PBOC adopts targeted tool for stimulus

China's economic rebound since the second quarter is likely powered by the People's Bank of China topping up funds again — but in a new and more surgical way, economists said.

China Development Bank, a government-funded policy bank, last week announced the establishment of a new department specializing in providing funds to projects for the rehabilitation of shantytowns and related infrastructure works.

The news followed an earlier China Business News report that the central bank had allocated 1 trillion yuan (US$160 billion) to China Development Bank in April, using a newly introduced tool called the "pledged supplementary loan."

The new tool is essentially a central bank loan to commercial banks at a below-market interest rate. In return, the central bank takes some bank assets, for example high-quality bonds or loans to other projects, as collateral.

The tool is meant to maintain money supply levels, minimize hindrance to structural reform efforts and set a medium-term policy-rate benchmark.

The People's Bank of China and China Development Bank have neither confirmed nor denied the report, but market players are convinced of its authenticity. The only element in doubt is the size of funding allocated to pledged supplementary loans.

Standard Chartered Bank economists noted that assets of China Development Bank expanded by 1.6 trillion yuan in the second quarter of this year, of which only 300 billion yuan came from the issuance of bonds.

The economists, unable to find evidence of 1 trillion in lending on the central bank's balance sheet, speculated that much of the new assets may come from the central bank and the central bank is still holding the assets as reserves.

Wang Tao, chief economist of UBS AG, said that the size of pledged supplementary loans actually put to work may stand at 300 billion yuan, much lower than market speculation, based on the central bank balance sheet and China Development Bank lending data.

"Even if we allow for various discrepancies in accounting rules, an injection of 1 trillion in base money liquidity should have resulted in a notable pickup in base money growth and much stronger-than-reported growth rates in money supply and credit in recent months," Wang said in a report.

She said the central bank could gradually step up financing with the new tool.

Whichever the size of the pledged supplementary loans, more central bank-backed lending is expected to be allocated to China Development Bank because cities have huge credit demand for social housing projects.

Within the past month, the central bank did announce a series of re-lending agreements with city-level commercial banks in the cities of Shanghai, Hankou and Changsha and in the Inner Mongolia Autonomous Region. The money was part of a 50 billion-yuan plan, announced in March, to support small businesses.

Central bank re-lending does not require collateral like the pledged supplementary loan tool does.

Accommodative stance

Economists said central bank loans to commercial banks indicated that the monetary authority is taking a more accommodative stance in order to power an economic recovery with ongoing credit expansion. Economic growth is still driven by government-initiated investment, requiring money input from financial institutions.

In the first half, the central bank has twice cut the reserve requirement ratio, which dictates the amount of money banks must set aside for risk management, for banks that focus heavily on small companies and rural needs.

Jiang Chao, chief analyst with Haitong Securities, concluded that an increasing cash supply was behind the economic rebound in the second quarter.

In the April-June period, China's GDP grew 7.5 percent from a year earlier, up 0.1 percent from the first quarter. At the same time, growth in M2, a broad measure of money supply, accelerated from 12.1 percent in March to 14.7 percent in June.

Jiang said the two reserve requirement cuts and the pledged supplementary loan operation injected 500 billion yuan into financial institutions in the second quarter, generating a ripple effect of 2 trillion yuan of liquidity in the market as banks use the central bank funding to extend more loans.

He forecast that 3 trillion yuan more of liquidity will be created in the second half because the central bank is likely to extend its pledged supplementary loan operation at a level of 100 billion yuan per month until the 1 trillion yuan quota is used up.

Analysts don't seem particularly worried that such a cash injection will lead to the problems created when China unleashed a 4 trillion yuan stimulus program in 2009. However, many analysts said China is postponing beneficiary reforms that could cut risks in the financial sector and transform the economy to a consumption-driven one.

The nation's post-financial crisis stimulus package created 20 trillion yuan of liquidity in the market, flooding every sector from housing to food, piling up record debt and creating a property bubble.

By comparison, the pledged supplementary loan operation is intended to be targeted and controlled. By offering loans at a lower interest rate and earmarking them for specific use, the central bank seems intent on reducing financing costs for certain sectors — in this case, businesses related to shantytown renovation.

That is in line with "targeted easing" and "fine-tuning" strategies enunciated by Premier Li Keqiang. The policies are meant to judiciously sprinkle, not flood, thirsty areas of the economy.

"The use of pledged supplementary loans, if confirmed, does not indicate a further easing of the central bank's policy stance," said Wang of UBS. "It is only a new way for the central bank to optimize its easing by keeping the cost of funding low and directing the initial flow of credit."

Pledged supplemental loans protect the central bank from potential credit losses because of the collateral taken from banks as guarantees for future repayment. As a tool, the loans allow more freedom for the central bank to adjust the size and target of its injections, Wang said.

In the case of China Development Bank, the rehabilitation of shantytowns qualifies for such funding, but a heavy industry sector burdened with excessive capacity may not.

HSBC said the central bank's latest tool shows its progressive sophistication in monetary policy. Pledged supplemental loans not only pump money into the economy, but they also help set a reference interest rate for similar lending.

Monetary tools

China has been heavily relying on quantitative methods, which create a certain liquidity but at the cost of creating uncertainty. Those methods are often deemed unfair because interest rates for various sectors sometimes depend on how closely they are related to government.

More advanced pricing tools will enable monetary authorities to control liquidity fluctuation based on market needs. China is not there yet, even though the central bank has come a long way in initiating a transition by conducting more open market operations, gradually deregulating deposit rates and freeing up lending rates.

Pledged supplemental loans will be "a useful bridging initiative" that will assist China during the transition phase to future price-based monetary policy, while also maintaining the integrity of the structural reform program, HSBC said in a report.

But the new tool is not merely a means to an end. As many economists have pointed out, any easing of monetary policies will be truly effective only when backed by economic reforms that empower the market and reduce government interference.