The establishment of a joint working group by the central bank and the Ministry of Finance signifies what

Key Points

• On October 9th, the People's Bank of China and the Ministry of Finance announced the establishment of a joint working group, which recently held its first formal meeting. The meeting established the operation mechanism of the joint working group, focusing on the stable operation of the bond market and the buying and selling of government bonds in the open market operations by the central bank.

We believe that the establishment of the joint working group can be seen as the establishment of a mechanism for the coordination of monetary and fiscal policies. The synergy between the two will be significantly enhanced in the future, and the consistency of macro policies will bring about a resonance in policy effects.

• Why is the consistency between monetary and fiscal policies different this time? This time it is a systematic forward-looking response. In our recent report "Breaking free from bull and bear thinking, embracing underlying logic," we pointed out that the intensive policy measures combined with the statements from the Political Bureau meeting have sent the market the following signals:

(1) This round of policy adjustments is a unified deployment at the central level, which means that future policies will no longer be reactive measures to specific issues; (2) Future policy responses will no longer be reactive and lagging, but strong and forward-looking. The establishment of the joint working group by the People's Bank of China and the Ministry of Finance further confirms our judgment on policies. In the future, monetary policy will be more consistent with fiscal policy in terms of pace, direction, and intensity.

• Why is there an emphasis on the consistency of monetary and fiscal policies now? There are three surface-level logics:

1. The short-term employment pressure and low inflation risks cannot be solved by monetary policy alone; 2. The primary goal of current monetary policy is to promote economic growth, aligning with fiscal policy; 3. With the Fed entering a rate-cutting cycle and temporary relief from exchange rate pressures, monetary and fiscal policies can both ease. The underlying logic is that China's current economic growth model is shifting from traditional land finance to new quality production forces, and cannot be achieved solely by monetary policy.

• How can monetary policy coordinate with fiscal policy? First, there may still be a 25-50 basis points reserve requirement ratio cut within the year, possibly timed with the introduction of incremental fiscal policies to smooth excessive fund fluctuations. Second, the central bank's open market operations in government bond trading will facilitate the smooth deployment of incremental fiscal tools. Third, there may still be a 10-20 basis points interest rate cut within the year, further driving down government bond yields.

• Impact on monetary policy, central bank balance sheet, and investments:

Facilitates the transition of monetary policy's intermediate targets to price-based regulation. Price-based regulation requires better anchoring the market benchmark interest rate to the policy rate. Currently, DR007 essentially serves as the market benchmark rate, and increasing government bond trading in open market operations, along with better coordination with government bond issuance pace, helps smooth the fluctuations of DR007. Drawing on international experience, if China were to use a market benchmark rate similar to SOFR for interest rate transmission, it would have a significant impact on the scale and liquidity of government bonds.

The government bond yield curve will become one of the important tools for monetary policy operations. Achieving a normal upward shape of the yield curve requires smooth coordination between government bond trading in the open market and government bond issuance pace.

The method of base money injection is changing, and the central bank's balance sheet expansion remains steady. China's monetary policy still has room for normal operations, and the central bank's government bond trading enriches the policy toolbox and can effectively complement other methods of injecting base moneyIn the past, the broad money supply growth mainly relied on increasing the money multiplier and the expansion of commercial bank balance sheets. In the future, as the money multiplier may decrease, the speed of base money growth will accelerate to support a reasonable growth in broad money supply. This means that the central bank's balance sheet expansion speed may increase compared to before, but will still remain prudent.

The restructuring of the central bank's balance sheet will be realized. The asset structure of the central bank's balance sheet will gradually change and become more diversified, with the proportions of "foreign exchange" and "claims on other deposit-taking corporations" likely to decrease. The proportions of "claims on government" and "claims on other financial corporations" may also increase.

Impact on investments: In terms of the equity market, the current consistency between monetary and fiscal policies is the current deployment at the central level, a systematic forward-looking solution to the economic structural transformation, and the reconstruction of underlying logic has been initiated, which will bring upward momentum to the equity market; In terms of the bond market, the coordination of fiscal policy and macro policies will safeguard the stable operation of the bond market, with the 10-year government bond yield expected to fluctuate in the range of 2.1%-2.2%.

Main Content

On October 9th, the central bank announced the establishment of a joint working group between the People's Bank of China and the Ministry of Finance, and recently held the first formal meeting of the working group. This meeting established the operation mechanism of the joint working group, focusing mainly on the stable operation of the bond market and the central bank's open market operations in government bond trading. We believe that the establishment of the joint working group can be seen as the establishment of a mechanism for the coordination of monetary and fiscal policies, and the synergy between the two will significantly increase in the future, bringing about a resonance in policy effects.

I. The coordination of monetary and fiscal policies this time is a systematic forward-looking response

Why is the coordination of monetary and fiscal policies different this time? It is a systematic forward-looking response.

In our recent report "Breaking free from bull and bear thinking, embracing underlying logic," we pointed out that the intensive policy measures combined with the statements from the political bureau meeting have sent the market the following two signals:

(1) This round of policy adjustments is a unified deployment at the central level, which means that future policies will no longer be reactive measures to specific issues; (2) Future policy responses will no longer be reactive and lagging, but will be strong and forward-looking. The establishment of a joint working group between the People's Bank of China and the Ministry of Finance further confirms our judgment on policies. In the future, monetary policy will be more aligned with fiscal policy in terms of pace, direction, and intensity.

Why emphasize the consistency of monetary and fiscal policies now?

