How China hopes to escape a liquidity trap using central bank credit guidance

As well as engineer a recovery in asset prices to enhance monetary policy effectiveness.

China has seen a decline in the effectiveness of its traditional monetary policy tools, just as Beijing steps up stimulus measures in response to ailing domestic demand and heightened geopolitical tensions.

Top domestic pundits impute the problem to a dynamic much akin to Japan’s balance sheet recession of the 1990s, alongside a deflationary environment that raises the real cost of borrowing above nominal costs.

They argue that Chinese households and enterprises are loathe to borrow and spend - irrespective of the cost of credit - due to the damage inflicted upon their asset holdings by a multi-year property slump.

Leading economists believe a solution lies in the state exercising precision control of credit distribution and interest rate cuts, via the Chinese central bank’s “structured monetary policy tools.”

The Chinese central bank has already unveiled a raft of bold adjustments to its structured monetary policy tools since the start of 2026, indicating that state credit guidance is set to play a more prominent role in the near-future.

The best cure for China’s sluggish credit growth, however, is expected to lie in Beijing’s plans to engineer a recovery in the stock and property markets, as the most expedient means of healing the nation’s hampered balance sheets.

Why traditional monetary policy won’t work for China right now

Zhang Ming (张明), deputy-head of the Chinese Academy of Social Sciences Financial Research Institute, argues that the traditional time-and-tested means for central banks to boost economic activity - trimming short-term interest rates - will prove to be of limited effectiveness under China’s current conditions.

This is because China is still struggling with the fallout of a multi-year property slump, which has caused widespread damage to household balance sheets and undermined the confidence of businesses.

China’s economy now faces the same challenges that Japan did in the 1990s, when the Land of Rising Sun found itself in the grip of a protracted balance sheet recession.

“Monetary policy is more effective when the economy is flourishing, but it declines in effectiveness when economic growth is easing” Zhang writes in an opinion piece for Caijing entitled “How to raise the effectiveness of monetary policy” (“张明：如何提高货币政策效力？”)

“The effectiveness of monetary policy transmission is related to the condition of the balance sheets of micro-economic actors such as households and businesses.

“When the balance sheets of households and enterprises are healthy, then the transmission effects of monetary policy are usually higher, as households and enterprises find it easier to use leveraging to expand consumption and investment.

“However, if the balance sheets of households and enterprises are subject to pronounced damage due to a shock of some kind - such as a sizeable drop in property prices, then the transmission effects of expansionary monetary policy will markedly decline.

“This is because the number one mission of households and enterprises that have suffered damage is to restore their balance sheets…the preference for micro-economic actors is to reduce their debts.”

Zhang’s assertion would appear to be vindicated by the cratering of growth in Chinese bank loans last year.

In 2025, new bank loans posted their second straight year of decline, falling 1.83 trillion yuan - for a drop of -10%. This dragged China’s new bank loans down to 16.27 trillion yuan, for their lowest level since 2018.

While Beijing signalled large-scale monetary loosening at the end of 2024, last year the central bank implemented only a single reduction to its main policy rate - the seven-day reverse repo rate, with a cut of 10 basis points in May.

The move brought the seven-day reverse repo rate down to just 1.4%.

In addition to being left with little room to maneuver, domestic analysts believe the Chinese central bank may have held off on further rate cuts due to senior officials concurring with Zhang’s view - that households and businesses are too busy repairing their balance sheets to take out loans for investment or consumption.

Deflation further undermines monetary policy

The challenges for monetary policy created by balance sheet damage are further compounded by China’s deflationary environment, which raises the real cost of credit for borrowers.

In 2025, China full-year CPI growth came in well below the target of 2% for the second consecutive year.

As of December 2025, year-on-year PPI growth had posted 39 consecutive months of negative prints, while as of the third quarter of 2025 China’s GDP deflator had seen its tenth consecutive quarter of negative performance.

This deflationary pressure means that real interest rates are higher than nominal interest rates, because borrowers need to pay back loans using money that requires the sale of more goods and services to acquire.

