DeepDive: Changes in the Monetary Policy Toolbox

DeepDive: Changes in the Monetary Policy Toolbox
Photo by Yigang Zhou / Unsplash

Last week, the governor of the PBoC hinted at a number of potential changes to the central bank's monetary policy toolbox, including government bond trading, a greater focus on price-based monetary instruments, and changes to the definition of narrow and broad money supply. Our latest DeepDive has more.

Last week, PBoC Governor Pan Gongsheng outlined a range of potential changes to the central bank’s monetary policy toolkit, including a greater shift from quantity-based to price-based policy instruments, with implications for policy rate tools; a change in the statistical scope of broad and narrow money supply; and the potential for the central bank to trade government bonds as a tool to manage liquidity.

Pan particularly focused on moving further towards a price-based approach to monetary policy. Compared to its peers in advanced economies, the PBoC has, for a long time, more heavily resorted to quantity-based policy instruments in conducting monetary policy, although the role of interest rates has gained more significance over the last decade. The PBoC’s quantity-based tools have, to a large extent, guided banks to increase or decrease the pace of lending to the economy, including the use of reserve requirement ratio (RRR) adjustments, medium-term liquidity injections, structural monetary tools such as relending facilities, and administrative directives. This has proven less effective in reviving growth and domestic demand in recent years.

Such a shift will take time, although it is possible that we are currently seeing some further signs, with the central bank’s communication since late last year focusing on addressing the inefficient use of existing loans in the market, a warning Pan reiterated in his remarks last week (see DeepDive: Key Messages from the PBoC’s Monetary Policy Outlook for our discussion last year). This contrasts with previous years when the PBoC was much more focused on providing new credit to the economy, including via frontloading at the beginning of the year. Such a shift from quantity-based towards price-based instruments would also suggest fewer RRR adjustments in the medium to long term.

Corporate loans and time deposits expanded massively in 2022 and 2023. New corporate loans, for example, grew at a compound annual rate of 17% from 2020 to 2023 compared to 6% from 2016 to 2019 and GDP growth of 5.2% in 2023. We began arguing in the middle of last year that the monetary transmission mechanism was losing its effectiveness, as corporate time deposits grew in lockstep with corporate credit, suggesting that businesses were borrowing for financial arbitrage (see QuickScan: Taking Stock of Money Supply Developments). This trend has begun to reverse recently, probably because the PBoC has stepped up its warnings to banks not to attract depositors with high interest rates (see DeepDive: Data Dump May 2024).

Pan also said the PBoC is considering changing its method of calculating narrow money supply (M1), which currently only includes currency in circulation (M0) and corporate demand deposits. This scope is much narrower than in the US, the eurozone and Japan. In his remarks, Pan signalled that household demand deposits and highly liquid financial products could be included in M1 to more accurately reflect actual money supply. M1 has recently fallen to new lows since at least 2006, suggesting that businesses remain very reluctant to increase spending.

Given there currently are quite a number of policy rate products, Pan said that the PBoC is also looking to set a main short-term policy rate to be able to send clearer signals to the market. He did not specify the short-term rate, but said this role is currently largely filled by the seven-day reverse repo rate. In our view, this suggests that the medium-term lending facility (MLF) rate, which was introduced in 2014, will lose (some of) its significance going forward.

Pan also said the central bank will gradually include government bond trading in the secondary market in its policy toolbox to better manage liquidity. We think this should be seen against the backdrop of diminishing scope for using RRR cuts to free up liquidity in the medium to long term, and a rapidly rising share of lending to banks on the PBoC’s balance sheet over the past decade due to its use of MLF operations, which we believe has been a tool for the PBoC to conduct its own version of quantitative easing (QE) in recent years. The PBoC has deployed RRR cuts less frequently in the past two years, and the share of bank lending has increased to over 36% as of May this year.

That said, the process is unlikely to play out in the short term. While central bank purchases of long-term government bonds would push long-term yields down further, we believe large purchases are unlikely in the current environment, as it would contradict the PBoC’s messaging that yields at the long end of the curve are too low, with Pan reiterating his warnings last week. It could also risk a further underutilisation of capital in the market, something the PBoC has sought to avoid. We maintain our view that market participants should be careful in chasing the bond bull, as we discussed in QuickScan: Watching the Long End of the Curve.

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This report has been prepared by Interlect Analytics Pte. Ltd. It is solely for information purposes and should not be taken as investment advice or a recommendation to buy or sell any security or investment product. Redistribution without prior consent is prohibited.