The People's Bank of China's (PBoC) quarterly monetary policy report released on Wednesday confirmed that the policy tide has turned towards easing as inflation has been declining. However, its tone is not dovish, as markets had priced in.

The easing was termed as "fine-tuning", and the policy stance will remain "prudent", implying no policy rate cut. This is because the central bank is not worried about a slowdown in growth, which it termed a "controlled" move needed to curb inflation, and thinks that data has underestimated actual growth in the money supply. Moreover, it thinks that the "foundation of price stability is not yet solid" and sees upside risks to its inflation expectations.

I believe that despite this cautious language, the PBoC has ample room to ease its policy stance without cutting policy rates - and that it will use this scope. Current money market rate levels are inconsistent with quickly declining inflation, which will fall to 4 percent year-on-year in the second quarter. I expect that the central bank will aim at pushing the benchmark seven-day repo rate down to 2.5 percent by then from current 3.4 percent. By global standards, this implies significant easing.

The PBoC has already started to push money market rates down by cutting yields at its open market operations. On October 20, it lowered the three-year yield by 1 basis point (bp); on November 8, the one-year yield by 1 bp; and on Wednesday, the 1-year yield again, by 8 bps. The size of cuts has increased, and so has their frequency, indicating an effort to ease money market conditions. However, on Thursday, the PBoC kept the three-month yield unchanged. I expect the yield to be reduced later this year, but Thursday's action suggests that markets should not expect too fast an easing.

However, it will not be enough to cut open-market-operation yields, and the PBoC will also have to engage in "quantitative easing" of sorts - by increasing interbank market liquidity. Indeed, the central bank routinely injects liquidity into the money market on an annual basis, given that the other three factors impacting total liquidity tend to be a drag. The government account typically drains cash on an annual basis, as do changes in cash in circulation, because nominal growth of the economy leads to rising cash balances of both the public sector and of the general population. With the internationalization of the yuan having started, the outflow of funds from the mainland is another drag. On the other hand, fast deposit growth - which will continue - leads to a major outflow of liquidity, because the required reserve ratio (RRR) is applied to a larger base.

In 2010 and earlier this year, the central bank was adding funds by reducing the outstanding volume of open market operations. However, by now there is only 1.9 trillion yuan outstanding, out of which only 0.6 trillion matures in 2012. This means that even if the PBoC stops issuing new bills and repos - and I think it will maintain modest issuance - it can no longer inject significant funds by reducing outstanding open-market-operation volume.

Thus, the RRR is the only tool the central bank still has at its disposal to inject enough liquidity into the market to bring money market rates significantly lower. I think it will not be necessary this year, because liquidity should improve as the central government spends its cash surplus, as it usually does towards the end of each fourth quarter. However, a 50 bps cut is still possible this year, if not for all banks, then certainly for some. Indeed, the quarterly report reiterated the policy of differentiated RRR. System-wide cuts will come in January at the latest, and I expect up to 150 bps by mid-2012.

The author is senior economist/strategist for Asia ex-Japan at Credit Agricole CIB. The views expressed here are entirely his own.

(HK Edition 11/18/2011 page2)