As China’s economy begins to stutter, what’s next for its monetary policy?

The People’s Bank of China (PBOC) kicked off the first round of 2019’s policy easing on Friday 4 January, slashing the required reserve ratio (RRR) by a full percentage point, in a bid to bolster bank lending by 1.5 trillion yuan (US$218 billion).

The order came after Chinese Premier Li Keqiang met with top financial regulators to address the need to shelter Chinese businesses from external shocks and to stabilise the economy.

As China continues to grapple with the effects of an economic slowdown domestically and a trade war with the United States externally, the RRR is likely to be a key element of its monetary policy this year.

What does it mean to cut the RRR?

Chinese banks, as with banks in other major countries, are required to hold a minimum amount of capital at the central bank to guard against potential losses, expressed as a ratio of a bank’s outstanding loans. By cutting this ratio, banks are required to hold less in reserve and, in theory, have more money to lend. This should release cash into the real economy, help generate economic activity and, in turn, boost growth.

Why cut the RRR now?

Slashing the RRR is likely to be a key tool for the PBOC this year, as it is a way of controlling one-time additions to market liquidity, carefully calibrated to the needs of the economy, without having distortional effects elsewhere in the economy.

In theory, PBOC Governor Yi Gang has significant leeway to cut the ratio, which now stands at 13.5 per cent for large state-owned banks, much higher than in other large economies.

In the US, where the ratio is placed on deposits themselves rather than the banks holding them, large savings deposits have an RRR of 10 per cent, while small deposits do not have any minimum reserve holding requirement at all. In the European Union, the ratio is 1 per cent, while it ranges from 0.05 per cent to 1.2 per cent for banks in Japan.

The market widely expects an additional cumulative cut of 100 to 200 basis points in China this year, depending on the economy’s performance over the course of 2019.

What are the other tools at the PBOC’s disposal?

The central bank could also cut the interest rates on tools, such as the reverse repo rate, used to adjust daily liquidity in the banking system. This would help to lower the cost of corporate borrowing and so boost economic activity.

However, such a move would send strong signals that the PBOC is easing, since it would reverse the modest rate hikes the central bank employed over the past two years in response to the rate increases by the US Federal Reserve.

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Reducing the difference between US and China interest rates would put downward pressure on the yuan’s exchange rate, which the government has promised to keep stable.

A more unconventional tool Beijing policymakers could use is “window guidance” – when governments use dialogue rather than legislation to persuade banks to loosen the purse strings and lend to small businesses. This would be directed towards the five largest state-owned banks, which receive a quarter of the country’s lending quota, and is widely viewed as an effective way to accomplish policy targets.

Are the floodgates now open?

Despite its continued effort to pump liquidity into the banking system – including four RRR cuts last year and the most recent cut last week – the central bank has stressed that it is support for bank lending rather than engaging in a major easing of monetary policy.

Some analysts view this as rhetoric designed to guide market expectations but, regardless, it is expected that fiscal expansion through tax cuts and government infrastructure spend will be the main drivers of stimulus this year.

Beijing is also trying to avoid a repeat of the policy mistakes it made with its massive stimulus efforts in response to the global financial crisis of 2008.

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That 4 trillion yuan fiscal and monetary policy loosening is credited with saving China’s economy from a crash, but also led to severe industrial overcapacity, a surge in risky lending, huge piles of local government debt, and delays in much-needed economic restructuring.

China’s top leaders also believe a major stimulus effort is unlikely to solve China’s deep-rooted structural problems.

Previous rounds of stimulus have shown that funding often does not flow to the areas the government wishes to support. Instead, excess liquidity can create asset bubbles in the economy, depreciate the currency and undermine ongoing structural adjustment efforts.

What is the PBOC monetary policy priority for 2019?

At its annual conference last week, the central bank made clear that supporting growth while maintaining control over financial risks will remain its priorities this year.

“[We] need to further strengthen counter-cyclical adjustment, maintain reasonably ample liquidity and reasonably stable market [interest] rates,” said its online statement, released after the meeting.

The PBOC will seek to fine-tune policy to keep national growth from dropping below the government’s target rate. This year’s government gross domestic product target figure will be released during the meeting of the National People’s Congress in March.

The central bank’s work will also concentrate on improving the way it communicates policy changes to the market, so that they can be more effectively implemented.