China’s monetary policy in 2013 can be described as a moderate tightening. The People’s Bank of China (PBOC), China’s central bank, provided enough credit and money to support steady growth of the real economy while alert against liquidity expansion. There was no adjustment to the required reserve ratio or benchmark interest rate, and open market operations were pursued with caution. The mismatch between “money crunch” at the micro level and adequate liquidity at the macro level, a major challenge facing the PBOC in 2013, is likely to persist in the year ahead.
The Central Economic Work Conference set a prudent tone for monetary policy in 2014. Credit and money supply is expected to return to normal, liquidity will be kept at an appropriate level, and systemic or regional risks will be watched closely. Thus, the major tasks of the PBOC in 2014 include pressing ahead with deleveraging, curbing the excessive expansion of local government financing vehicles (LGFVs), guarding against real estate bubbles and rolling out financial sector reform.
Although the policy outlook is stable and manageable, there is an undercurrent of local government overinvestment just beneath the surface. Despite central government efforts to downplay GDP growth and remove it from the assessment criteria of local officials, it is quite unlikely for them to get promotion in the absence of robust economic performance. What is more, local government investment is often fuelled by greed for lucrative personal gains. The surge in revenue from land sales in 2013, totalling three trillion yuan, reflected how powerful such incentives could be.
As for credit and money markets, last year’s capital squeeze is unlikely to be thoroughly prevented due to the dual-track market under credit regulation and excessive financing thirst on the part of local governments, hence the probability of recurring liquidity shortages in the months ahead.
It is reported that the China Banking Regulatory Commission will soon unveil rules for regulating inter-bank financing. The market is watching this very closely. If the report is true, the rules will be a further blow to non-standard banking assets. On the other hand, despite the fact that the new rules will reduce the chances of future “money crunches”, they will most certainly aggravate capital shortages experienced by small and med-sized banks. They will also mean that banks will have less profit to make.
On the supply side of the market, the soundness of the monetary policy arises partly from the fact that the market is under regulation. So long as the lending rates are not liberalized and benchmark rates not transformed, tension will remain high in the dual-track credit market. On the demand side, the two main destinations for capital flow continue to be “hollow holes”. Although LGFVs are singled out for rectification, it will only improve their “legality” rather than dampen obsession with them. In fact, the rectification may on the contrary heighten local thirst for money. Meanwhile, recent policies have, if anything, increased profit margins in the real estate sector. There is a greater expectation for speculative investment, driving up credit demand that relies on bank borrowing. So long as home prices continue to surge, credit demand in the housing sector will grow rather than weaken. If the abovementioned two “hollow holes” (local financing & home loans) are not plugged, a credit squeeze can be expected in 2014 and overall financing costs will go up. To stave off such risks, monetary policy needs to be prudent bordering on tight.
The PBOC will also focus on a stable RMB in 2014. The recent market-oriented reform of the exchange rate regime seems to herald a new round of appreciation. Both the central parity rate and spot rate of the RMB against the US dollar reached all-time highs in 2013: the yuan appreciated almost 3% against the dollar, much faster than in previous years, leading to a substantial increase in arbitrage transactions. However, the rapid strengthening of the yuan is more likely to reverse than continue in 2014.
Still, two major developments may be expected. As reform deepens, one-way appreciation may come to an end and the RMB will enter the new territory of two-way floating, though within a band of no more than 3%. The other development to watch is how US tapering of its unconventional monetary policy will impact China, especially its exchange rate. Should there be a massive capital outflow as a result of the taper, China will see a slump in the RMB equivalent of foreign exchange holdings, which will have a significant impact on the base currency. Domestic liquidity will be seriously affected and the value of RMB may be weakened. How the PBOC will respond to this scenario and adjust its monetary policy remains to be seen.
In sum, despite the general tone of a prudent monetary policy in 2014, the PBOC will face considerable uncertainty and many dilemmas. It will be a delicate balancing act for it to pursue multiple policy goals in the unpredictable economic environment.
Yi Xianrong is a Researcher at the Finance Institute of the Chinese Academy of Social Sciences.