China’s financial system has undergone a significant transformation over the past few months, but it has happened so quietly that it has remained off the radar for many investors.
The big change is the way in which the central bank conducts monetary policy. The People’s Bank of China has dramatically ramped up its use of open market operations, relying almost exclusively on bond repurchase agreements to inject cash into the economy.
Although this mode of liquidity management is the norm in developed economies such as the US and Europe, it is a new development in China – and it is loaded with economic and political significance.
Previously, the Chinese central bank used required reserve ratios, in effect forcing banks to lock up a portion of their deposits, thereby limiting how much they could lend. When inflation was running high, the central bank raised the ratio; when growth was weak, it lowered the ratio, releasing money back into the financial system.
Heading into the second half of this year, analysts had expected that the central bank would cut required reserves to cushion the slowing economy. Barely a week went by without rumours of an imminent cut, but the rumours and the forecasts came to naught. The central bank did not cut required reserves and many in the market grew worried that it was sitting on its hands.
But with little fanfare, the central bank has been active. Twice a week at its auctions of bills and bond repurchase agreements (repos), it has made net injections of about Rmb1tn in the second half so far – equivalent in magnitude to a cut in required reserves of more than 100 basis points.
The People’s Bank has shed little light on why it has made such a pronounced shift. In its third-quarter monetary policy report, published on Friday, it simply declared its satisfaction with the results, saying there was an “appropriate amount of liquidity” in the banking system.
It is more complicated than that. For the economy, the transformation reflects the central bank’s concerns as well as the rise of a more market-driven financial system in China.
Zhu Haibin, an economist with JPMorgan, says the central bank is worried house prices could spiral up if it loosens policy too much. Since 2010, the government has been trying to cool an overheated property market and the central bank does not want to undermine those efforts. With open market operations, it has the flexibility to cap liquidity at the first sign of trouble.
“Reverse repos are only a temporary injection of liquidity, so can be withdrawn anytime that the central bank thinks it necessary,” Mr Zhu says. “RRR [required reserve ratio] cuts are more like a permanent injection of liquidity, so it is more awkward to cut and then reverse direction.”
The rapid evolution of financing channels in China is an even more important factor from a long-term perspective. China has traditionally been dependent on bank lending, with companies sourcing about 80 per cent of their funding needs from banks. But a booming corporate bond market and other forms of financing, notably credit from trust companies, have reduced banks to about a 60 per cent share this year.
“The change in the financial system has led to the change in the central bank’s policy tools. Now, both bank lending and non-bank lending need to be controlled,” says Zhou Wenyuan, head of fixed income research at Guotai Junan Securities. “Banks can normally be managed directly but non-bank institutions can’t be managed in the same way, so interest rate adjustments are more important.”
There are also politics at play in the move to open market operations. The People’s Bank of China has considerable leeway in managing the financial system, but it falls well short of full independence. Decisions about interest rates are made by the State Council, or cabinet, and the central bank merely plays an advisory role.
Required reserve decisions used to be the central bank’s alone to make, but after seeing the impact these moves can have, the State Council is now believed to demand a report before any change. That leaves open market operations as the only big monetary policy tool the central bank can wield on its own.
Nevertheless, there is little chance that the central bank would have been as bold as it has been in recent months with its weekly cash injections if it did not have backing from China’s top leaders – and this leads to one final explanation for the open market operations.
The Communist party will launch a once-in-a-decade political transition at a big congress starting on Thursday. Before such a momentous occasion, the party wants everything to be just right. A scramble to cut interest rates or deploy large-scale stimulus would look as if the economy had been mismanaged.
As Louis Kuijs, an economist with Royal Bank of Scotland, wrote this week, the government appears to have opted for “low-profile ways to support growth”.
Additional reporting by Emma Dong
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