PBOC Expected to Further Cut Reserve Ratios, Restrict MLF Use in 2018

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Domestic analysts expect the Chinese central bank to undertake further cuts to required reserve ratios before the end of the year to unleash greater liquidity, while simultaneously dialling back on the use of medium-term lending facilities (MLF) as part of open market operations.

The People’s Bank of China recently stated in its “Q1 China Monetary Policy Execution Report” (一季度中国货币政策执行报告) that it would engage in “innovation of financial adjustment mentalities and methods,” while simultaneously “maintaining policy continuity and stability, and implementing stable and neutral monetary policy.”

The statement followed a reduction in the reserve ratio requirement for a range of lenders by 1 percentage point on 25 April, unleashing 1.3 trillion yuan in liquidity, of which 900 billion yuan was designated for repayment of the medium-term lending facilities (MLF)  borrowed by banks from PBOC as part of the latter’s open market operations.

Domestic analysts now expect PBOC to restrict the use of MLF’s this year, instead resorting to further required reserve ratio cuts to shore up liquidity.

Pan Xiangdong (潘向东), chief economist with New Times Securities, said to China Securities Journal that PBOC began to make more extensive use of MLFs following the first quarter of 2016 as a means of supplementing liquidity.

According to Pan MLF are unable to completely replace reserve ratio reductions given that they suffer from a number of limitations.

The first of these is the fact that MLF exacerbate the problem of unequal liquidity distribution because they require collateral, which makes it difficult for smaller financial institutions to access funds from the central bank via the instrument.

They also lengthen the “financing chain,” while their longer maturities and uncertainty over whether PBOC will choose to extend them can unsettle market expectations of liquidity.

According to Pan cuts to required reserve ratio have the advantages of increasing long-term supply of funds, which is of benefit to stabilising liquidity and reducing the capital costs of banks.

Xu Gao (徐高), chief economist for Everbright Securities Asset Management, also points out that changing circumstances have diminished the utility of MLF for PBOC’s open market operations.

“Current conditions are similar to 2014 – growth in total social financing lacks vigour, and loose monetary policy is mainly expressed in expansion of base money,” said Xu.

“However, if after expansion of base money total social financing doesn’t increase, then base money can only accumulate within financial markets, without transforming into growth in financing for the real economy.

“This can be considered a ‘landslide dam’ for liquidity….there is the possibility that once financial liquidity spreads around a bubble in the prices of financial assets could follow in its wake.

“Under these conditions, domestic monetary policy is in extreme need of increases of liquidity for the real economy, otherwise the difficulty that the real economy faces in obtaining financing could become even more pronounced.”

Zhu Hongming (朱鸿鸣), a State Council economic researcher, said that Chinese liquidity will be determined by two main factors in the near-term – the first being US treasury yields and the pace of normalisation of US monetary policy, and the second being domestic liquidity conditions.

If economic and financial conditions remain stable, then liquidity will also be kept on a fundamentally stable footing.

Shen Jianguang (沈建光), chief economist with Mizuho Securities, said that a rise in 10-year US Treasury yields was driving the US risk-free rate higher, and a narrowing interest rate spread between China and the US is increasing the appeal of US dollar assets, spurring funds to flow back to America.

This is already putting depreciation pressure on the renminbi, making it extremely difficult for China to further loosen monetary policy.

For this reason Shen expects no change to the basic direction of monetary policy in the near-term, while gradual rate hikes by the US Fed will make steady, neutral monetary policy in China a necessity moving ahead.

With regard to MLF, Shen said that the instruments are an innovative tool for supplementing liquidity but have their limitations.

According to Shen MLF are a key part of the transition in China’s monetary policy framework, and are in fact a “transitional tool.”

“Following further marketisation of interest rates, MLF cannot be used without limit, and their scope is likely to come under control….use of required reserve reductions to offset MLF is a sign of a shift in the monetary policy framework.”

Other leading observers within China also expect the central bank to make increasing use of reserve ratio cuts while dialling back on MLF operations.

These include Wang Tao, chief economist for UBS China, who said that PBOC hopes to restore adjustments to the reserve ratio requirement as a liquidity management tool, as well as veteran banking regulator Yue Xuejun, who opined that reductions in the required reserve ratio may prove to be more effective than open market operations when it comes to channelling funds to the real economy.

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