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Monetary policy to go neutral, rate cuts expected

2014-08-11 09:09 Shanghai Daily Web Editor: Qin Dexing

The People's Bank of China recently published its second-quarter monetary policy report. We highlight some interesting points to note.

The average bank lending rate edged lower in the second quarter but remain elevated at around 7 percent.

The share of bank loans priced above the benchmark rate recorded sharp increase and decline in the first half. The share jumped further to about 73 percent in April-May from around 70 percent in March and about 67 percent in February. We think this reflects higher credit risk premium after the bond default in March and the regulators' increasing scrutiny on the shadow banking business. The share has come down markedly to 69.1 percent in June, after the targeted reserve requirement ratio cuts and relending at lower rates to selective sectors.

Even though CPI inflation edged lower to 2.2 percent in the second quarter from 2.3 percent in the first, the central bank expressed its concern about upside inflation risks on the back of a recovering in demand in the second half as was the case in 2013.

We also look for inflation to rise to around 3 percent in the fourth quarter, which could be more a constraining factor to monetary easing by year-end and hurt market sentiment.

The central bank presented its explanations behind the high cost of financing. It described the currency environment as: relatively fast money and credit growth, ample liquidity, and rising debt ratios.

The central bank thinks the rising real interest rates amid overall slowing investment growth is attributable to the visibly faster decline in the savings ratio compared with the investment ratio, which in turn is a reflection of strong investment and debt demand relative to savings.

It highlighted a few structural reasons: the corporate sector high debt ratio resulted in continued financing and debt payment demand; soft-budget constraints and interest rate insensitive sectors (local governments and state-owned enterprises) have pushed up borrowing rate and crowded out financing for small and medium-sized enterprises (SMEs); and subdued equity financing. It emphasized the need to push for structural reforms to address this issue.

The central bank also reviewed the targeted reserve requirement ratio (RRR) cuts in April and June. The purposes include to guide the commercial banks' credit allocation toward the agriculture sector and SMEs and to set the right incentives and to proactively support adjusting the economy's structure using monetary policy tools.

On the other hand, the central bank reiterated that monetary policy is to address the aggregate demand and it is not appropriate to rely on large expansion of the money and credit to address structural issues, especially given an already large and fast growing stock of money and credit. It also pointed out that the targeted RRR cuts can't be used as a long-term tool.

On risks and challenges, the central bank emphasized fast rising debt levels and the ensuing financial risks, and said structural adjustment and reform are challenging tasks.

Under financial institution reform, the central bank emphasized to deepen the China Development Bank reform, and to support the "shantytown" redevelopment program and urban infrastructure construction.

The more neutral second-quarter monetary policy report does not change our view on the monetary policy outlook. We've been highlighting since May that the central bank is resisting more broad-based easing and has gained increasing independence.

The rebound in June activities, upside surprises in the July Purchasing Managers' Indexes, and strong money and credit number reduced the need for further significant easing. That said, we expect more easing measures to come because President Xi Jinping reiterated the importance of the economy growing at a certain pace and Premier Li Keqiang remains concerned about downside risks to growth and keen to maintain an 7.5 percent growth.

In July, more banks were offering mortgages at a discount (a 5 percent discount to the benchmark versus a premium of 5-10 percent previously). The central bank also has offered relending facilities and pledged supplementary loans (PSLs) at low rates (4-5 percent compared with the 6 percent benchmark lending rate) to select local and policy banks.

We continue to expect the central bank to maintain an easing to neutral bias in the interbank market. Lowering financing costs remains a top policy priority in the second half. We think its focus is to guide down medium-term interest rates through various new policy tools (relending and PSL) or targeted interest rate cuts.

Reflecting the above, we maintain our forecast of two interest rate cuts in the second half. More fundamentally, we think broad-based rate cuts are probably a better policy for China's deleveraging given the necessary structural reforms will take time and involve bankruptcy and financial risks.

Given capital outflows, the probability of a system-wide RRR cut is rising.

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