Chief China economist, UBS

China is easing monetary policy with quantitative measures, as it typically has done in the past. This should not be treated with the same significance as the “quantitative easing” undertaken by the US Federal Reserve or the European Central Bank after exhausting their other conventional ways of monetary easing. Such an analogy overstates the amount of easing in China, in our view.

Unlike typical central banks in developed countries and many emerging markets, the People’s Bank of China relies mainly on quantitative means to manage its monetary policy. Each year, it sets a monetary aggregate target (M2). To achieve this target, the central bank has two methods.

The first is on-lending facilities and its variations, open market operations, foreign-exchange market intervention and reserve requirement ratios to manage money supply. The second are additional means, such as loan quotas and loan-deposit ratios to manage bank credit quantity.

China’s most recent monetary easing was the announced expansion of the so-called pledged supplementary lending, or PSL, to policy banks. In such an operation, the central bank will provide liquidity to the China Development Bank via PSL, and the bank subsequently increases its lending to infrastructure projects and other government-supported investments.

PSL was reportedly collateralized with CDB loan assets in 2014, and in the future, will likely be collateralized with local government bonds. It is also possible that commercial banks may, in the future, be able to use local government bonds as collateral to access “on-lending” liquidity from the central bank. Fundamentally, we do not consider this to be materially different from how the central bank has managed China’s base money supply in the past. The only difference is that the type of collateral used will now include new provincial government bonds once they are available, along with longer terms of liquidity provision.

The expansion of PSL does not mean that China has run out of other means to increase base money supply or that it has exhausted the interest rate tool. The central bank could have easily cut still high reserve requirement ratios more aggressively, but the government chose to use PSL and similar liquidity facilities instead, out of a belief that PSL can deliver more targeted easing to fund infrastructure projects while other measures are seen as more general easing. Interest rates can, of course, be further lowered, but that won’t have much impact on the quantity of credit or monetary aggregates.

With regard to local government debt swaps, the central bank’s acceptance of local government bonds as collateral for its long-term liquidity facilities does not equate to a direct purchase of government debt by the People’s Bank of China. Although some may see this only as a technicality, this debt will actually continue to officially sit on the balance sheets of local government.

To the Chinese government, for moral hazard reasons, it is important to differentiate between providing liquidity to local governments versus assuming direct responsibility of local government debt. We do not see this line crossed any time soon.

Base money growth

How much easing has happened and how much more could come?

The People’s Bank of China has cut the benchmark lending interest rate by 65 basis points since late November and the reserve requirement ratio by 150 points since early February. The latter action released more than 1.8 trillion yuan (US$290 billion) in base money liquidity. However, this must be viewed against a backdrop of declining forex accumulation and currency intervention. Despite the reserve ratio cuts and liquidity operations, China’s base money growth slowed markedly in the first two months of 2015. That said, we think the latest cut and the easing of capital outflows in April will likely lead to a pickup in base money growth.

Benchmark lending rate cuts since November have led to a 45 basis points drop in prime lending rates charged by banks. However, the real lending rate is currently still 90-100 points higher from last October due to an accelerated decline in inflation. We think real rates likely dropped further in April.

For the rest of 2015, we expect the central bank to:

• Cut the reserve requirement ratio by at least another 100 basis points to help offset larger-than-expected capital outflows and lower market interest rates, and to facilitate local government debt swaps;

• Lower benchmark interest rates by at least 50 points to bring real rates back to their average 2014 level;

• Increase the use of both short-term and longer-term liquidity facilities. We think new PSLs alone could exceed 1.5 trillion yuan;

• Increase the yuan-backed loan quota and ease ratios that would allow more bank lending to help offset the slowdown in shadow credit expansion.

Why hasn’t the government done more? While some people have criticized China for easing again instead of forcing through faster structural changes in the real economy, many investors agree with us that the central bank has been behind the curve with respect to monetary easing, resulting in a notable rise in real interest rates and a slowdown in base money growth.

We think the government has been reluctant to ease because it may have been concerned about making the same mistake as in 2009 by easing too much instead of allowing restructuring. It may be concerned about aggravating China’s already high leverage ratio. And it may be concerned that easing that is ineffective in stimulating growth will end up being “wasted.”

We think more people in the government and think-tank circles now recognize the need to fight deflationary pressures and contain financial risk. In addition, there is also better recognition that capital outflows have increased and that the consequent effect of liquidity-tightening needs to be offset by other measures.

We think additional economic data deterioration and pressures in the real economy will trigger more easing.