By Peter Bergman (MoneyAmped.com)
The People’s Bank of China is aiming to change its policy approach by focusing on the cost of credit rather than its magnitude. However, challenges related to liquidity risks and uncooperative markets are posing obstacles to the transition of the economy from state-directed bank lending.
The objective of enhancing the role of markets in resource allocation was reiterated at a Communist Party leadership meeting held approximately every five years in July. The People’s Bank of China (PBOC) is anticipated to have a significant role in driving these reforms.
Major Changes
Over the past few months, the PBOC has been working on developing an interest rate curve that is influenced by market forces. It is anticipated that additional adjustments will be made to ensure that credit demand is more sensitive to changes in monetary policy.
In the future, regulators are optimistic that these modifications can also pave the way for the growth of capital markets as an alternative means of funding, thereby mitigating the potential for inefficient investments by a banking system controlled by the state.
However, with an economy that is experiencing a decrease in growth and heavily depends on government-led infrastructure investment, along with ongoing efforts to modernize its industrial sector, there is a pressing need for adequate liquidity. Markets might be hesitant to offer financing in manners that the PBOC deems advantageous for the achievement of national development objectives.
During a recent battle between the PBOC and bond markets, the influx of funds into bonds caused government debt yields to drop, indicating a pessimistic view of China’s growth prospects.
The PBOC plans to enhance further its monetary policy framework in line with the approach followed by major central banks worldwide. “The pace of change will be gradual,” stated Louis Kuijs, the chief economist for Asia Pacific at S&P Global Ratings.
The PBOC has changed its focus to the shorter end of the interest rate curve and has revealed intentions to gradually enhance bond trading in order to impact long-term borrowing costs. However, further measures are required to improve the effectiveness of its policy transmission.
“We are making progress towards establishing interest rates based on market conditions, but it is a challenging endeavor that will require significant effort and time,” stated an anonymous government advisor, who cannot disclose their identity due to media restrictions.
According to analysts and policy advisers, upcoming reforms may entail the gradual elimination of tools used to provide liquidity, such as credit guidance.
Important Facts
Requirements for available funds
Guidance on credit and various quantitative tools incentivize banks to provide loans regardless of market demand.
This has led to inefficiencies, as excess funds circulate within the financial system when borrowers frequently deposit or invest the money back with the banks.
However, eliminating these tools comes with potential dangers.
With debt levels reaching approximately three times the annual economic output and the pursuit of yearly ambitious growth targets, which for this year is set at around 5%, it becomes necessary to inject greater liquidity each year.
According to Xing Zhaopeng, a senior China strategist at ANZ, it is estimated that the central bank will need to provide around 2 trillion yuan ($281 billion) of new liquidity each year to bolster the economy.
The People’s Bank of China (PBOC) has suggested that the Medium-term Lending Facility (MLF) will be the initial target for a diminished role in monetary policy.
However, by the conclusion of June, the total amount of funding provided through MLF reached 7.07 trillion yuan ($994.6 billion), which accounts for approximately 5.6% of GDP.
“I anticipate that the MLF will not be suddenly terminated as it continues to hold significant importance for financing in the long run,” expressed Lynn Song, the chief economist for China at ING. “It will take some time to complete.”
Market Turmoil
According to ANZ’s Xing, if the central bank were to release interest rates too soon, the market’s inclination towards safe assets rather than other forms of investment could potentially result in an inverted yield curve.
When long-term borrowing costs dip below short-term rates, it often serves as an indication of an impending recession. In the case of China, this could undermine the value of the yuan and lead to the outflow of capital.
“If interest rates are fully liberalized, any form of intervention would become impossible,” Xing stated. “It’s an interesting paradox: when you allow the market to function freely, your flexibility becomes more limited.”
To facilitate the financing of growth, it is essential to implement significant structural changes in the economy in addition to reforming interest rates.
Individual investors primarily control the stock markets in China and are often referred to as a “gambling den” due to limited trading activity. On the other hand, government-owned entities are the primary players in the debt markets, with banks serving as the leading investors.
Due to the relatively low household incomes compared to the size of the economy, the private pension and insurance markets are small. As a result, there are only a limited number of institutional investors in stocks and bonds, which in turn leads to a shallow capital pool for these assets.
Foreign financial investor flows are restricted due to China’s strict control over its capital account.
There needs to be more public discourse regarding the resolution of these constraints on the advancement of capital market growth.
Kuijs of S&P Global Ratings expressed concern about the PBOC’s actions on long-term interest rates, stating that they do not align with the long-term reform agenda.
