Assessing China’s “Structural” Monetary Policy

The overarching economic goal of China’s leadership is to transform its old growth model to a more sustainable path, addressing the long-term challenges of an aging population, declining productivity and less and less room for policy stimulus. Ongoing policies such as rebalancing, deleveraging, and “Made in China 2025,” which are designed to achieve this transition, are likely to remain in place with some implementation details to be adjusted along the way.

China has recently unveiled a “dual circulation” economic strategy that is likely to be included in China’s upcoming 14th five-year plan (2021-2025) to guide the country’s economic policies. The idea is for China to rely predominantly on its domestic economic system (“internal circulation"), which will be supported by international markets (“external circulation”). While some may view China’s long-term attempt to reduce its dependence on overseas markets and technology as reverting to a closed-door policy, we believe that it reflects a strategic adjustment in response to a more contentious geopolitical environment.

As U.S.-China tensions escalate and protectionism rises across the globe, foreign demand is becoming less reliable, so China is focusing on stimulating domestic demand to absorb its huge production capacity. China has, over the years, pursued and seen increases in final consumption and services as a share of GDP. However, industrial production remains a key contributor to the economy and the supply chain continues to involve critical links to imports and foreign expertise. With potential disruptions of global supply chains and less accessible foreign technology or key products, China’s policymakers see an urgent need to upgrade the country’s manufacturing sector, to develop a full-spectrum supply chain and to achieve technology self-sufficiency.

Although a forced financial de-coupling remains a tail risk, we believe China will accelerate the internationalization of the renminbi (RMB) to mitigate potential disruptions of international transactions and further open its financial markets to foreign investors. Investors should expect some market volatility during this period of transition, and be more selective when choosing which sectors and asset classes to invest in.

China’s increasing emphasis on employing targeted monetary policy tools reflects the central bank’s alignment with the government’s long-term agenda. The People's Bank of China’s (PBOC) “structural” monetary policy is essentially a set of differentiated policies that aim to optimise liquidity and credit allocation, to support key sectors and weak links in the economy, while avoiding bubbles and overheating in sectors such as real estate, industries that are experiencing overcapacity and shadow banking. We view this “precision irrigation” approach as walking a tightrope between supporting growth and maintaining financial stability. The country is facing high domestic debt and increasingly complicated macro-financial linkage, while the room for monetary stimulus is diminishing. Being mindful of the ultra-accommodative monetary policy in many developed countries in the aftermath of the global financial crisis and some of the side effects of its own massive stimulus in 2008-09, which led to surging debt, China has pursued a more prudent monetary policy over the past few years.

Examples of the PBOC’s structural monetary policy include a targeted and differentiated reserve requirement ratio (RRR) framework and the use of re-lending facilities to support small and medium-sized enterprises (SMEs). While this is an interesting experiment and diverges from conventional monetary policy, we believe it is important for the PBOC to strike a balance between targeted measures and market-based resource allocation, and to minimize unnecessary influence on market participants.

The PBOC took swift and pre-emptive monetary easing measures in early 2020 in response to an unprecedented national health crisis, but we expect monetary policy to become more balanced as the economy recovers. In our view, a near-term rate cut is unlikely, given China’s solid recovery, accommodative credit conditions, sizeable bond issuance despite higher yields, and the PBOC’s active approach to liquidity management. We expect the central bank to continue to implement more targeted monetary policies in favor of SME loans and medium- and long-term loans to the manufacturing sector.

Should a super-V economic recovery occur in 2021, risk prevention will regain momentum. We would likely see credit tightening and fiscal tapering, further restrictions on the housing market, and a resumption of deleveraging. However, the bar for a policy rate hike will be high given the elevated debt in the economy and the government’s emphasis on maintaining financial stability. China will try to avoid over-tightening by encouraging better coordination among regulators.

In the medium-to-long term, we expect China to focus on promoting quality growth and controlling risk. Monetary policy will continue to be carefully calibrated depending on growth, reforms, and the external environment. Structural tools could be designed to support SMEs, industrial upgrading, technology development, effective investment, urbanization and environmental protection.

With China’s growth picture having relative cyclical strength versus other major markets, along with a sustainable monetary policy that provides a positive interest rate differential, we expect the Chinese currency to continue its appreciating trend and to attract portfolio flows. China onshore government bonds potentially should serve as a decent source of duration, which provides a favorable asymmetric profile with the PBOC having substantial capacity to cut rates if needed while near-term policy will be more balanced. In addition, these bonds should provide potential portfolio diversification benefits as they gain wider adoption in bellwether indices.