Balance Sheet Expansion is not Everything
The lack of PBoC balance sheet expansion since the Covid-19 pandemic stands in contrast with that of advanced economies and has garnered increasing attention recently. We think, however, that conceptually there need not be a direct relationship between the size of the central bank’s balance sheet and its policy stance. This is especially the case for China, where the largely state-owned financing system enables the PBoC to have much more direct control over the economy’s money supply/credit growth (price, quantity, administrative/regulatory – both over supply and target of money/credit flows) vs. other jurisdictions.
The relatively unchanged size of the PBoC’s balance sheet in recent years reflect other factors (some of which are within balance of payments dynamics), such as: a) shrinkage of the current account surplus (hence less need/space for FX reserve accumulation), b) the recycling of external surplus towards the Belt-Road-Initiative (this is done largely through policy/state banks and thus outside of PBoC’s balance sheet), 3) the channeling of FX intervention through the large state banks, 4) higher inherent capital outflows found in E&O, and 5) the shifting of liquidity injections to shorter-term OMO operations, and 6) only a modest increase in claims on banks (relending/rediscount programmes/various credit facilities), amongst others. Movements (or lack thereof) in such balance sheet components should not be taken as definitive indications of PBoC’s policy stance. This is notwithstanding the institutional illegality to purchase government bonds in primary markets, and a seemingly sustained philosophical leaning against QE-like asset purchases from the PBoC.
PBoC’s Restraint and its Inherent Considerations
The PBoC’s monetary policy restraint since the Covid-19 outbreak is instead more apparent through other channels as we consider its wide-ranging toolkit. For example, net OMO operations have largely shown neutral/negative liquidity injection over the course of Jul-Aug (following a complete halt from Apr-late-May), while usage of the MLF is rising but still muted. Price-based stimulus is also limited, with the OMO/MLF rates left unchanged since the 30bps cuts in February-March. Both M2 growth and TSF flow have also peaked in recent months, and at levels far below advanced economies. Onshore markets have since interpreted a pivot in PBoC policy via the rise in onshore bond yields since the peak of the crisis. Since May, the CGB curve bear-flattened and year-to-date moves contrast with those in developed rates markets (this is also compounded by the rise in local-government bond issuances).
In our view, PBoC’s policy restraint thus far stems from three main considerations:
(1) Authorities are cognizant of risks surrounding another significant rise in leverage from here; given that much of policy ammunition have cumulatively been exhausted between 2008 and 2019. Beyond absolute levels of debt, the economy’s ability to take on ever-higher levels of leverage within its current institutional framework has clearly weakened, evident by the much lower return on capital in recent years.
(2) The financing system architecture domestically (via its embedded incentive structures/high concentration in both lending sources and destinations/deeper financial innovation) has also impeded monetary policy transmission previously. In this instance, the loosening in credit policy in the immediate aftermath of the virus outbreak resulted in a buildup of banking system structured deposits placed by corporates (these products typically combine traditional deposits with higher-return investment products; and provide a positive carry relative to onshore funding costs for large corporates/SOEs, essentially allowing them to run a financial arbitrage trade). Structured deposits contributed over 25% of the new banking system deposits from January to April. The re-emergence of financial arbitrage opportunities led to renewed concerns on financial system instability, and the inability of credit creation to be fully channeled into real economic activity.
(3) Another argument behind PBoC’s monetary conservatism – articulated in this particular FT article – pertains to CN’s balance of payments. The article highlighted the linkage between a deteriorating US-China relationship and the subsequent incentive to maintain/rebuild economic buffers. Indeed, we have noted the tendency for Chinese authorities to shore up balance of payments defences during periods of increased vulnerabilities (supply-side stimulus/tightened capital controls etc.). Considering the global response to the pandemic, we expect CN’s current account surplus to further widen going forward, with the drivers including lower commodity prices and the lack of travel (recall capital outflows being disguised as tourist services outflows as flagged out earlier). The focus on supply-side stimulus (geared towards production rather than demand) so far is also juxtaposed with a higher proportion of demand-side stimulus in advanced economies (e.g.UE benefits in the US/furlough or ST employment schemes in EU). At the same time, we expect capital outflows to continue to remain very restrained – SOEs/large corporates are likely to be dis-incentivized to pursue large-scale M&A or asset purchases overseas. Measures pertaining to the capital account will likely be concentrated on driving portfolio inflows. The irony is that, while balance of payments pressures will be less of a constraint/concern for China going forward, a corresponding wider external deficit (likely borne by the US again) for the rest of the world risks worsening US-China relations – back to the central theme of the article. The impact on the rest of the world is also likely to be dis-inflationary.
Considerations (ii) and (iii) will be more temporary in nature. Recently, CBIRC has tightened the regulation on structured deposits, and has required all banks to reduce the size of such products. We do not see balance of payments pressures building to an extent which threatens China’s reserve position as well. As such, developments thus far may not represent a prolonged hawkish monetary policy stance. As financial arbitrage/leverage mechanisms are partially nullified, and the widening of external surpluses become more apparent/prolonged, conditions will likely be more conducive for PBoC to resume a net easing stance before year-end; albeit limited in degree and targeted in nature. The pressure to ease policy should also intensify as higher CGB yields are counter-productive to cope with the economic downturn (instead, we think the domestic economy will benefit from lower risk-free rates but more differentiation in risk-based credit spreads).
PBoC’s Policy Stance and ‘Dual-Circulation’
We continue to see PBoC’s overall policy stance as a key component in relation to the broader economy; previously we have highlighted the need – both domestically, and from a global re-balancing standpoint – for the Chinese economy to rebalance towards domestic consumption. It remains far from clear if the recent public emphasis on 双循环理论 (dual-circulation/feedback) would indicate such a policy shift in the near term (we suspect that it would resemble more a sectoral shift in industrial policies, prioritizing self-sufficiency in strategic segments/markets and focusing on broader technological innovation).
Ultimately, a healthy re-balancing will require a higher income share for households. This can come directly via improved wages or enhanced social security. Income distribution may also occur indirectly via elements such as strength/weakness of the currency, the degree of speculative activity in residential property, the extent of the credit cycle, and which segments of the economy do credit flow to/from, amongst others. All these elements will continue to be heavily influenced by PBoC’s overall policy stance going forward, regardless of its balance sheet size.
Moreover, income shifts can occur via inherent cost attribution, this is especially pertinent as credit risks/bad debt inevitably rise (beyond reported NPL ratios in the banking system) amidst the economic slowdown. CN’s inherent credit costs have historically been funded by financial repression of the masses (via deeply negative real deposit rates on captive savings), that has contributed to the low consumption share of income previously. A rebalance to domestic consumption will require inherent credit costs to be attributed to other economic agents this time round. We have seen initial signs of costs shifting to the banking system – authorities have ‘encouraged’ banks to sacrifice up to RMB 1.5trn in profits. The headline figure (>70% of banking system’s 2019 net profits) appears significant, although details suggest the majority are likely to come in the form of forgone opportunity costs (via rate cuts, reduced service fees, and loan repayment deferments) which will be amortized over a prolonged period of time.
Even as PBoC’s balance sheet (as a proportion of GDP) declines – especially relative to other central banks – its overall policy stance and its inherent intentions/trade-offs will continue to play a critical role in China’s economic trajectory.
