A New Paradigm for Chinese Monetary Policy?
The rise of less-credit intensive growth drivers and China's capital markets could mean a shift in the central bank's triggers for monetary tightening.
(Part one of a two-part series)
The Chinese central bank (PBOC) could be shifting the focus of its monetary policy framework, as the economy shift towards less credit-intensive growth drivers, and capital markets assume a more prominent role in the financial system.
Zhang Yu (张瑜), a researcher at the International Monetary Institute of Beijing’s Renmin University and chief macroeconomist at Huachuang Securities, sees PBOC focusing far more on containing speculative investment and the “empty circulation” of funds, as opposed to the inflationary expansion of the money supply.
“Since, 2025, the rules have changed,” she writes in the paper A New Ship Has Arrived, and the “Waters” Are Layered—Reflections on the Credit System, Where an Old Ruler Cannot Measure a New Ship” (“张瑜：新舟已现，流“水”分层——旧尺难刻新舟之信用体系思考”),
“When the economy recovers, interbank rates have not risen, but instead displayed a downward trend.”
According to Zhang, the relationship between GDP growth, bank loans and monetary policy have all undergone profound change, as a result of a shift in China’s development model driven by the prolonged housing slump, persistently weak household consumption, long-standing deflationary pressure and the rise of advanced manufacturing and hi-tech exports.
The old model
For most of the past two decades, China’s economic growth has been heavily contingent upon the performance of the property market.
Following Premier Zhu Rongji’s reforms during the 1990s, housing gradually became one of the Chinese economy’s principal drivers of investment, employment and household wealth.
Zhang’s view is that the “old economy was dependent upon real estate, and real estate was at the core of economic circulation.”
Because real estate is highly credit-intensive, periods of stronger economic growth typically generated rapid increases in the demand for bank loans.
Commercial bank lending created new deposits, expanding both the balance sheets of banks and the broad money supply. Accelerated growth in the money supply in turn increased the risk of inflation and economic overheating.
PBOC would respond to this by seeking to curb interbank liquidity and excessive monetary growth - oftentimes simultaneously grappling with the expansion in base money created by the forex inflows associated with China’s mounting trade surpluses.
“Under the old economy, whenever prices rose, this would prompt the central bank to contract liquidity expansion,” Zhang writes.
A key means for PBOC to do this has been use of the required reserve ratios (RRR) as a core instrument of monetary policy - a practice discontinued by many of the world’s other major central banks.
The RRR requires commercial banks to hold a certain volume of base money (in the form of currency or reserve accounts at the central bank) on the asset side of their ledgers, as a percentage of the demand deposits on the liabilities side that are categorized as part of the broader money supply.
As commercial banks expand lending, the resulting deposit growth increases their required reserve obligations. This acts as an automatic brake on growth in credit and the money supply.
If the PBOC does not inject additional reserves, the stock of excess reserves within the banking system declines as required reserves rise, increasing the scarcity of reserve balances.
Competition among banks for those increasingly scarce excess reserves pushes interbank lending rates higher, which in turn raises funding costs throughout the financial system and thus slows the pace of credit creation.
PBOC could also reinforce this process by conducting liquidity-draining open market operations, or simply refraining from offsetting the increase in demand for reserves. From March 2016 - March 2018, January 2020 to June 2021, the central bank made no cuts to the RRR which would free up reserves.
Zhang points out that under this traditional framework, interbank interest rates and economic fundamentals displayed a highly pro-cyclical relationship.
Periods of improving producer prices, industrial activity and economic sentiment generally coincided with higher interbank funding costs, because stronger credit demand increased reserve requirements, while the central bank would simultaneously become less accommodating.
“From 2005 to 2024, interbank interest rates and economic growth were largely characterised by a pro-cyclical association,” Zhang writes.
“If we use PMI to represent economic sentiment, and use the PMI six month rolling average to smooth out short-term fluctuations, we can see that whenever the PMI trend increase, often there would be a corresponding rise in interbank interest rates as represented by the DR007.”
The new economy
Zhang argues that the money supply dynamics which characterised most of the past two decades are no longer functioning in the same way.
The reason for this change lies in structural changes to the Chinese economy that have accelerated since the Covid-pandemic - chief amongst them a shift towards less-credit intensive drivers of growth and the rising importance of the capital market in China’s financial system.
The prolonged weakness of the property sector has reduced the importance of one of the most credit-intensive parts of the Chinese economy. At the same time, advanced manufacturing, hi-tech industries and exports have become increasingly prominent drivers of growth.
These new drivers differ fundamentally from the housing sector. They require less bank credit, instead relying more heavily on retained earnings and direct financing via bond issuance and equity financing.
This in turn means they lead to much weaker expansion of commercial bank balance sheets during periods of stronger economic performance. Robust economic expansion no longer automatically translates into rapid growth in bank loans or the broad money supply.
As a consequence, Zhang argues that economic performance, bank loans and interbank liquidity are becoming increasingly decoupled.
PBOC Governor Pan Gongsheng acknowledged the importance of this structural transition during the latest Lujiazui Forum held in Shanghai’s eponymous financial district, when he foresaw “slower credit growth yet more efficient credit allocation perhaps becoming the new normal in China's macro economy.”
Beijing’s push for capital markets to play a greater role in the financial system could also have a particularly profound impact upon the relationship between economic growth and changes to the money supply.
In his speech, Pan highlighted the fact that direct financing through bond and equity markets had accounted for a larger share of new aggregate financing than traditional bank loans for the first time last year.
“In 2025, loans accounted for 45 percent of the new Aggregate Financing to the Real Economy (AFRE), while bond and equity financing combined accounted for 47 percent, outstripping loans for the first time.”
The implications of this shift for monetary policy are highly significant.
Traditional bank lending creates new deposits and therefore expands the broad money supply. By contrast, non-bank financial institutions purchasing newly issued bonds or equities generally reallocate deposits that already exist, rather than creating new money.
Consequently, economic upturns driven by China’s new growth drivers of advanced manufacturing and hi-tech exports may no longer readily produce the same expansion in bank loans or balance sheets that characterised China’s growth in the past, when the property market played a more prominent role.
The rise of these growth drivers that are both less credit-intensive and make more sparing use of bank financing means that China’s future economic expansion could increasingly occur without generating the same boosts to the broad money supply that accompanied previous upswings.
Reading PBOC’s intentions
Zhang argues that observers now need to largely reconsider the way they read the tea leaves of PBOC’s monetary policy decisions as a result of these structural shifts - particularly given the persistence of deflationary pressure in the Chinese economy.
Instead of focusing primarily on inflation or headline credit growth, Zhang believes that policymakers will be increasingly concerned with containing speculative excess, as capital markets assume a more prominent role in the Chinese financial system.
That requires placing greater emphasis on distinguishing between productive financing for the real economy, and what Chinese policymakers describe as the “empty circulation” of funds within the financial system that fuels speculative investment.
If liquidity is viewed as fuelling excessive financial speculation or asset-price inflation via “empty circulation”, policymakers may feel they have reached the limits of monetary easing and start to tighten.
This represents an important analytical shift, as many of the traditional indicators used to forecast Chinese monetary policy - including interbank rates, growth in the broad money supply and bank loans - may no longer harbour the same significance that they did in the past.
As China’s financial system evolves, interpreting these indicators could require a new understanding of how liquidity flows through different parts of the financial system.
Observers can also no longer assume that stronger growth will automatically translate into tighter interbank liquidity, or less accommodating monetary policy.
In Part Two, we explore the emergence of new liquidity ecosystems in the Chinese financial system and the forces that underlie each of them.