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April 13, 2015

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Home » Business » Benchmark

China recalibrates monetary policy amid reform

Premier Li Keqiang announced in March that China’s economic growth target had been lowered to around 7 percent from 7.5 percent last year. In doing so he signaled the government’s willingness to accept slower growth as it presses ahead with structural reforms.

The inflation target was also lowered to around 3 percent from around 3.5 percent in 2014. Given that inflation of 1.8 percent is widely expected this year, many believe much room exists for monetary stimulus.

Nevertheless, the government has stressed the importance of “monetary prudence” despite decelerating domestic demand. The intention of monetary policy is not to engineer a V-shaped rebound but to support a minimum acceptable level of growth. This is an important departure from past macro-management philosophy.

So too is the new way of dealing with debt and credit-driven growth. The global financial crisis left a legacy of massive local government debt, overcapacity and a property bubble, with domestic debt almost reaching 250 percent of GDP in 2014.

Faced with this, the central government chose not to tread its usual policy path. Instead it introduced new prudential macroeconomic management measures.

Even though GDP growth has run below 8.0 percent since 2012 and decelerated to 7.4 percent in 2014, monetary loosening has remained restrained. The central bank has been offsetting temporary liquidity crunches with a combination of short-term operations, standing lending facilities, and medium-term lending facilities. It has also lowered the reserve requirement ratio (RRR) for some banks to boost lending to rural and small businesses. Moreover, the few interest rate cuts — one each in June, July, November and February — have been counter-balanced by the lifting of the deposit rate ceiling, which furthers interest rate liberalization.

Back in 1997, benchmark lending and deposit rates were cut by 144 basis points (bps) and 180 bps respectively after GDP growth fell from 9.7 percent in the fourth quarter of 1996 to 8.0 percent in the third quarter of 1997. The central bank lowered the RRR to 8 percent from 13 percent at one go in March 1998 when GDP growth was 7.2 percent. Compared to that, today’s easing has been practically nonexistent — the RRR remains at 19.5 percent after a 50 bps cut in February 2015.

Another shift is how the central bank approaches property prices in the context of inflation. Historically, interest rates were cut in response to sharp falls in the Consumer Price Index (CPI). In 2008 for example, China cut rates to 5.31 percent from 7.47 percent within four months of a drop in inflation to 1.2 percent in December from 7.1 percent in January that year.

While interest rate decisions will still largely hinge on inflation, there is reason to believe the government will place more emphasis on property prices in the near future. After all, the real estate sector makes up about 25 percent of China’s GDP, and the slowdown in the sector poses serious risks as much of China’s debt is tied to real estate. The fact that property prices in many cities have recorded month-on-month declines continuously since May 2014 was probably what triggered the rate cuts in November 2014 and February 2015.

Given property prices are still moderating across the country, we expect one more rate cut and a further 100-bps reduction in the RRR in the months ahead.

Reforms in the financial sector produces long term benefits China’s deposit insurance scheme will be introduced on May 1, bringing the country another step closer to full liberalization of bank deposit rates. Deposits of up to 500,000 yuan will be covered.

Central bank governor Zhou Xiaochuan said in March that deposit rate liberalization might be completed in 2015. This looks increasingly likely.

When this occurs, competition among the banks will likely drive up deposit rates. The central bank may wish to bring down the cost of capital to aid business. But in this scenario banks could face rising risk premiums and higher funding costs which could prevent the lending rate from coming down.

Furthermore, banks may be reluctant to lend to the extent they become more risk averse. That would be tough for would-be borrowers initially, but ultimately it would lift asset quality. Taking everything into account, it is not surprising that China’s 2015 growth target has been lowered to 7 percent. The idea is to support a modicum of growth while restructuring proceeds, not to stimulate the economy per se.


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