Why China is Shifting to a ‘Neutral’ Monetary Policy Stance

China's monetary transitionChina's monetary transition
Hu Shuli via Caixin | Ever since the Central Economic Work Conference outlined a prudent and neutral monetary policy stance in December, the central bank has pushed up lending costs after the Lunar New Year in late January through a series of open-market operations, including raising the rates or medium-term lending facilities (MLFs), standing lending facility (SLF) loans and reverse repo agreements. Although the People’s Bank of China stated that it has no intention to hike the benchmark interest rate, its recent moves through liquidity tools have influenced market sentiment and signaled China’s shift toward a new credit-tightening cycle.

It has been six years since China adopted what has been tagged “a prudent monetary policy stance” in 2011. In practice, policies have been slightly eased to alleviate pressure from a slowing economy and rein in financial market fluctuations. As the country’s economic health continues to evolve, the central bank proposed “a prudent and neutral” policy stance in November. The shift in tone indicated that while keeping its monetary policy stable, it will lean toward tightening it in order to curb the emergence of asset bubbles and to mitigate financial risks. This would also create more room for economic reforms.

China’s economy is expected to steady this year, but the country is struggling to diffuse asset bubbles across the board, from commodities to fine wines, and identify long-term risks to financial markets and nip them in the bud.

According to a central bank official, as China transitions from being the world’s factory to a more service-and-consumption-driven economy, its monetary policy must seek to balance multiple objectives, including maintaining stable growth, deflating asset bubbles, and reducing leverage and potential financial risks. A “neutral stance” is a rational option given the complexity of monetary operations.

A volatile international economic environment also poses challenges to China’s monetary policy. U.S. President Donald Trump’s pledge to “revive U.S. trade” has made it harder to predict the U.S. Federal Reserve’s future policy swings. Any move by the Fed has a strong effect on the yuan’s exchange rate and China’s capital outflows.

According to regulators, implementing a prudent and neutral monetary policy requires focusing on four aspects: maintaining overall liquidity levels stable, improving the structure of the credit market, promoting financial reform and reducing risks. This year, we can expect the monetary authority to rely more on its toolbox for managing liquidity and money market rates instead of adjusting the deposit reserve ratio and benchmark interest rate. Along with the market-oriented reform of China’s interest rate system, financial institutions have started offering diverse and complex financial and credit products, requiring regulators to adjust their policy tools accordingly.

Although the economy was bouncing back, it is still on shaky grounds and financial markets are still volatile. Therefore, the central bank should be very judicious when raising banks’ reserve ratio and the interest rate, as these moves often have a strong impact on the market. The prudent use of lending facilities and open market operations will give the central bank more maneuvering space and guide interest rates with more market-driven pricing tools.

This year’s monetary policy changes will be accompanied by proactive fiscal policy alternations. So central and local governments will continue to issue bonds and promote a debt-for equity swap program to support growth. All this requires interest rates to remain at a stable level.

China’s top leadership has repeatedly vowed to strengthen the quality and effectiveness of the financial sector to better serve the real economy. This year, policymakers should pay special attention to ensuring balanced development among finance and property markets and the real economy, adjusting monetary policy to prevent the first two from sucking out capital from the productive economy. Financial institutions should direct loans to support economic and social development, but in practice, massive amounts of money have been diverted to nonproductive sectors through the shadow banking system. Whether such problems can be fixed will be the litmus test to judge whether the central bank has got policy right.

Manufacturers have seen an uptick in profit in recent months, but most of them are still struggling with weak demand and rising costs. Policymakers should carefully monitor the impact of interest rate changes on the economy so that they won’t hurt industrial productivity.

As monetary policy gradually shifts directions, it is important to make sure that the policy’s effects are properly translated into other sectors, especially the way money and bond market rates affect the credit market. In addition to hedging risks in the financial market, the government should also push forward structural reforms such as enhancing the efficiency of state-owned enterprises and further open up the service sector to private investors. These changes will lay a solid foundation for effective monetary policy enforcement. Coordinating reforms in different areas of the economy will be key to the success of prudent and neutral monetary policy.

This year will still be full of uncertainties, and it is difficult to look into the crystal ball and predict the trajectory of the Chinese economy. Given the challenges posed by the economic slowdown, inflation and bubbling financial risks, China’s central bank needs to be nimble to push forward policy changes at the right pace and balance between competing objectives. More importantly, efforts are needed to push forward structural reforms to ensure the economy transits smoothly into a more-sustainable growth model.

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The Corner
The Corner has a team of on-the-ground reporters in capital cities ranging from New York to Beijing. Their stories are edited by the teams at the Spanish magazine Consejeros (for members of companies’ boards of directors) and at the stock market news site Consenso Del Mercado (market consensus). They have worked in economics and communication for over 25 years.