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Why Is China Using A Different Monetary Policy?

When Others Say Increase, China Says Decrease

To maintain the economy's strength, many countries have been wrestling between increasing interest rates and letting inflation rise since early 2022.

The U.S. Federal Reserve started to increase the Federal Fund Rate in March 2022 and has increased the rate 11 times within 16 months: from 0.25% raised to 5.50%. It is not uncommon for other countries to follow suit by increasing their lending rates as well.

For example, the Bank of England increased its interest rate 14 times between Dec 2021 and Sep 2023 (from 0.1% to 5.50%). European Central Bank also raised the deposit rate to a record high of 4.00% recently while the rate was a negative 0.50% about a year ago.

Due to their different issues, China, being the world's second-largest economy, has adopted a totally different monetary policy.

China is Facing A Different Set of Challenges

Despite China reopening following the Covid-19 lock down, the "retaliatory economy rebound" was not as strong as anticipated; and it dropped rapidly. It was clear that warning signs were everywhere: exports were worsening, fears of unemployment were rising, stagflation was knocking on the door, and rival countries were competing for global manufacturing and supply hubs. In addition, researchers have found that local governments are hiding trillions of dollars in debt. Although there is no publicly available data on the scale of hidden debts, they mainly involve bonds issued by local government financing vehicles (LGFVs), state-owned companies that finance local investments. Local governments also use public-private partnership projects, shady loan contracts, and other methods to hide debt and raise funds.

The property market is also struggling since the public has lost trust in developers. In addition to the well-known Evergrande credit crunch, similar cases have been reported from time to time since 2021. Following the missed coupon payment in early August, people were overwhelmed by Country Garden's (2007.HK) halt to their bond trading. In an internal assessment of sales, profits, and debits, Country Garden, one of the top developers in China, was praised as a "role model" of good and healthy liquidity management. Although they managed to avoid default and settle within the grace period, the market was disappointing, further hurting sales of properties in China.

Liquidity: Not Too Much; Not Enough 

The Chinese Lending Interest Rate is benchmarked by the Loan Prime Rate (LPR), which is released by the People's Bank of China (PBoC). LPR is divided into two categories: LPR_1 year & LPR_5 years. LPR_1 year is pegged for household and corporation loans and LPR_5 years is pegged for mortgages.

There is a tendency for money to flow from lower-interest-rate countries to higher interest-rate countries like a pendulum. Therefore, the RMB would face depreciation pressure if China did not follow the trend of increasing interest rates. Chinese LPR was higher than other countries before the interest rate hikes began in early 2022. The Chinese government does not have much room to play with interest rates.

Instead, China needs to ease the pressure on many stakeholders who are in heavy debt. By lowering interest rates, these parties would be able to reduce their interest expenses and have the resources to rebound their activities. Additionally, some schools of thought suggest that a low deposit rate (as a consequence of lowering the LPR) can motivate households to spend rather than keep their money in the bank: the high saving rate post-Covid-19 indicates that a lack of confidence prevented people from spending.

As a result, PBoC adjusted LPR 6 times in the last 24 months as shown here:

Exchange Rate and FDI Concerns

As seen on the interest rate cut table, the amplitude of the adjustment was smaller than the market expected because policymakers also have other concerns. Increasing the interest rate gap by cutting lending rates aggressively increases exchange rate pressure. Reports indicated that Foreign holdings of Chinese equities and debt have fallen by ~1.37 trillion RMB ($188 billion) from Dec 2021 to Jun 2023. Compared to Dec 2021, this represents a 17% reduction. A $12 billion outflow was recorded for August 2023.

There are two ways in which the fall of Foreign Direct Investment has impacted China: reduced investment slows down the economy; and huge capital outflow creates pressure on the exchange rate. The expectation of depreciation also creates the tendency for other capital to panic and outflow: a self-fulfilling prophecy. In Sep 8, the RMB touched 7.351 against the dollar, the lowest level in 16 years. Even though the rate rebounded a bit, it indicates a weakening RMB.

In recent news, the PBoC tightened its approval processes for entities requesting to exchange foreign currency in lots exceeding $50 million. Although the authority does not intend to stop legitimate and essential big-ticket FX transactions for normal business activities, it wishes to make a gesture to the public about stopping FX speculation trades.

Loosening Mortgage Controls

Since property and affiliated sectors account for a quarter of the Chinese economy, slow sales of property trigger the alarm of an economy in further decline.

In order to drive the property market, PBoC lifted the "Restriction of Second Home Mortgage" restriction launched a few years ago for counteracting real estate speculation.  In general, banks and local governments use “first home mortgage” (lower payment ratios and more favorable mortgage rates) to influence home buying desires.

In the old policy, if the borrower had a home registered in his name (now or in the past), the new mortgage would be treated as a second home, and tougher terms applied. This included both second home investments and upgrades.

As per the new policy, a person can apply for a first mortgage as long as he has no home registered under his name at the time of application.  Some local cities further relax the requirement that mortgage applicants have no home in that particular city: they are treated as first-time home buyers. By doing this, potential buyers, usually young couples or buyers with tight budgets for a down-payment, feel more encouraged to enter the property market.

A Low Reserved Ratio Means More Money to the Market

As an alternative to lowering interest rates, Chinese policymakers inject liquidity by lowering the Required Reserve Ratio (RRR) of banks. Since 2021, there have been six cuts and the RRR has been lowered from 12.5% to 10.5%. It is important to note that the 10.5% RRR applies only to large size financial institutions; small and medium financial institutions, including local banks and credit unions, already follow a more relaxed RRR requirement, and have only until the latest cut to meet 7.75% RRR. As per the PBoC, the weighted average RRR of Chinese financial institutions is 7.4%, with 500 billion RMB ($68.7 billion) set to be freed up for medium- and long-term liquidity. 7.4% RRR for an institute is very tight if any bad news or rumors trigger a bank run.  

Chinese Bank Required Reserved Ratio (RRR) cuts and liquidity released   

More Stimulus Policies Needed in the Pipeline

Chinese Policy Makers were working very hard to find an appropriate mix to let the economy locomotives get back to their former speed, or at least a speed comparable to before Covid-19. It was still too early to see the light at the end of the tunnel, with market watchers still expecting more stimulus policies would be released from now until the end of the year. 

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