters secular decline, a radical rethink of monetary policy is underway. Quantitative easing appears the point of destination as the country battles the liquidity trap and the risk of balance sheet recession.
“The GDP deflator, a measure of the price level across the whole economy, has fallen for five consecutive quarters, declining by 0.7% on an annual basis in the second quarter. This is the longest period of deflation in China since the late 1990s,” said Alex Muscatelli, director, economics, at Fitch in London.
“The People’s Bank of China cut interest rates by 20bp in July to 2.3%. This was a lot earlier than we had expected and the size of the cut took market participants by surprise, which speaks to China’s deflationary pressure. In previous periods of weak nominal growth, monetary easing relied more on directly boosting credit and liquidity, including through cuts in the reserve requirement ratio (RRR). But these have been modest over the past year, and credit growth is at an all-time low.”
According to Reuters, Chinese banks extended Rmb900bn (US$127bn) in new loans in August, more than double the July tally but short of analyst expectations; credit growth hit a 15-year low in July and although further action can be expected to boost the supply side of the Chinese economy, such as cuts in the policy rate and the RRR – UBS analysts expect a 25bp RRR cut before the end of the year – it is the demand side of the economy that requires urgent attention.
“We need to see China’s policymakers taking bolder steps, maybe thinking a bit out of the box, to really stimulate the economy,” said Tommy Wu, China economist and director of group research at Commerzbank in Singapore.
“So far, their measures have been piecemeal and somewhat traditional, for example boosting infrastructure investment and attempting to resuscitate the real estate sector. They have refrained from transferring money into households, instead issuing consumption vouchers or providing subsidies, but these have proved rather ineffective.”
The catastrophic state of China’s real estate sector is the lightening rod of the country’s economic woes and the harbinger of a Japan-style balance sheet recession.
In the year to August, prices for existing homes fell by 9%, chalking up the fastest pace of decline on record, while in the year to May, housing starts collapsed by 63%. The consequent drag on sentiment pushes the country deeper into the “liquidity trap” wherein monetary policy becomes ineffective as a tool to stimulate demand due to the reluctance of households and businesses to borrow, preferring instead to hoard cash.
But signs are emerging that the PBoC under governor Pan Gongsheng – in office since July 2023 – is fully cognisant of the impediments facing China’s quest to reach the government’s GDP growth target (of 5% real growth in 2024) and is executing a major realignment of its modus operandi.
Since delivering a policy speech in Shanghai in mid-June, governor Pan has initiated some recalibrations to the PBoC’s approach to monetary policy. In the speech, he downplayed the significance of quantity targets and indicated a switch to the seven-day reverse repo rate as the key policy rate rather than the one-year mid-term lending facility rate and indicated a shift to the narrowing of the interest rate corridor (which moved from 245bp to 70bp in July).
He also cautioned about the risk of low yields in medium to long-tenor Treasury bonds – which hit an all-time 2.065% low at the 10-year liquid benchmark point on September 13.
Speculation around the time of that low print was that the PBoC had orchestrated a market intervention via the selling of long-dated bonds in the secondary market by state banks – involving the shorting of a special 10-year sovereign bond said to be held largely by the central bank – in addition to injecting short-term cash into the banking system via its open-market operations.
“From a medium to longer-term perspective, the PBoC needs another policy tool, because there's a limit to how much you can cut policy rates and the RRR. The latter is already at what Chinese policymakers considered as a threshold for the small banks,” said Commerzbank’s Wu.
“Also, nowadays, yields are so low. Banks and local governments can issue bonds to take advantage of the low yields. The financial authorities are afraid of a bond market bubble and pushing yields too low and hence have been trying to put a floor on long-term yields.”
Other intriguing developments in July indicated a newly minted PBoC focus on the China Government Bond market. On July 1, the central bank announced it would borrow CGBs from primary dealers and added an ad hoc overnight bond repo and reverse repo at 20bp and 50bp below the official seven-day reverse repo rate, with the latter rate cut by 10bp on July 22 to 1.7% – the first repo rate cut in a year – and the bidding process altered from rate bidding at a given quantity to quantity bidding at a fixed rate.
