China’s Evolving Toolkit to Manage Monetary Policy
(Bloomberg) -- China’s monetary policy is in flux, as the central bank tries to weed out risky lending while ensuring money keeps flowing to the economy. To achieve those sometimes competing goals, the People’s Bank of China is engaging a mix of liquidity tools and pricing signals, while keeping its historical benchmarks dormant. An added complication: managing the impact of the Federal Reserve’s exit from years of ultra-loose policy and calibrating the speed at which it opens the financial system to outsiders. The bigger picture is the PBOC’s transition from being China’s only lender under Mao Zedong to something resembling the Federal Reserve or the European Central Bank -- a modern institution that sets the price of short-term money using interest rates to lend in financial markets. But for now, it’s not clear what that lending benchmark will be. Yi Gang, who took over the reins of the PBOC this year, cautioned recently against a too-rapid pace of change -- suggesting that officials are still focused on tweaking their own framework. That means investors need to keep watch on a variety of fronts to discern policy direction. Here’s a look at the main items in the PBOC’s ever-evolving toolkit.
Open Market Operations
While OMOs cover a variety of tools, it usually refers to the PBOC offering reverse-repurchase agreements in the open market. The contracts are short-term loans to banks and are the most common tool to smooth money-market rates. The 7-day operation, which steers the short-end of the money-market curve, may have potential to develop into China’s new policy rate. Reverse repo operations are gaining prominence as the PBOC increases the frequency of operations and adds tenors. In a broader sense, open market operations also include tools with longer tenors such as central bank bills. Regardless of the tenors, the operations can result in either a net injection or withdrawal of cash from the financial system and hence have an immediate effect on the money market. The PBOC has typically tweaked the reverse repurchase rate to keep in line with the Fed -- though it didn’t immediately do so this week following a 25 basis point hike in Washington.
Required Reserve Ratio
A measure of how much cash banks must deposit at the central bank, nominally as a prudential measure to ensure lenders can handle customer withdrawals. But in China, it’s an important means to manage the money supply, especially with the nation’s persistent current account surpluses. While this tool had been eclipsed by innovative methods such as the Medium-term Lending Facility in recent years, it looks to be returning to favor. In contrast to many of the central bank’s lending tools, a reserve-ratio cut is a nearly cost-free liquidity source for banks. RRR cuts ensure lenders have cash to dole out to borrowers as the move toward more market-oriented interest rates drives up deposit rates.
Medium-term Lending Facility
The MLF started in 2014 and allows the central bank to provide funds with longer maturities, stabilizing market expectations with tenors ranging from three months to a year. As the funds come with higher interest rates compared with reverse repos, MLFs can ensure adequate funding without flooding the banking system. MLFs also help improve rates transmission in China where financial markets still lack depth, as they set borrowing costs at the longer end of the curve. After declining in April as banks used funds that were freed up by an RRR cut to repay 900 billion yuan ($141 billion) of loans, outstanding MLF rose again in June when the PBOC injected more than expected. While the central bank says that move was intended to help fund smaller businesses and the green economy, it might not remove the need for further RRR cuts, as more than 4 trillion yuan is still outstanding.
Benchmark Interest Rates
The PBOC historically used benchmark lending and deposit rates to set the basic fundraising costs for banks, companies and individuals. These are the most powerful, but bluntest tools in the PBOC’s arsenal, with impact across the entire economy when changed. The rates were last altered in October 2015 and the central bank is now allowing banks some leeway above or below the official rate, as part of its liberalization. According to Yi, the strategy is to gradually "unify" these rates with money market rates, which the central bank controls through other tools.
The PBOC’s balance sheet is different in many ways from those of its western peers. With about $5.6 trillion in assets, it’s the world’s biggest. It’s mainly foreign currency assets, because the bank bought large amounts of foreign currency to keep the yuan stable in spite of the nation’s huge trade surplus and capital inflows. As China’s cross-border capital flows become more balanced, the size of this position in foreign exchange will stabilize. For now, that pile forms China’s war chest to manage the currency, a task entrusted to the PBOC’s subsidiary, the State Administration of Foreign Exchange, or SAFE. The FX hoard was deployed to support the currency when a mini devaluation in mid-2015 and fears over the nation’s economic slowdown weakened the yuan.
The PBOC is also trying to build an interest-rate corridor that could help reduce central bank intervention in the market, by setting upper and lower bounds. It hasn’t been completely successful. Part of the reason is that the intended upper bound of the corridor - the Standing Lending Facility, or the Chinese version of U.S. Discount Window - is only available for larger lenders, and actually asking to access the loans is seen as frowned upon. There have been times that the 7-day repo rate, the short-term borrowing cost of financial institutions, surged beyond the SLF lending rate with the same maturity.
The PBOC has created many tools similar to the MLF to offer funding to various banks in different scenarios.
- Pledged Supplementary Lending is a program used to fund investment by the nation’s three policy banks in areas including shantytown re-development.
- Short-term Liquidity Operation was introduced in 2013, aiming to address temporary fluctuations in the money market. It hasn’t been used in recent years as the central bank moves to daily open-market operations.
- Contingent Reserve Allowance is a new addition to the PBOC’s toolkit, and is aimed at providing temporary liquidity to banks during the Chinese New Year, when there is usually a cash shortage. The tool replaces the Temporary Liquidity Facility, which was used only once last year to ease a cash crunch before the Lunar New Year holidays.
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