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Will Chinese Currency Policies Change Directions After An Interest Rate Cut?

Mar 27 , 2015
  • Yi Xianrong

    Researcher, Chinese Academy of Social Sciences

The Chinese central bank suddenly declared a symmetrical cut in interest rates on February 28. Judging from its explanation, the cut intends to consolidate achievements in reducing the business sector’s financing cost, preventing the automatic tightening of currency policies resulting from excessively high real interest rates, and to create a “neutral, moderate monetary and financial environment” for economic restructuring and upgrading. The market, however, is more concerned about whether the latest cut means China is officially in the sweeping global game of quantitative easing. Will there be a major shift in China’s currency policy?

In the wake of the People’s Bank of China’s unexpected announcement of an interest cut in November 2014, many international investment banks had predicted Chinese currency would enter a cycle of cutting reserve requirement ratios and interest rates. Following the latest rate cut, international investment banks sound even more exaggerated about their prediction. However, judging from either the bank’s monetary policy execution report, or the post-cut explanations, the Chinese central bank doesn’t think the rate cuts means any fundamental change in the orientation of monetary policies, not to mention the excessive quantitative easing as in Europe and the U.S. But from the perspective of actual operation, the Chinese central bank’s monetary policies do appear in a fix, and their orientation remains very unclear.

First, the abrupt rate cut was meant mainly to solve three problems. 1) The central bank is most concerned about the risk of deflation when international oil prices continued to drop, PPI continued its negative growth, and inflation remained below 1%. Hence when inflation dropped below 1% at home, the central bank had to cut interest rates and prevent automatic tightening of domestic monetary policies. But in fact, considering the current speed of currency increase at home, level of residents’ monetary incomes, and the actual CPI level, the Chinese economy remains far from deflation. The central bank’s rate cut has more emphasis on expectation management.

2)The biggest problems for the Chinese economy now are the all-round withering of investments and sales in the housing market. This not only results in the downward tendency of domestic economic growth and oversupply in many industries, but may also trigger risks in the domestic financial system and local fund-raising platforms. The most outstanding trouble for the Chinese real estate market at the moment is how to digest stocks and increase demands. The rate cut may play a huge role in lowering home-buyers financing cost. It not only directly reduced their loan-repayment cost, but can reverse expectations in the entire housing market, reigniting a vigorous housing market. Judging from the effects of the new housing credit policies since 2014, however, it won’t be easy for the rate cut to fulfill the set goal.

3) The main idea behind the latest rate cut is to “reform through adjustment”. On the surface, the cut was a symmetrical one. But by raising the upper limit of the range of the upward movement of deposit rates of all financial institutions to 1.3 times,it has taken a significant step forward in the rate-based reform of domestic banks. The 1.3-time expansion not only increases domestic banks’ autonomy in risk-based pricing, but also calls for more competent management of risk-based pricing on the part of commercial banks. For commercial banks, deposit rates are hard constraints on their cost. Rising interest rates will not only lower banks’ profit levels, but also require banks to come up with better risk pricing for their loans. Under such conditions, the time when domestic banks could win exorbitant profits with the help of preferential policies without making any efforts is gone.

Second, just as the central bank has been emphasizing, the cut doesn’t mean the orientation of the prudent monetary policy has changed. However, in the face of the complicated economic conditions at home and abroad, in order to guarantee the economy’s steady progress this year, the central bank has to use different combinations of monetary policy tools – either regular ones (like rates cut) or irregular ones (like various tools of targeted adjustments) – to maintain rational and sufficient liquidity in the banking system, and create a “neutral, moderate monetary and financial environment” for the economy’s structural adjustments as well as transformation and upgrade. This year, the central bank’s monetary policies are different from previous years. They place more emphasis on active use of policy tools and diversity of such tools.

Third, the current proposal to guarantee the prevention of regional, systematic financial crisis via comprehensive precautions marks a significant difference between the Chinese central bank’s monetary policies for 2015 and 2014. In 2015, the Chinese financial system may face risks in three aspects. 1) Shocks from external markets. The Fed’s interest rate hikes, the strong U.S. dollar, continuous nosedives in oil prices, additional quantitative easing by central banks of various countries, and escalating geopolitical conflicts will worsen fluctuations in the international markets. 2) Optimistic anticipations about the Chinese stock market and rampant speculation may lead to abrupt ups and downs in the market. Yet there is little hope for the insanely bullish performance of the A Shares in 2014 to repeat itself in 2015. 3) The periodical adjustments in the housing market in 2015 may trigger a debt crisis for real estate companies as well as the burst of the real estate bubble. Each of these factors may result in regional or systematic risks for China, which is why the Chinese central bank must be cautious about its monetary policies, avoid excessive “leveraging” and “deleveraging”, and make sure its monetary policies return to neutrality.

It is thus obvious that the Chinese central bank is now in a dilemma regarding monetary policies. It is neither willing to embark on the track of excessive quantitative easing, nor ready to tighten currency policies. Instead, it is returning to neutrality. The current rate cut, therefore, doesn’t mean an orientation change in its monetary policies.

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