The six biggest state banks heeded the message and cut deposit rates three days later, followed by the remainder of the banking sector over subsequent days.
“The PBoC now has amassed hundreds of billions of CGBs at its disposal. Crowded CGB purchases by banks, NBFIs (non-bank financial institutions) and global investors have driven CGB yields to record lows. The PBoC has been warning against maturity mismatch and interest rate risks since April. With access to CGBs held by dealers, the PBoC is now positioned to support back-end CGB yields. The PBoC's current yield curve control aims at maintaining a steeper yield curve,” wrote Gene Ma, head of China research at the International Institute of Finance in Washington, in a paper published last month.
The turbo-charged CGB rally – driven in part by massive regional bank demand for long-dated CGBs, which purchased Rmb270bn in the first quarter, according to BNP Paribas data – has raised fears among China’s regulators of a Silicon Valley Bank-style liquidity crisis.
“If a large amount of funds are locked in long-term bonds with low yields and if the cost of the liability increases significantly, the funds will be caught into a passive situation of sizeable drawdown from a sharp repricing,” said an unnamed PBoC official to state-owned Financial News in April, months before the full head of steam in the CGB market erupted.
Twist or stick
For now, the PBoC appears be engaging in the approach of the Federal Reserve under its “Operation Twist” programme, implemented between late 2011 and 2012, whereby the central bank sells short-dated securities and simultaneously buys long-duration debt.
The primary aim of the PBoC appears to be retaining a positive CGB yield curve, controlling the long end by setting an effective floor on yields, reducing short-term rates within the newly trimmed interest rate corridor and avoiding liquidity crunches in the event of large-scale bond sales.
But it won’t be lost on seasoned Fed watchers that Operation Twist gave way to quantitative easing – the direct purchase of securities by the central bank involving the massive expansion of its balance sheet in a bid to flood the economy with liquidity in order to boost demand – after the programme was abandoned in late 2012. And many PBoC watchers are convinced that QE is the direction of travel in China as conventional monetary tools fail to boost aggregate demand to lift the economy out of its liquidity trap.
Others take a different view, among them Commerzbank’s Wu. ”Perhaps QE is the answer, but there is the issue of ideology,” he said.
“The Chinese authorities seek to conduct economic policy differently to what we've seen in the West, because there, Chinese authorities viewed that QE plus fiscal boost have created inflation even though these countercyclical policies have been instrumental to recovery from deep recession. Chinese policymakers are also wary about moral hazard involved, as was the case with the “Fed put” during the easy money period in the US.”
Balance sheet recession caused by households and companies paying down debt might not yet be on the cards in China – a concerted regulatory effort to deleverage the economy has been in place since 2017 – although the price action in long-end CGBs might suggest otherwise, and it is possible that conventional monetary policy tools and structural reform might do the trick.
In the latter case, the inefficient allocation of capital via “round-tripping” whereby Chinese banks offer short-term loans at preferential rates to blue-chip customers and simultaneously offer positive carry in the form of higher-yielding longer-duration time deposits has been outlawed.
In all this, the great economist John Maynard Keynes’ solution to the liquidity trap looms: if the private sector will not pick up the slack via spending, it behoves the public sector to assume that role.
And if the required Keynsian fiscal policy boost is to be assumed by the Chinese government, it calls into question the country’s ability to continue its vast overseas lending programme, conducted usually in the form of soft loans to developing countries, with limited publicly disclosed documentation.
That should provide pause for thought for the World Bank, after the Biden administration’s much-touted plan to counter China’s lending to the developing world via a US$3.3bn capital infusion to the multilateral lender that would then generate US$25bn in US-sponsored lending failed in April to meet congressional approval. As China faces its liquidity trap, perhaps the plan should be dusted off.
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