China still has further room for RRR, interest rate cuts

The People's Bank of China, the country's central bank, proposed in its third quarter monetary policy implementation report that a reasonable pickup in prices should be taken as a key consideration in monetary policymaking to keep prices at a reasonable level.

However, prices are still running low at present.

In October, China's CPI, or consumer price index, increased by 0.3 percent year-on-year. The growth rate was 0.1 percentage point lower than that in September, and the cumulative year-on-year growth rate of the index in the January-October period was only 0.3 percent.

The PPI, or producer price index, fell by 2.8 percent year-on-year and 0.1 percent month-on-month in October — the second year in a row when it has recorded a negative result.

The decline further expanded from the September level and was the lowest since last December.

These figures are a clear sign of the fact that corporate willingness to invest has yet to be restored. And with the central bank maintaining its stance on a supportive monetary policy, we believe that there is still room for further RRR, or reserve requirement ratio, and interest rate cuts.

Compared to other major economies, China still has considerable room for RRR cuts. The PBOC might share the same thoughts, as it had lowered the RRR for financial institutions by 0.5 percentage point in September, injecting around 1 trillion yuan ($137.5 billion) of long-term liquidity into the financial markets.

After the cut, the second of this year, the weighted average reserve requirement ratio for financial institutions is about 6.6 percent. During a conference on the financial support for high-quality development in September, PBOC Governor Pan Gongsheng also gave a forward-looking guidance on monetary policy, indicating that China may further reduce the reserve requirement ratio by 0.25 to 0.5 percentage point at an opportune time later this year.

In terms of liquidity support, among various monetary policy tools RRR cuts have the longest term and the lowest cost, helping reduce funding costs for commercial banks and alleviate the pressure on interest rate spreads.

As of the end of the third quarter, the net interest margin of commercial banks had dropped to 1.53 percent, a record low. Currently, loan prime rates, or LPR, for loans of one year, as well as five years and above stand at 3.1 percent and 3.6 percent, respectively, marking the lowest levels since the LPR reform in 2019.

The central bank pays an interest rate of 1.62 percent on required reserve deposits, which also represents the cost of injecting liquidity via RRR cuts. However, from the asset side, the weighted average interest rate on RMB loans for financial institutions was 3.67 percent as of the end of the third quarter, more than twice the former.

Additionally, most of the national and local bonds are purchased by commercial banks. At present, about 70 percent of China's treasury bonds are held by commercial banks, and they also hold about 82 percent of local bonds.

According to the incremental fiscal policy announced in November, the nation is expected to directly increase local debt resources by 10 trillion yuan in the next few years. With signs clearly showing that the scale of government bond issuance will increase, the RRR cut will increase the funds that commercial banks can use freely, so as to better support the issuance of national and local bonds.

The RRR cut, to this end, will help maintain reasonable and sufficient market liquidity during bond issuance, while interest rate cuts will facilitate swaps between central and local debts in terms of policy effectiveness.

Since the current interest rate on statutory debt is much lower than the interest rate on implicit debt, the replacement will greatly save local interest expenses — about 600 billion yuan can be saved in five years, according to official estimates.

There is also room for interest rate cuts. Based on the difference between the 10-year treasury bond yield, which is around 2.1 percent, and the core CPI — 0.2 percent in October — the current real interest rate is around 2 percent.

Based on previous cases of dealing with deflation, if given a minimum real interest rate of 0.88 percent — same as the level of October 2016 — and the core CPI can reach a year-on-year growth rate of 0.8 percent in the future, which is the average annual growth rate of core CPI since the COVID-19 pandemic, the nominal interest rate can be reduced to about 1.7 percent.

Considering that the current 10-year treasury bond yield is around 2.1 percent, it is expected that there is still room for interest rate cuts of about 40 basis points in the near future. The US Federal Reserve's entry into the interest rate reduction cycle has also provided a favorable external environment for China's interest rate cuts.

Whether it is an RRR cut or an interest-rate cut, it will be conducive to further bringing into play the effectiveness of monetary policy in conjunction with proactive fiscal policy.

The writer is a professor at China Europe International Business School and former director-general of the statistics and analysis department of the People's Bank of China.

This op-ed is a translated version of a speech by the writer at a financial forum held by CEIBS in November.

The views do not necessarily reflect those of China Daily.