How can China remedy deflation risks without ditching long-held economic strategy?
- Prudent monetary moves and an emphasis on restructuring local government debt have sparked debate over how long it will take policymakers to ‘walk it off’
- Meanwhile, the pitfalls of a potential liquidity trap are deepening as bank deposits rise from consumers and investors hoarding cash, curtailing policy impacts
Persistent risks of deflation and a weakened banking sector may compromise the effectiveness of China’s monetary policy, and such lingering threats could dash hopes for a sustained recovery in trying economic times, according to analysts.
The People’s Bank of China is widely expected to embrace further policy-easing measures to shore up growth. But with low inflation, insufficient demand and the possibility of the US Federal Reserve holding firm on high interest rates, there are growing questions about how far those policy moves can go without significantly changing how Beijing manages the economy.
The International Monetary Fund has warned of risks from overstretched lenders and developers, and it has urged Beijing to find new means of maintaining economic growth, beyond relying on construction and other industrial investments.
China’s banking sector has so far borne the brunt of the debt burden. S&P Global Ratings projected that the non-performing assets ratio for Chinese commercial banks would rise to 5.75 per cent in 2026 from its estimate of 5.55 per cent in 2023.
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The US rating agency also expects more restructuring of local government debt at China’s commercial banks, and such moves could weigh on their capital and earnings in the coming months.
The Bank of Guizhou, a significant lender to the local government of Guizhou province, said its non-performing ratio of real estate loans in 2023 saw a year-on-year growth of 20.18 percentage points to 40.39 per cent, according to a filing with the Hong Kong stock exchange on March 28.
“Chinese policymakers will probably need to take time to walk it off,” said Yao Wei, chief Asia-Pacific economist at Societe Generale, referring to the diffusing of China’s debt bombs. “The banks can digest some of the bad debt, but only if they can still make some money.”
The PBOC’s monetary policy committee said in an April 3 statement, following its quarterly meeting on March 29, that it would adhere to the principle of “enriching its monetary policy toolbox”. It touched on plans to guide large banks to play a main role in the “real economy” while encouraging small to medium-sized banks to focus on their “main business”, all while helping banks replenish their capital.
The central bank also added that it was monitoring “changes in long-term yields” and pledged to improve the efficiency of fund use.
Analysts have been warning of a so-called liquidity trap – an economic phenomenon in which consumers and investors hoard cash in bank deposits, fearful of spending or investing, and thus curtailing the impact of a looser monetary policy.
Yang Delong, chief economist at the Shenzhen-based First Seafront Fund, suggested that the PBOC could consider buying treasury bonds and local government bonds to boost market confidence.
This type of “new mechanism” could help the economy absorb liquidity while reducing “the idling of funds within financial institutions, thus improving the effectiveness of monetary policy”, Yang said in a commentary published by the Shanghai-based China Chief Economist Forum think tank on April 2.
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The PBOC is barred by law from purchasing Chinese government bonds in primary markets but has always been allowed to buy and sell such debt in the secondary market.
Guan Tao, global chief economist at Bank of China International, said that more trading of government bonds from the PBOC could improve liquidity in the market because domestic investors tend to hold bonds till maturity, as demonstrated by the record-low yields on long-term Chinese government bonds in recent months.
A combination of low interest rates, poor stock returns and a prolonged property downturn has prompted investors – including some smaller banks – in China to ignore duration risks by snapping up long-term government bonds, plummeting the yields.
Bonds that take longer to mature are more sensitive to changes in interest rates than shorter-term bonds, meaning longer-term bonds will see a greater change to their price – rising when rates fall and falling when rates rise.
The yield on a 30-year Chinese treasury bond is just 2.46 per cent, compared with the 2.26 per cent yield on a 10-year offering.
“China’s implementation of quantitative easing (QE) would require a more radical fiscal policy and a series of technical issues. The current conditions are not mature, and China’s monetary policy is still in a normal space, so there is no need to resort to QE,” Guan said in a commentary last Monday.
Quantitative easing is a monetary policy in which a central bank purchases government bonds in the open market to reduce interest rates and increase money supply – a measure aimed at stimulating economic activity.
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Rory Green, head of Asia research at GlobalData TS Lombard, said that the PBOC is in a “tricky situation” as it seeks to balance having a stable currency with a looser monetary policy to maintain economic activity and financial stability.
The yuan has been under depreciation pressure against the US dollar following aggressive rate cuts by the US Fed that started in 2022.
“We reckon that the PBOC can maintain divergent policy objectives for the next few months by using quantity/structural easing measures, instead of rate cuts, and combined with capital controls and FX market intervention,” Green said.
The PBOC made two moderate policy rate cuts last year and in January. It also reduced the ratio of reserves that banks must hold, in a bid to boost credit growth.
Lending rates have since fallen, which is more desirable for individuals and businesses wanting to take advantage of low funding costs to meet their borrowing needs.
Unlike many other economies, China has been battling low inflation, with its consumer price index (CPI) growing by only 0.2 per cent in 2023. It means real interest rates are much higher than the central bank’s lending benchmarks.
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China’s producer price index (PPI) – which measures the cost of goods at the factory gate – declined in March by 2.8 per cent, year on year, compared with a fall of 2.7 per cent in February.
The PPI-adjusted real lending rate in China could be as high as 6 per cent based on the one-year loan prime rate of 3.45 per cent, and 7 per cent based on the five-year loan prime rate of 3.95 per cent, according to estimates by securities firm CICC on April 9.
Peng Wenshang, chief economist of CICC, said that one way for the PBOC to bring down real interest rates to boost demand is to raise expectations of inflation through the purchase of government bonds. However, the Ministry of Finance also needs to increase the sale of such debt, he said.
So far, Beijing has refrained from aggressive fiscal stimulus measures that significantly increase China’s deficit-to-GDP ratio. Beijing’s 2024 inflation target is 3 per cent.
“In short, without the coordination of fiscal expansion, the central bank’s purchase of government bonds could increase liquidity, but its effect on promoting aggregate demand may be limited,” Peng said in a March speech that was publicised on April 13 by the Beijing-based China Wealth Management 50 Forum think tank.
