Rate cut or reserve requirement cut?

Recent changes in the domestic and international economic and financial environment, can the interest rates on existing home loans be significantly reduced? Is there still room for reserve requirement ratio cuts? We will conduct an in-depth analysis based on the latest policy signals conveyed during the press conference held by the State Council Information Office, the People's Bank of China, and the State Administration of Foreign Exchange on the afternoon of September 5th.

1. Structural Transformation Reduces Monetary Sensitivity, Monetary Policy Shifts to Supportive Stance

The acceleration of economic structural transformation and the reduced sensitivity to monetary stimulus have led to a shift in monetary policy towards a more neutral countercyclical "supportive" stance. The current downward pressure on the economy mainly stems from two aspects: the downward pressure on exports due to the increasingly severe external environment, and the insufficient domestic demand caused by simultaneous deleveraging in real estate and infrastructure. The former requires boosting domestic durable consumer goods demand for hedging, while the latter is a painful adjustment unavoidable in the proactive upgrade of the economic structure, requiring patience and caution. Even if monetary policy is further eased, economic transformation is irreversible, and the diminishing effects of easing may also bring new systemic risks.

Deputy Governor Lu Lei emphasized that "the People's Bank of China will continue to adhere to a supportive monetary policy," while Director Zou Lan pointed out that "the acceleration of China's economic structural transformation has led to a decrease in the measurability, controllability, and relevance of the money supply." Against this backdrop, the probability of monetary policy returning to a significantly loose path is low.

2. Quantity Transmission Shifts to "Supply According to Demand," Significant Room for Reserve Requirement Ratio Cuts, Optimization of Monetary Injection Methods

Improving the efficiency of quantity transmission means the era of "supply according to demand" has arrived, with significant room for reserve requirement ratio cuts and increased necessity for buying and selling government bonds to replace MLF operations. Since the middle of the year, the central bank has significantly accelerated its efforts to improve the monetary policy framework and build a modern central bank system. In terms of improving the efficiency of quantity transmission, the highlight is the shift from "supply to stimulate demand" to the new model of "supply according to demand." Faced with the new environment where the internal borrowing demand of enterprises and residents has significantly cooled due to simultaneous deleveraging in real estate and infrastructure, the central bank currently observes the changes in the endogenous demand for credit financing in the real economy first, and then deduces how much liquidity needs to be provided to the financial markets, aiming to achieve the dual goals of stabilizing the financing needs of the real economy and avoiding arbitrage within the financial system.

Since 2018, the People's Bank of China has reduced the reserve requirement ratio 17 times, releasing approximately RMB 13.4 trillion in long-term funds. Among them, in 2023, the reserve requirement ratio was cut twice by 25 basis points, releasing liquidity of about RMB 1.0 trillion. On January 24, 2024, ahead of the first FOMC meeting of the year by the Federal Reserve, a one-time 50 basis points reserve requirement ratio cut was announced, injecting RMB 1 trillion in long-term liquidity, while achieving the goal of stabilizing the pace of credit expansion around the Chinese New Year and avoiding a significant depreciation of the renminbi exchange rate. Currently, the average reserve requirement ratio for financial institutions is about 7.0%, with large, medium, and small banks having reserve requirement ratios of 8.5%, 6.5%, and 5.0%, respectively Director Zou Lanshi pointed out, "The focus on quantitative targets will gradually fade, and they will be more regarded as observational, referential, and anticipatory indicators." This means that the central bank's buying and selling of government bonds to replace MLF operations will not be interpreted by the market as a signal of excessive easing by the central bank, but rather as having greater long-term necessity due to advantages such as lengthening the basic currency duration and having better scientific and precise management of "short, medium, and long-term liquidity" (for detailed analysis, please refer to our previous reports). However, because the current central bank has a relatively small position in government bonds, it needs to go through a period of buying government bonds to replace MLF operations before it can have a greater impact on quantity control and the reasonable steepening of the interest rate curve.

During this transitional period, RRR reduction is a more complementary operation that can combine long-term liquidity injection strength, efficiency, and cost advantages. The current average statutory reserve ratio in China is 7%, and in recent years, a lower limit of 5% for RRR has gradually formed, leaving a considerable amount of space between the two that can be utilized. Liquidity injection was tight in September last year, and September this year is a reasonable time point for RRR reduction that we have been clearly expecting since the beginning of the year. We maintain our forecast of a comprehensive 50BP RRR reduction to maintain a reasonable level of credit financing demand support and avoid short-term spikes in money market interest rates.

3. Market-oriented interest rate transmission reform, net interest margin constraints limit interest rate cuts

In terms of improving interest rate transmission efficiency, the strengthening of the market-oriented pricing attributes of long-term interest rates means that commercial banks' net interest margin has shifted from a passive result to an input variable. Under the constraints of limited room for deposit rate cuts and the trend of real estate demand insensitivity to monetary easing, the feasibility of significantly reducing existing mortgage rates remains to be discussed. Under the model where the long-term policy rate cut exceeds the short-term policy rate cut, the continuous compression of net interest margins may lead to a contradiction in the banking system between the potential increase in non-performing loan ratios and the decline in profit transfer to capital and provisioning capacity. Since July, the central bank has accelerated the upgrade and restructuring of the interest rate transmission mechanism, weakening the policy attributes of MLF rates and LPR, and clearly defining the 7-day reverse repo rate as the sole policy rate tool actively adjusted by the central bank, strengthening the market-oriented transmission mechanism of interest rates from short to long term. This indicates that the central bank has fully recognized the crucial importance of commercial banks' net interest margin in ensuring the systemic risk-bearing capacity of the financial system during the cooling process of credit financing demand in the real economy.

Director Zou Lanshi pointed out, "Due to factors such as the speed at which bank deposits flow into wealth management products and the extent of narrowing of net interest margins, further downward pressure on deposit and loan interest rates faces certain constraints," indicating that under the accelerated market-oriented interest rate transmission mechanism, there is limited room for deposit rate cuts and the necessity of maintaining stable net interest margins, which reduces the feasibility of significantly lowering existing mortgage rates. At the same time, as this round of deep adjustments in the real estate market mainly reflects long-term structural factors such as accelerated population aging, imbalanced regional industrial layout leading to intensified differentiation of house price-to-income ratios, rather than tightening of monetary and financial conditions, the sensitivity of real estate demand to monetary easing has significantly decreased since 2022 Even if the interest rates on existing housing loans are significantly reduced, it is difficult to reverse the pressure on banks' asset size contraction caused by residents' concentrated early repayment of housing loans. In addition to weakening the net interest margin, this policy seems unlikely to lead to an expansion in credit financing. It is believed that the monetary authorities will comprehensively and prudently evaluate its necessity.

Author: Qin Tai (SAC Practicing Certificate No.: S0910523080002), Source: Huajin Securities, Excerpt from "Rate Cut or Reserve Requirement Cut?"