Monetary policy may ease on the margin amidst rising uncertainties

In 2Q2019, underlying financial conditions may have tightened despite the  small QoQ decline in weighted average lending rate (WALR) and the flattish adjusted TSF growth – WALR is still higher than in 4Q2018, credit spread widened visibly, funding channels tightened for various sectors. According to the 2QMPR, weighted average lending rate (WALR) edged down by 3bp in 2Q2019 to 5.66%. More specifically, average interest rate of general loans declined by 10bp to 5.94%, average mortgage rate fell by 15bp to 5.53% in 2Q2019, while weighted average rate of bill financing stayed flat at 3.64%. Meanwhile, Adjusted TSF growth1 remained flat at 11.2 % YoY in June 2019, meanwhile, “M2 proxy”2 growth edged down to 10.0% from 10.1% YoY in March 2019. However, financial conditions have tightened for various economic sectors in 2Q, some of which may not have been captured by the “aggregate” numbers such as WATL and adjusted TSF growth. In our view, it is likely that overall financial conditions tightened on the margin in 2Q, especially relative to the growth and inflation trajectory. On one hand, after the Baoshang Bank (BSB) takeover and a series of policy “amendments” aiming to “tie up the loose ends” of financial regulations, funding accessibility divergence visibly for different sectors. As we have detailed in our research3, funding conditions deteriorated for small banks, non-bank financial institutions, SMEs, developers, and home buyers in response to the overlapping effect from BSB takeover and regulatory tightening. On the other hand, it is worth noting that WALR actually rose by 2bp in 2Q2019 compared with 4Q2018, while core measures of inflation such as core CPI & PPI fell visibly, suggesting that real interest rate is on the rise. In 2Q2019, the excess reserve ratio (ESR) rose by 70bp QoQ to 2%. The QoQ increase is somewhat larger than the usual seasonality suggest, potentially pointing to reduced risk appetite and loan demand.

In its assessment for the global macro conditions in the 2QMPR, the PBoC toned down the assessment on global growth further compared with the 1QMPR. In regards to China, the 2QMPR replaced the notion of “better than expected growth” in 1QMPR, and replaced it with “growth in reasonable range”. Inflation pressure is seen as isolated within food and some raw materials. In the 1QMPR, the PBoC saw global growth as “diverged”, although some downside risks were emerging. In the 2QMPR, the central bank has become more vocal about concerns over global economy growth, noting that “growth in developed markets has declined, while EM growth continued to be anemic. The central bank has clearly become more concerns over growth outlook, as it dedicated a box in the 2QMPR titled “weak global growth and rising downside risks”. More specifically, US growth started to slow more visibly in 2019 as the boost form the 2018 tax cut started to subside. Meanwhile, the PBoC expressed concerns over the negative impacts on growth from geopolitical tensions, brexit uncertainties, trade tensions, and the potential issues with the European banking system.In regards to the domestic economic growth, the PBoC has also toned down the optimism saw in the 1QMPR, stating that growth remains within a “reasonable range”, however, uncertainties are on the rise on both domestic and external demand fronts. The central bank appears especially concerned over the falling investment risk appetite by the corporate sector amidst rising uncertainties domestically and abroad. In regards to inflation, the PBoC sees rising food prices and selected raw material prices a somewhat isolated incident, while core CPI and PPI are declining. In our view, inflation will likely become a constraint for monetary easing (See Figure 1 for the comparison of the wording from 2Q2019 and 1Q2019 PBoC MPRs).

Considering rising uncertainties on growth, it is sensible for the central bank to loosen monetary policy on the margin. We foresee further liquidity injection via OMO instruments, and we maintain our forecast of potential OMO rate cuts and RRR cuts in the remainder of 2019. Comparing the 1Q and 2Q MPR, it is clear that the central bank has become more alert over potential headwinds on growth both domestically and abroad. Therefore, it is natural for monetary policy to loosen on the margin. More specific to the notion over monetary policy conduct, the PBoC added “keeping liquidity conditions reasonably buoyant” to the statement.  In our view, it is necessary for monetary easing to offset some of the tightening effects from small bank deleveraging and targeted financial regulatory tightening (esp. the property market related ones). Meanwhile, deteriorating growth and inflation expectations also calls for further decline of the risk-free rates and weighted average lending rate, in order to combat the potential deflationary pressures. Although it is unlikely for the central bank to resort to large-scale easing, it is reasonable to expect some monetary loosening to offset the contractionary impact from regulatory tightening and rising US-China trade tensions. In this regard, with limited scope for FX reserve accumulation, we foresee policy moves to support base money growth and/or boost money multiplier, in order to maintain pace of money supply growth – these measures include continued liquidity injection via OMOs, potential cut in OMO rates to guide down the market rates, and RRR cuts in the pipeline.

Apart from moderate counter-cyclical efforts, it appears that the central bank will continue focusing on “financial supply side reform” to tackle the complex structural issues in the Chinese economy, more specifically, we see the central bank focusing on the following 3 areas in terms of structural reforms, as indicated by the assignment of “boxes” in addition to the standard MPR contents. More specifically, we see the following items in regards to “structural” (, as opposed to “cyclical”) measures on the PBoC’s agenda:

Interest rate liberalization, i.e. promoting the convergence of market and policy (benchmark) interest rates. As we have discussed in our recent research , the PBoC may phase out the benchmark interest rate in the next year or two. In the 2QMPR, the central bank promoted the LPR as a potential vehicle for market-oriented lending rate reforms. In our view, the PBoC will likely anchor LPR with the OMO rates, while also referencing the risk-free rates (i.e. treasury yields). Therefore, in order to guide the effective lending rate lower for the real economy, we see OMO cuts as an integral part of not only short term cyclical management, but also the structural reform goal of interest rate liberalization.

Safeguarding the deleveraging process for selected small banks, while facilitating further capital injection to repair their balance sheets.  The central bank acknowledged the structural issues associated with the rapid expansion of smaller banks, fueled by interbank asset expansion in the past few years. While the PBoC aims to facilitate a smooth “deleveraging” process of the small banks, the central bank has also expanded in box dedicated to this issue that it is important to rein in the growth of interbank assets and unregulated shadow-banking activities.  Interestingly, the PBoC specified that the issues surrounding the potential “pains” of small bank deleveraging is not just a liquidity issue, but also one of inadequate capital. Therefore, we expect the pace of capital replenishment/injection to speed up in the remainder of the year – indicating potential pick up in perpetual bond issuance for the large and medium sized banks, and likely injection via other channels for the smaller banks.

Continued efforts to channel funding to the SMEs, using a combination of OMO tools and positive incentives for the banks. The central bank continues to emphasize the policy objective to channel more funding to the SMEs. The 2QMPR disclosed that by June 2019, the weighted average lending rate for SMEs has dropped by 66bp vs. 2018, to 4.78% p.a. Furthermore, combined reduction in fees and other transaction costs amounted to another 57bp decline for SME borrowing cost. In addition, the central bank will likely use more TMLF, and regulatory incentive to motivate banks to lend to the SMEs, including targeted RRR cuts & etc.