Guan Tao: The market is helping the central bank to cut interest rates

On December 9, 2024, the Central Political Bureau meeting emphasized that in 2025, a more proactive macro policy will be implemented, combining a more active fiscal policy with a moderately loose monetary policy. The mention of "moderately loose monetary policy" after fourteen years has led the market to anticipate greater reductions in reserve requirements and interest rates. However, expectations have repeatedly fallen short. The market interprets this as a need to stabilize the exchange rate. The author believes that a deeper reason may be that the market has helped the People's Bank of China (i.e., the central bank of China) implement a "quasi-rate cut."

Prudent monetary policy operations are not neutral

Most major central banks globally have adopted an inflation-targeting monetary policy framework. Under this framework, central banks make discretionary choices, adopting neutral, restrictive, or supportive monetary policy stances. After the outbreak of the global financial crisis in 2008, to break through the constraint of the zero lower bound where interest rates cannot be negative, major Western central banks implemented quantitative easing (QE) operations by purchasing assets to inject base money, which is considered unconventional monetary policy (UMP).

Before 1993, China primarily used administrative means of governance and rectification to smooth out cyclical economic fluctuations. Starting in the second half of 1993, China began to use monetary and fiscal policies for macroeconomic regulation. At the end of that year, the decision made at the Third Plenary Session of the 14th Central Committee of the Communist Party of China proposed for the first time to transform government functions and establish a sound macroeconomic regulation system.

Over the past thirty years, based on the changes in economic conditions, China has adopted different monetary policy stances while balancing growth, employment, price stability, and international balance of payments goals. To address inflation and economic overheating, China implemented a tight monetary policy from the second half of 1993 to 1995. As inflation receded and the economy achieved a "soft landing," a moderately tight monetary policy was adopted starting in 1996. In response to the spillover effects of the Asian financial crisis, a prudent monetary policy was adopted in mid-1998, lasting until 2007. In the first half of 2008, to prevent economic overheating and inflation, a tight monetary policy was again implemented. However, as the U.S. subprime mortgage crisis evolved into a global financial tsunami, leading to a worldwide economic recession, a moderately loose monetary policy was adopted starting in September of that year, lasting until 2010. In 2011, with a V-shaped economic rebound and renewed inflationary pressures, a prudent monetary policy was implemented. Since then, although the domestic economic situation has experienced multiple fluctuations, the tone of "prudent monetary policy" has remained unchanged until 2024. In 2025, a moderately loose monetary policy will be implemented again.

Literally correlating the aforementioned Chinese monetary policy operations with those of the West, "tight" and "moderately tight" both belong to restrictive monetary policy stances, with "tight" being more restrictive than "moderately tight"; "moderately loose" belongs to a supportive monetary policy stance, and there has never been a mention of "loose" in China's history, which should belong to a stronger supportive monetary policy stance; "prudent" belongs to a neutral monetary policy stance However, in recent years, especially since 2022, China's monetary policy stance has not been neutral. In fact, since mid-2012, China has entered a more than ten-year cycle of interest rate cuts.

From June 2012 to October 2015, before the completion of the narrow interest rate marketization reform, the central bank cumulatively lowered the one-year benchmark interest rates for RMB deposits and loans 8 times, by 2.0 and 1.9 percentage points, respectively.

In October 2015, the central bank announced the removal of the upper limit on deposit interest rates, marking a new phase in the marketization of RMB interest rates. The central bank began to construct and improve the policy interest rate system to guide and regulate the overall market interest rates. At that time, the policy interest rates included open market operations (OMO) of different maturities, medium-term lending facility (MLF), standing lending facility (SLF), pledged supplementary lending (PSL), and various relending rates, but it was unclear which rates were more important. Meanwhile, the transmission channels from policy interest rates to market interest rates also needed to be clarified. Looking at the one-year loan market quoted interest rate (LPR), it remained basically stable from November 2015 to July 2019 (see Chart 1). This reflects that from the "8·11" exchange rate reform in 2015 to the breaking of the 7 level of the RMB exchange rate in 2019, the task of "exchange rate stability" constrained interest rate policy.

In early August 2019, the RMB broke the 7 level, increasing the degree of exchange rate marketization and flexibility, which expanded the central bank's monetary policy space. In that month, the central bank promoted the marketization reform of loan interest rates. The reformed LPR is quoted by each quoting bank based on the loan interest rates applied to the best quality customers, formed on the 20th of each month (postponed in case of holidays) by adding points to the MLF rate. From the one-year MLF rate perspective, from August 2019 to June 2024, it was cumulatively lowered 7 times, by 0.80 percentage points. During the same period, the one-year and five-year LPRs fell by 0.86 and 0.90 percentage points, respectively (see Chart 1).

