Author: Kevin Yao
BEIJING (Reuters) – China’s central bank is expected to deploy its most aggressive monetary tactics in a decade this year as it tries to stimulate the economy and soften the blow of impending U.S. tariff hikes, but risks quickly exhausting its firepower.
The People’s Bank of China’s (PBOC) announcement on Friday that it has suspended purchases of government bonds due to a lack of assets underscores the constraints on its resources as it faces an increasingly challenging economic environment.
Policy implementation is complicated by various factors, analysts say. There is a risk of currency and capital outflows, weak domestic credit demand and less and less room to reduce interest rates and inject liquidity by reducing the required reserve ratio (RRR) – the amount of cash that banks need to keep for rainy days.
All these limitations are interrelated. Further bond purchases, rate cuts or liquidity injections could put depreciation pressure on the yuan, potentially causing funds needed for domestic growth to flow abroad.
The restrictions were evident even before the suspension of bond purchases.
PBOC Governor Pan Gongsheng, in rare forward-looking remarks, flagged in September the possibility of another RRR cut by the end of the year, depending on market conditions, but no cut has taken place despite the looser policy.
More monetary easing could support the economy in the short term, but fuel asset bubbles in the long term.
The PBOC has repeatedly warned that the bond rally that has pushed yields to record lows could undermine financial stability when markets turn.
“Short versus long, domestic versus external and exchange rate versus interest rates – these are multiple conflicts,” said Xing Zhaopeng, ANZ’s senior China strategist.
Faced with deflationary pressures and rising headwinds to already faltering growth, China’s top leaders in December ditched their 14-year-old “prudent” stance on monetary policy and adopted a “moderately loose” stance.
But the room to cut interest rates and bank reserve requirements is less than the extent of easing applied during the “prudential” era, implying that the PBOC may have to be more cautious in practice than before, analysts said.
The PBOC’s seven-day reverse repo rate, its new benchmark rate since last year, is 1.5% after a total of 30 basis points (bps) cuts in 2024. That’s 203 basis points lower than in May 2012, the first data point publicly available.
“Theoretically, the interest rate floor is zero, as seen in the US and Japan. However, I don’t think rates in China will go to zero,” said Larry Hu, chief China economist at Macquarie.
Hu predicts a 40 bps rate cut, which would still be the most aggressive annual cut since 2015.
“If credit demand does not pick up, further interest rate cuts may not lead to increased lending and may instead create bubbles in the financial market,” Hu said, adding that it would also hurt bank profitability and increase the risks of capital outflows by weakening the currency too quickly. and curbing confidence in the economy.
Business confidence is muted, and consumer sentiment is close to record lows. Net interest margins in banks, a key measure of lending profitability, fell to an all-time low of 1.53% in the third quarter of 2024.
Still, most analysts expect RRR to cut this month and a cumulative cut of up to 100 basis points over 2025 from a weighted average ratio of 6.6%. This would bring the average RRR closer to the 5% threshold – which is currently the requirement for the smallest banks, which is generally considered the lowest limit.
DIFFICULT TRANSITION
The shrinking room for lowering rates and RRR could also put a wrench in the works on central bank reforms.
The PBOC’s stated goal – to reduce its “quantity-based” practices of relying on banks to expand credit and rely more on interest rates to transmit policy so that markets play a more prominent role in financing the economy – is becoming more difficult.
“A moderately loose monetary policy will include both interest rates and quantitative measures,” said Xu Hongcai, deputy director of the economic policy commission at the state-run Chinese Political Science Association.
Xu, who also foresees a 40 basis point cut, cautions that the pace of easing must be balanced with exchange rate concerns.
“Excessive currency devaluation could destabilize financial markets, affect expectations and cause panic,” Xu said.
Some analysts, including Hu and Xing, believe the suspension of government bond purchases suggests the PBOC is uneasy about the devastating effects of the yuan’s rapid weakening.
But not all economists are so worried about the softer currency. In theory, this could make exports more competitive and cushion the impact of US tariffs, which President-elect Donald Trump has threatened to raise to 60% on all imports of Chinese goods.
“Sacrificing monetary policy flexibility to maintain exchange rate stability would be a case of putting the cart before the horse,” Zhang Ming, a senior economist at the Chinese Academy of Social Sciences think tank, said in a Jan. 2 article on his WeChat account.
If a rate cut boosts growth, the exchange rate could rise instead of depreciate, he said.
(1 USD = 7.3317 )