While deflation undermines the effectiveness of interest rate cuts, Zhang argues that it also makes them a more urgent necessity.

Reductions to nominal interest rates are needed, to ensure that the real cost of borrowing is kept low enough to preserve whatever demand for credit remains available.

For this reason, Zhang believes that the central bank has no choice but to further reduce its policy rate - already sitting at just 1.4% - to deal with the dilemma of deflation raising the real cost of borrowing.

“Under current conditions, rate cuts are of greater necessity than cuts to the required reserve ratio,” he writes.

“Because CPI is weak, the actual interest rate on loans is markedly higher than nominal interest rates.

“Reducing rates can spur reductions in real interest rates on loans, which will help drive demand for loans.”

Given the low level of the seven-day reverse repo rate, China nonetheless faces the possibility of monetary policy in the form of rate cuts further losing its ability to budge the economy.

“Downward adjustments could cause interest rates to hit the zero lower bound and encounter a liquidity trap,” Zhang writes.

“Even if the nominal interest rate is reduced to zero, households could continue to choose not to consume, and enterprises could continue to choose to continue to not invest.”

Credit guidance viewed as the solution

While broad-stroke interest rate cuts are unlikely to prove a strong enough tonic for boosting economic activity in China at present, the central bank has recourse to other monetary policy tools that it hopes will do the trick.

Zhang points in particular to structured monetary policy as likely the best means for the Chinese central bank to boost the nation’s economic health.

Structured monetary policy has emerged as the signature innovation of the Chinese central bank in the post-Covid era.

It in essence involves the selective provision of credit at reduced interest rates to targeted sectors of the economy.

This process involves the Chinese central bank providing re-loans to commercial banks at discounted rates, for funding they channel to sectors of the economy prioritised by policymakers - chief amongst them tech innovation, green and low carbon development, as well as small private enterprise.

Zhang Ming refers to structured monetary policy as a form of “precision irrigation.”

“Monetary policy is originally a classic form of quantitative policy,” Zhang writes

“However, structured monetary policy is distinguished by its ability to both expand aggregate quantities and undertake structural adjustments.”

Sheng Songcheng (盛松成), the former head of the Chinese central bank’s statistical office, highlights the rising prominence of structured monetary policy as a form of innovative credit guidance since the Covid pandemic.

“Especially in the past several years, China’s structured monetary policy tools have seen continuous innovation, playing an increasingly important role, and serving as an effective means of driving high-quality economic development,” Sheng writes in an opinion piece for Yicai entitled “Structured interest rate reductions are more apt and precise” (“盛松成：结构性“降息”更为精准和适宜”)

“The implementation of structured monetary policy has certainly helped to raise the transmission efficiency of monetary policy, and can compel commercial banks to extend loan resources to areas targeted by policy.”

Sheng also draws parallels between the Chinese central bank’s use of structured monetary policy, and the US Federal Reserve’s adoption of innovative monetary policy expedients during the Covid pandemic.

“In terms of international experience, China is far from the only nation to make use of structured tools in its implementation of monetary policy,” he writes.

“When dealing with the shock of the Covid pandemic, the Federal Reserve, in addition to large-scale purchases of Treasuries to provide the market with liquidity, also included mortgage-backed securities in its asset purchase plan, to provide targeted support to the housing market, and put direct pressure on mortgage rates.

“This was a far more direct and effective means of influencing the housing market than simply reducing Treasury rates.”

Central bank signals greater credit guidance in 2026

Zhang and Sheng’s praise for structured monetary policy tools arrives just as the Chinese central bank makes its first adjustments to settings for the instruments since the new year, in bid to get the economy off to a running start in 2026.

On 15 January, the Chinese central bank announced the launch of eight new monetary policy measures to support the economy, including a raft of adjustments to its structured tools.

The measures included:

1. A 0.25 percentage point reduction to the interest rate for various structured monetary policy tools, and a reduction in the one-year re-loan rate from 1.5% to 1.25%.

