Xia Le: New Tools Allow for Shrewder Chinese Monetary Policy

2017-03-21 IMI

This article appeared on Nikkei Asian Review on March 8, 2017. Xia Le, Chief Economist for Asia, Research Department, Banco Bilbao Vizcaya Argentaria Central bank must improve market communications to avoid increased confusion In defending Beijing's official economic growth target of "around 6.5%" for 2017, Chinese Premier Li Keqiang pointed out to the National People's Congress last Sunday that the authorities now have more options in their policy toolkit to offset potential negative economic or financial shocks. While this year's growth target may be challenging given escalating external risks and domestic financial vulnerabilities, Li is right about the greater availability of policy tools, at least monetary ones. Over the past few years, the People's Bank of China, the central bank, has established a new interest rate corridor system along with an accompanying set of policy instruments. These are starting to take center stage in China's monetary policy, pushing to the side traditional tools such as benchmark lending and deposit rates and required reserved ratios. As revealed in the PBOC's last two quarterly monetary policy reports, the upper boundary of the new interest rate corridor is formed by the interest rates the central bank charges on its overnight, 7-day and 1-month standing lending facility to qualified commercial banks. The central bank also now has medium-term lending facilities for three and six months, as well as one year, for injecting liquidity. At the bottom boundary of the rate corridor is the interest rate which the central bank pays on banks' excess deposit reserves, currently 0.72%. Banks can withdraw liquidity from the money market at the bottom of the corridor when the money market interest rate falls below this level. The new policy rate is the pledged 7-day interbank market rate, which is the interest rate for bank-to-bank borrowings. By design, the policy rate will fluctuate only within the new corridor. When the policy rate target rises to the upper bounds of the corridor, banks can directly resort to the PBOC to meet their short-term liquidity demand instead of borrowing in the interbank market. Similarly, banks can deposit their liquidity as excess reserves on the PBOC's books if they find the policy rate falling to the bottom of the corridor. The central bank is expected to frequently conduct open market operations to align the policy rate with the authorities' desired level. Currently the main open-market policy tools include 7-day, 14-day and 28-day repurchases, known as repo, and reverse repo, operations. These repo agreements allow the central bank to withdraw liquidity from, or inject it into, the money market. The PBOC announced last year that it would conduct open-market operations daily, up from twice a week. Not Shibor Some had expected the 7-day repo or 3-month Shanghai Interbank Offered Rate to become the new policy rate. Both of these important money market rates are used as benchmarks for large amounts of financial products. But the pledged 7-day interbank market rate applies only to bank-to-bank transactions while the other two rates also apply to transactions between banks and other financial institutions. Given that only banks are eligible for the standing lending facility and the medium-term lending facility, it makes sense to target a policy rate purely for bank-to-bank transactions so that its movements can be effectively confined to the corridor. The corridor system features a diversity of policy tools and flexibility for pursuing multiple policy objectives. The standing lending facility and medium-term lending facility rates at the top of the rate corridor almost form a yield curve. In conducting monetary policy, the PBOC can choose to adjust the amount of liquidity injection via open-market operations or by moving lending facility rates. The central bank can select the term of its lending facilities to indicate its policy stance. In this respect, the PBOC has frequently used the 6-month and 1-year medium-term lending facilities to inject liquidity into the money market since last August, attempting to raise financing costs for small banks to discourage them from building up leverage. The flexibility of the corridor system lies in the fact that the policy rate, or the pledged 7-day interbank market rate, is dictated by market forces. The central bank can guide it up and down, albeit within the corridor, to achieve monetary policy objectives other than economic growth and price stability, for example, the management of stable capital flows. When pressure for capital outflows rises, the central bank can swiftly raise the upper bound of the rate corridor or withdraw liquidity from the money market via open-market operations so as to lift the policy rate and discourage further outflows. This is a useful tool as China still faces enormous pressure for capital flight despite the announcement Tuesday that foreign reserves are on the rise again. Mixed signals The corridor system however can send confusing signals to the market, due in part to its multiplicity of tools and policy objectives. The market could misinterpret the central bank's intentions if signaling is not improved. For example, policymakers might guide the policy rate higher to try to attract more capital inflows, but domestic investors might misread this as a signal of further policy tightening, leading potentially to a major market selloff. The launch of the corridor system has thus increased the need for the authorities to improve their capacity and skills in market communication. Traditional monetary policy tools remain however as potential useful supplements to the corridor system. If needed, the authorities can give a clearer, stronger policy signals to the market by deploying such instruments. The authorities are likely to continue tinkering with the corridor system. The PBOC may gradually narrow the height of the corridor, most likely by raising the lower boundary, as the authorities want to keep a prudent monetary policy stance. Second, the authorities will likely promote the policy rate as the new benchmark for pricing financial products to enhance the efficiency of policy transmission. Despite the PBOC's enlarged toolkit, China's monetary policy stance is constrained. Central bank officials recently identified obstacles to further policy easing including: growing asset bubbles, especially in the housing market; continued expectations of yuan depreciation; rising inflation expectations, especially with the producer price index climbing; and the country's unbalanced economic structure. Room for the further tightening of monetary policy is also limited this year because although growth momentum has visibly picked up, its sustainability remains a question. With the authorities apparently drawing up ambitious plans to curb the huge shadow banking sector to contain rising financial risk, such regulation could exert significant tightening effects on the banking sector and the entire economy. On balance, the country's monetary policy stance this year is likely to be prudent as stated by Premier Li. In the face of enormous uncertainties externally and domestically, the authorities have to walk a fine line between containing financial risks and averting a sharp deceleration in economic growth. Even with a more flexible monetary policy framework, this year's growth target could still be missed.

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Xia Le: New Tools Allow for Shrewder Chinese Monetary Policy

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