Central Bank Could Combine Interest Rate Hikes with Reserve Ratio Cuts in 2018

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Speculation on 2018 monetary policy in the lead up to China’s Central Economic Work Conference points to the possibility of a reserve requirement ratio cut as well as interest rate hikes next year.

The Central Economic Work Conference scheduled for 18 – 20 December is expected to serve as a weather-vane for the formulation of economic policy in 2018, prompting speculation on what signals will emerge with respect to monetary policy.

Based upon the contents of the recent 19th National Chinese Communist Party Congress report, observers expect the conference to focus upon “quality” economic growth as well as the prevention and resolution of key forms of risk.

Given this emphasis upon risk containment, Chinese monetary policy is expected to remain stable and neutral in 2018, given its critical importance to both deleveraging and the stepping up of financial regulation.

“Next year the basic theme of monetary policy will not undergo major change, and will maintain the trend of neutrality and slight tightening,” Sun Lulu (孙璐璐) of China Securities Journal.

“We can expect upward adjustments in open market operations target rates + direct reductions in reserve requirement ratios to be the ‘boxing combination’ of stable and neutral monetary policy next year.”

Given that the US Federal Reserve is likely to raise rates next year, which will put pressure on cross-border capital flows, and a tighter monetary policy environment is of benefit to compelling financial institutions to deleverage, Sun considers it necessary for China to following the lead of the Fed in hiking rates next years, by raising the open market operations target rate when appropriate.

Sun points out that general consensus on the market is that next year will see upward adjustment of the open market operations rate.

In order to compensate for the constrained liquidity conditions that interest rate hikes will create, Sun expects PBOC to implement a cut in the reserve requirement ratio as compensating measure

“Of course, interest rate hikes in tandem with heavy financial regulation could exacerbate tightening of financial market liquidity. In particular, under conditions where interbank operations are subject to strict restrictions, small and medium-sized banks face the need to fill in liquidity gaps.

“This will necessitate reserve requirement ratio cut to supplement liquidity needed by the market.

“However, given that the loosening signal released by traditional reserve ratio cuts is quite strong, it is expected that [PBOC] could continue to use directed cuts, which on the one hand can provide the required liquidity to financial markets, and on the other hand…place emphasis on guiding institutions in expanding the vigour of their support for micro-enterprises and the poor.

“[This] can permit targeted release of liquidity, killing two birds with one stone.”

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