The boast by People’s Bank of China governor Yi Gang this month that he has “tremendous room” to adjust policy could soon be tested as the economy slows, throwing attention on the impact on the nation’s fragile currency and financial markets.
Compared to European and Japanese peers, China does have more obvious policy space. Its benchmark one-year lending rate has stayed at 4.35% since 2015, far above zero.
The Federal Reserve’s dovish turn also eases the depreciation pressures on the yuan, leaving Yi even more room for manoeuvre.
Yi may be looking at his toolkit more carefully after data released Friday showed industrial output growth in May slowed to the weakest pace since 2002, highlighting headwinds from the trade war with the US Production slowed across the board even as solid readings for property investment and retail sales suggest some measures to cushion the slowdown are filtering through.
“Policymakers always have room but they need to ask themselves ‘at what cost?”’ said Rob Subbaraman, head of emerging markets economics at Nomura Holdings Inc in Singapore. “Easing monetary policy aggressively could come at the cost of a yuan depreciation overshoot or another debt-fuelled property market bubble.”
The government and central bank have already unveiled various targeted measures to boost infrastructure spending, support credit growth, cut taxes and increase consumption even as so far they have avoided resorting to massive stimulus like in previous downturns.
Here are the key options Yi and policy makers will consider should they need to respond more aggressively:
Interest rates: Some economists predict that a worsening trade war and job-market outlook could prompt the central bank to take bolder easing steps, like cutting the benchmark rate that governs a broad range of lending across the economy, including mortgages.
As tariffs dampen growth and confidence, economists at Bank of America Merrill Lynch and Bloomberg Economics see reductions of as much as 50 basis points this year.
A cut would likely send the yuan plunging though, testing Yi’s recent statement that no “one number” on the exchange rate is more important than any other.
Beyond the benchmark rate, the central bank could also steer banks’ short-term borrowing costs lower, a move posing a lower risk of currency depreciation.
Reserve ratio: The amount of funds that the PBoC requires banks to park as reserves is a legacy of an era of massive capital inflows. Nevertheless, it’s still at an elevated 13.5% for major banks after being reduced via universal or targeted cuts from 16% a year ago, steps that released billions of yuan of liquidity to the financial system. That space means Yi is likely to turn to this tool before cutting rates.
As authorities look to keep the credit taps flowing, Morgan Stanley, China International Capital Corp and Macquarie Securities expect further cuts to the proportion of deposits banks are forced to lock away. Bloomberg Economist David Qu estimates another 1.5-2 percentage points of reserve requirement cuts by year-end while a Bloomberg survey in May sees 100 basis points in cuts.
Reserve cuts are no panacea, though. Policy makers have repeatedly warned against flooding the financial system with cash, wary of the emergence of bubbles in the property sector and risky lending elsewhere.
Small-scale cuts targeted at small businesses or rural borrowers have less broad-based impact, while across-the-board reductions bear a similar risk of yuan weakness as benchmark changes.
“The market consensus on China’s monetary policy remains focused on targeted easing. Based on conditions facing the People’s Bank of China right now, that makes sense. Based on conditions they will likely face in the second half of the year, it does not. We anticipate two rate cuts as an intensifying trade war hits already-fragile growth”, says David Qu and Tom Orlik, Bloomberg Economics.
Yuan: Whatever levers China pulls in response to a slowdown, it must calibrate the impact it will have on the yuan. Yi hinted that the level of 7-per-dollar is not a line in the sand and Goldman Sachs Group expects the yuan to breach 7 within the next three months, as its decline could be a natural offset to higher US tariffs, strategists including New York-based Zach Pandl wrote in a note.
“China can do whatever it takes to backstop growth,” said Michael Every, head of Asia financial markets research at Rabobank in Hong Kong. “They just can’t do that and expect to maintain currency stability.”
China still has a fiscal war chest of about $3.65tn to counter any further fallout from the trade war, according to an analysis of government spending by Bloomberg last month.
Central and local authorities had at least 25.1tn yuan ($3.65tn) unspent in their budgets this year, data compiled using official budget plans showed. That’s 2tn yuan more than the ammunition China had in the same period last year.
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