There are three points to the surface logic: 1. Short-term employment pressure and low inflation risks cannot be solved by monetary policy alone;

1. The primary goal of current monetary policy is to promote economic growth, in line with fiscal policy. Governor Yi Gang elaborated on several important considerations in the process of adjusting monetary policy tools at the press conference on September 24. We believe that the current sequence of priorities for the central bank's monetary policy may be: first, to support stable growth of the Chinese economy; second, to promote moderate price increases; third, to balance support for real economic growth and the health of the banking industry; fourth, to maintain the basic stability of the RMB exchange rate at a reasonable equilibrium level; fifth, to coordinate monetary and fiscal policies
2. In September, the Federal Reserve cut interest rates by 50 basis points, officially starting this round of interest rate cuts. Except for the Bank of Japan, the monetary policies of major economies have entered an interest rate reduction cycle. With the Federal Reserve entering an interest rate reduction cycle, exchange rate pressure is temporarily relieved, and monetary and fiscal policies can both become accommodative.

The underlying logic is that the current economic growth model in China is shifting from traditional land finance to new quality productivity. Relying solely on the power of monetary policy faces two problems. First, China is currently in a downward financial cycle, with the real estate cycle and credit cycle both declining. Clearing and stabilizing the real estate market cannot be achieved solely through monetary policy.

Second, there is currently insufficient total demand, and credit growth has shifted from supply constraints to demand constraints. Simply lowering interest rates and reserve requirements may not stimulate effective demand but could increase idle funds. Private sector financing demand is weak, requiring an upward pull from government sector financing, which in turn relies on fiscal reinforcement.

How can monetary policy coordinate with fiscal policy? Coordination between monetary policy and fiscal policy, reflecting macro policy consistency, may have three implementation paths, including reserve requirement cuts, interest rate cuts, and net purchases of government bonds in the open market.

First, there may still be a 25-50 basis point reserve requirement cut within the year, with the timing of the cut possibly coinciding with the introduction of incremental fiscal policies, releasing liquidity at the peak of government bond supply to smooth excessive fund fluctuations, with a magnitude possibly at 50 basis points. Second, open market operations in government bond trading serve as the intersection of monetary and fiscal policies, with central bank government bond trading assisting in the smooth deployment of incremental fiscal tools. Third, the central bank may still cut interest rates by 10-20 basis points within the year, further lowering government bond yields.

2. Impact on Monetary Policy, Central Bank Balance Sheet, and Investments

Facilitates the transition of monetary policy's intermediate targets to price-based regulation. Price-based regulation requires better anchoring market benchmark interest rates to policy rates, reducing volatility. Currently, the DR007 essentially serves as the market benchmark interest rate, with increased government bond trading in open market operations better aligning with the pace of government bond issuance, helping smooth DR007 fluctuations and enhance the effectiveness of price-based regulation.

Moreover, we believe that the future interest rate transmission mechanism may further optimize based on the foundation of "market rates + central bank guidance → LPR → loan rates," possibly referencing international experience and clarifying that "market rates" are similar to market benchmark rates like SOFRThe large trading volume of SOFR is an important guarantee for its effectiveness, and its collateral is U.S. Treasury bonds.

If China uses a similar market benchmark interest rate like SOFR, its collateral may also be government bonds, which will have a significant impact on the scale and liquidity of government bonds, requiring better coordination between monetary and fiscal policies.

The government bond yield curve will become one of the important monetary policy operational targets, with the aim of maintaining a normal upward slope of the yield curve. The central bank has four considerations for maintaining a normal upward slope of the yield curve: maintaining positive investment incentives, easing bank net interest margins, guiding inflation expectations, and achieving autonomous interest rate cuts. Achieving the operational goal of a normal upward slope requires smooth coordination between open market trading of government bonds and the pace of government bond issuance.

There is a shift in the way base money is injected, and the central bank's balance sheet expansion remains steady. China's monetary policy still has room for normal operations, and the central bank's open market trading of government bonds enriches the policy toolbox. The timing of open market government bond trading operations is more flexible, covering a wider range of maturities, and can be an effective supplement to other base money injection methods.

In the past, the broad money M2 was mainly derived from commercial bank balance sheet expansion to increase the money multiplier. In the future, with the increase in derived from fiscal net spending, the money multiplier may decrease, and the growth rate of base money will accelerate to support a reasonable growth rate of broad money. This means that the speed of commercial bank balance sheet expansion may slow down, while the central bank's balance sheet expansion speed may increase compared to before, but still remain steady.

The central bank's balance sheet will undergo structural reshaping. The asset structure of the central bank's balance sheet will gradually change and become more diversified, with the proportions of "foreign exchange" and "claims on other deposit-taking corporations" likely to decrease. Short-term central bank open market government bond purchases may lead to an increase in the proportion of "claims on the government".

At the same time, the central bank recently proposed the establishment of "securities, funds, and insurance companies' exchange convenience", which will lead to a decrease in "claims on the government" and an increase in "claims on other financial corporations", with the proportion of "claims on other financial corporations" in total assets also likely to increase.

Impact on investments: In terms of the equity market, the current consistency of monetary and fiscal policies at the central level is a systematic forward-looking solution to the economic structural transformation, and the reconstruction of underlying logic has been initiated, which will bring upward momentum to the equity market; In the bond market, the coordination of fiscal and macro policies will safeguard the stable operation of the bond market, with the 10-year government bond yield expected to fluctuate in the range of 2.1%-2.2%.

Authors: Zhang Jun (S0130523070003), Zhang Di, Zhan Lu, Source: Galaxy Macro, Original Title: "What Does the Establishment of a Joint Working Group by the Central Bank and Ministry of Finance Mean" by Galaxy Macro