In June 2024, the central bank governor Pan Gongsheng publicly stated at the Lujiazui Forum that it would further improve the market-oriented interest rate adjustment mechanism, clearly designating the 7-day reverse repurchase rate as the main policy interest rate, downplaying the policy interest rate characteristics of other term rates, and gradually clarifying the transmission relationship from short to long. On July 22, the central bank announced adjustments to the bidding method for the 7-day reverse repurchase operations and lowered the rate by 0.10 percentage points. On September 29, it further lowered the 7-day reverse repurchase rate by 0.20 percentage points. From July to December 2024, the one-year and five-year LPRs each cumulatively fell by 0.35 percentage points (see Chart 1) Since the end of 2011, China has entered a more than ten-year cycle of interest rate cuts. From November 2011 to December 2024, the required reserve ratio for large and small deposit-taking financial institutions has been cumulatively lowered 23 times, by 12.0 and 13.0 percentage points respectively (see Chart 2). At the same time, the central bank has also established a series of structural monetary policy tools to increase financial support for key areas and weak links. By the end of September 2024, the balance of structural monetary policy tools was 6.66 trillion yuan, equivalent to 17.6% of the balance of base currency during the same period.

In particular, from March 2022 to July 2023, during the Federal Reserve's aggressive interest rate hikes and balance sheet reduction to combat inflation, the People's Bank of China cumulatively lowered the one-year MLF rate twice, by 0.20 percentage points, and reduced the reserve requirement ratio for large and small deposit-taking financial institutions three times, by 0.75 percentage points, guiding the one-year and five-year LPR down by 0.15 and 0.40 percentage points respectively. Starting in August 2023, the Federal Reserve maintained its stance until it began this round of interest rate cuts in September 2024, cumulatively lowering rates three times by 1.0 percentage points by the end of 2024. During the same period, the People's Bank of China lowered the seven-day reverse repurchase rate three times, by 0.40 percentage points, and reduced the reserve requirement ratio three times, by 1.25 percentage points, guiding the one-year and five-year LPR down by 0.45 and 0.60 percentage points respectively (see Chart 1 and Chart 2).

In this context, Pan Gongsheng pointed out at the aforementioned Lujiazui Forum that although some central banks have already begun or are about to start cutting interest rates, they generally maintain a high interest rate and restrictive monetary policy stance. China's situation is different, as the monetary policy stance is supportive, providing financial support for the sustained recovery of the economy. It is evident that the reiteration of "moderately loose monetary policy" is a confirmation of previous monetary policy operations rather than a major directional adjustment.

Bond Market Rally Helps Central Bank Cut Rates

Such occurrences have also happened in developed economies. With high inflation resurfacing, the Federal Reserve cumulatively raised interest rates 11 times, by 5.25 percentage points, between March 2022 and July 2023. Subsequently, the Federal Reserve pressed the "pause button" eight times, not cutting rates for the first time until September 2024. Notably, just before the November 2023 monetary policy meeting, several Federal Reserve officials indicated that since mid to late October, the rise in long-term U.S. Treasury yields and the overall tightening of financial conditions had acted as a "quasi-rate hike," reducing the necessity for further rate increases. This provided justification for the second pause in rate hikes in November 2023 A similar situation has occurred in China, where the accelerated decline in long-term bond yields since the end of 2024 has had a "quasi-rate cut" effect, reducing the necessity for the central bank to lower interest rates.

Since April 2024, the People's Bank of China has repeatedly warned about the systemic risks accumulated from the unilateral decline in long-term interest rates. On October 18 of the same year, Pan Gongsheng explained three main considerations in policy formulation at the Financial Street Forum annual meeting, noting that the third consideration is that the central bank needs to observe and assess financial market risks from a macro-prudential management perspective and take appropriate measures to block or weaken the accumulation of financial market risks. At that time, he particularly emphasized that the People's Bank had strengthened communication with the market regarding the operation of long-term government bond yields multiple times recently, aiming to curb the systemic risks hidden in the unilateral decline of long-term government bond yields caused by herd behavior.