2. A 500 billion yuan increase in the quota for re-loans to support agriculture and small enterprise, as well as the establishment of a 1 trillion yuan re-loan quota for private businesses.

3. Raising the quota for science and tech innovation re-loans to 1.2 trillion yuan, with a focus on small and medium-sized private enterprises.

4. The integration of the private enterprise bond financing support instrument and the science and tech innovation bond risk sharing instrument, to provide a combined re-loan quota of 200 billion yuan.

5. Expanding the scope of carbon emissions reduction support tools; expanding the scope of eligible green projects, and guiding banks to provide support for China’s green transition.

6. Expanding the scope of support for re-loans in the areas of services consumption and aged care - including the fitness industry.

7. Reducing the initial down payment ratio for commercial housing loans to 30%, to assist the reduction of real estate inventories.

8. Encouraging financial institutions to improve their exchange rate hedging services and reduce enterprise risk.

“This is markedly different from just an interest rate cut in the classical sense,” Sheng Songcheng writes.

“[The measures] directly guide financial institutions to lower financing costs for key areas of the real economy.

“With regard to the policy support required by economic conditions at present, it’s far more targeted and apt.”

“They support key areas and weak linkages including scientific and technological innovation, green and low carbon development and the private economy.”

Chinese economic commentator Mo Kaiwei (莫开伟) writes that the eight monetary policy measures are “unprecedented” in nature.

“They indicate that the central bank’s earnest implementation of the call from the Central Economic Work Conference for the continuation of moderately loose monetary policy has already commenced,” Mo writes in an opinion piece published by Sina entitled “The role of the eight structured monetary policy tools unveiled by the central bank” (“莫开伟：央行推出八项结构性货币政策工具将产生哪些作用？”)

“They also indicate that the central bank - in accordance with the Party Central Committee and the State Council’s decisions, are expanding the intensity of counter-cyclical and cross-cyclical adjustments, to ensure that the 15th Five Year Plan (2026 - 2030) has a strong start.”

The real solution to China’s monetary policy dilemma

Zhang Ming argues that for a truly sustainable restoration of the effectiveness of monetary policy, Chinese policymakers will need to engineer a recovery in asset prices - with an especial focus on the housing market.

This is because the precondition for the return of healthy borrowing levels will be the broad-based recovery of household balance sheets - a task which can best be achieved via a rebound in stock and property prices.

“If we want to raise the transmission efficiency of monetary policy, then we need to help micro-economic actors to stabilise and restore their balance sheets,” Zhang writes.

“This means enabling asset prices to stymie their declines and return to stability as soon as possible, or even stabilise and rebound.”

Beijing signalled that a recovery in asset markets would be a policy priority at the Central Economic Work Conference held at the end of 2024, when it highlighted the need to “stabilise property and stocks.”

Zhang has called for “raising the intensity of stabilisation of the housing market” moving ahead, with measures that could include expanding purchases of commercial housing by government authorities for conversion into social homes.

Other policies for boosting China’s housing market could include the cancellation of purchasing and lending restrictions in tier-1 cities,; actively dealing with the debt risk of systemically important property developers, as well as deepening reforms of the housing provident funds.

In addition to wealth effects, Zhang points out that a rebound in property prices will provide Chinese households with the high quality collateral they need to secure loans from commercial banks.

“The effectiveness of monetary policy transmission is related to the quality of the collateral for commercial banks,” he writes.

“Real estate has always been the most important form of collateral for China’s banking system.

“From this perspective, if we want to raise the effectiveness of monetary policy transition, the Chinese government will either need to adopt measures to enable the property market to recover as quickly as possible, or it should provide the commercial banking system with new supplementary forms of high-quality collateral.”

In the same vein, Zhang argues for Beijing to increase the issuance of Treasury bonds across different maturities, in order to expand the volume of high-quality collateral available to the banking system.

The move has the added advantages of already being needed to fund Beijing’s plans for more profligate fiscal spending.

It will also help the central bank to manage the yield curve, as well as drive internationalisation of the renminbi via the provision of a greater volume of secure assets for global investors.