The reality is that the aforementioned warnings have not been effective. Starting from December 2, 2024, the yield on 10-year Chinese government bonds officially fell below 2%. After the Central Political Bureau meeting on December 9, which reiterated a moderately loose monetary policy, the yield further accelerated its decline, dipping below 1.6% during the session, implying market expectations of a 0.30 to 0.40 percentage point rate cut by the central bank. By January 24, 2025, it closed at 1.66%, down 0.30 percentage points from December 6, 2024 (the trading day before the Political Bureau meeting). By the end of 2024, the yields on 20-year and 30-year government bonds also fell below 2%, closing at 1.95% and 1.89% respectively on January 24, 2025, down 24 and 27 basis points from December 6, 2024 (see Chart 3).

Government bond yields represent the domestic risk-free rate and serve as the pricing benchmark for other financial assets. The decline in 10-year government bond yields has effectively acted as a rate cut in the domestic bond market. For instance, between December 9, 2024, and January 24, 2025, the yields on 10-year policy bank bonds and local government bonds fell by 35 and 27 basis points respectively, while the yields on 5-year AAA-rated commercial bank ordinary bonds and AAA-rated corporate bonds fell by 19 and 17 basis points respectively (see Chart 4).

However, the transmission of the declining risk-free rate to the domestic stock and credit markets has been ineffective.

Theoretically, the decline in the 10-year government bond yield, which serves as the anchor for pricing risk-free assets, should help boost market risk appetite and raise stock valuations, and vice versa. For example, in 2022, it was precisely due to the Federal Reserve's aggressive tightening and the rapid rise in the 10-year U.S. Treasury yield that led to a "double whammy" for U.S. stocks and bonds However, from December 9, 2024, to January 24, 2025, the 10-year China government bond yield declined, while the Shanghai Composite Index, Shenzhen Component Index, CSI 300, and Wind All A Index fell by 4.4%, 4.6%, 3.5%, and 5.6%, respectively. This is partly related to the decline in the 10-year government bond yield, reflecting the market's comprehensive judgment on future macroeconomic trends and inflation expectations.

Government bond yields are still the benchmark for determining bank loan interest rates. After the market-oriented reform of deposit rates in 2022, banks can refer to bond market interest rates represented by the 10-year government bond yield and loan market interest rates represented by the 1-year Loan Prime Rate (LPR) to reasonably adjust deposit rate levels. However, the unilateral decline in the 10-year government bond yield has not led to a further reduction in the cost of bank liabilities, thereby constraining the adjustment of the LPR. Since the first quarter of 2022, affected by the asymmetric decline in asset and liability side interest rates, banks' net interest margins have narrowed and have continued to be lower than the ratio of non-performing loans since the second quarter of 2024. Balancing the health of the banking sector's balance sheets with the declining financing costs of the real economy has become an important consideration for the current central bank's monetary policy.

Some may not take this seriously, believing that a shrinking net interest margin, even falling below the non-performing loan ratio, simply means banks earn less. However, this overlooks the need to provide banks with positive incentives for interest rate transmission through credit channels. For example, the inversion of net interest margins and non-performing loan ratios for city commercial banks and rural commercial banks occurred earlier and to a greater extent (see Chart 5). As the LPR continues to decline, the risk appetite of these two types of banks decreases, leading them to allocate more to high-credit-quality assets such as government bonds. According to the People's Bank of China, by the end of the third quarter of 2024, government debt accounted for 12.4% of the total assets of small Chinese banks, an increase of 2.9 percentage points from the end of 2021, which is higher than the increases of 1.4 and 1.3 percentage points for large and medium-sized Chinese banks during the same period. This has exacerbated the shortage of safe assets and pushed down government bond yields.

On the morning of January 10, 2025, the central bank announced a temporary suspension of open market purchases of government bonds. Subsequently, money market interest rates rose rapidly, and liquidity tightened. From January 10 to 24, the average 7-day interbank pledged repo rate (R007) was 58 basis points higher than the 7-day deposit-taking institutions' pledged repo rate (DR007), far exceeding the average level of 15 basis points from early 2024 to January 9, 2025, reflecting an increase in market credit risk premiums (see Chart 6).

Although the central bank has increased liquidity injection through 14-day reverse repos and MLF operations, the prediction of a potential 0.25 to 0.5 percentage point reserve requirement ratio cut by the end of September 2024 has not materialized. This may be because the current fluctuations in the money market are only seasonal, and a reserve requirement ratio cut is intended to deeply release medium to long-term liquidity, which is not suitable for "overkill."

Author of this article: Guan Tao, Chief Economist of Bank of China Securities, Source: Pinglan Guantao, Original title: "Guan Tao: The market is helping the central bank to cut interest rates"

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