Dr.Lian Ping: Beijing Should Further Ease Monetary Policy to Boost Market Confidence

Chairman of the China Chief Economist Forum on Impact of Fed Rate Cuts on China and Policy Recommendations

After Federal Reserves announced a 50-point rate cut on Sep 18. Its influence on the Chinese economy has been a hot topic. In general, it’s good news for the Chinese economy, especially the stock market(I hope…).

I'd like to share Dr. Lian Ping's perspective on Chinese monetary policy. Dr. Lian is the Director and Chief Economist of Guangkai Chief Industry Research Institute and Honorary Director of the School of Economics and Management at East China Normal University.

The one I bring today is published on the Wechat Account of China Chief Economist Forum(首席经济学家论坛), arguing that the Fed rate cuts provide China with greater room for monetary easing, a chance for a new round of reserve requirement ratio cuts and interest rate reductions. He also suggests that China review its current Prudent monetary policy to boost market confidence.

Lian Ping: Recommends Adjusting Monetary Policy Stance to “Moderately Loose”

Since 2011, China has maintained a “prudent” monetary policy stance for 14 years. However, the current domestic and international economic situations have undergone significant changes. Domestically, China faces severe challenges of insufficient demand, deflationary pressures, and economic downturn. Meanwhile, monetary policies in the US and Europe are comprehensively shifting towards easing.

Against this backdrop, should China's monetary policy continue to maintain its 'prudent' stance? Or should it be adjusted in a timely manner to send a more positive and clear policy signal to the market, thereby better leveraging the countercyclical function of monetary policy?

Flexible Adjustment of Monetary Policy Should Be the Norm

Looking back at China's monetary policy practice over the past 30 years, the monetary policy stance can be categorized from tight to loose as “tight”, “moderately tight”, “prudent”, “moderately loose”, and “loose”. The monetary authorities, based on objective changes in circumstances, have flexibly adjusted between “tight” and “loose” with “prudent” as the pivot, to achieve economic stability and countercyclical regulation.

In 1993, China experienced economic overheating and severe inflation. The central government adopted a moderately tight monetary policy. By the end of 1996, the three-year-long inflation had significantly declined. In 1997, facing weak domestic demand and severe external shocks from the Asian Financial Crisis, which led to deflation, the monetary policy stance shifted from “moderately tight” to “prudent” to address internal and external pressures. This was done by appropriately increasing money supply to maintain the stability of the RMB and using credit leverage to promote domestic demand expansion and increase exports.

At the end of 2007, to prevent economic growth from shifting from rapid to overheating, the Central Economic Work Conference set the 2008 monetary policy stance as “tight”. In September 2008, marked by the bankruptcy of Lehman Brothers, the U.S. subprime crisis escalated, affecting China's economy. The central government decided to implement an active fiscal policy and a moderately loose monetary policy, which continued until 2010.

From 2011, to prevent inflation, asset price bubbles, abnormal “hot money” movements, and financial risks, China returned to a “prudent” monetary policy stance. For about 14 years since then, China's monetary policy stance has not changed significantly, only showing loose or tight tendencies in practical operations. Specifically:

• 2011-2013: The prudent monetary policy was generally tight, emphasizing inflation prevention.

• 2014-2019: The prudent monetary policy returned to 'prudent and neutral', emphasizing neither loose nor tight.

• 2020-2024: The prudent monetary policy has been essentially loose, highlighting flexibility, moderation, precision, and effectiveness."

Reflecting on the past, several points are worth noting regarding China's monetary policy stance in practice:

Firstly, when the economy faces severe shocks, the monetary policy stance often undergoes directional or significant adjustments. Historical experience shows that under threats of economic overheating or inflation, the monetary policy stance usually shifts quickly towards tightening. For instance, the "moderately tight" policy in 1993 and the "tight" policy in 2008. Conversely, in the context of contractionary shocks, the monetary policy stance is promptly adjusted towards easing. This adjustment may involve one or two levels of change. For example, in 1997, the monetary policy stance shifted from "moderately tight" to "prudent". More dramatically, in 2009, it jumped from "tight" directly to "moderately loose", skipping the "moderately tight" and "prudent" stages altogether.

Secondly, there are instances where the actual implementation of the monetary policy stance doesn't match its official description. Among the five major stances, "tight", "moderately tight", "prudent", and "moderately loose" have all appeared at different times, with only "loose" seemingly absent. However, this doesn't mean that a "loose" stance was truly missing. During 2009-2010, China experienced rapid growth in money and credit. Particularly from late 2009 to early 2010, M1 year-on-year growth reached 38.96%, M2 growth approached 30%, and RMB loan balance growth exceeded 34% for several consecutive months. Correspondingly, local financing platforms proliferated, with some regions establishing over ten platforms in a short period. Evidently, the monetary policy stance at that time was far from the nominal "moderately loose", but was in fact "loose". Similarly, "prudent" sometimes actually meant "moderately loose" (as in 1997) and at other times "moderately tight" (as in 2011-2013). Often, its description moves in the opposite direction of the previous policy stance, requiring an understanding of the actual situation to grasp its relative tightness or looseness.

Thirdly, in recent years, the monetary policy stance has lacked flexibility. Before 2011, the monetary policy stance switched timely between "tight", "moderately tight", "prudent", and "moderately loose" based on objective changes in circumstances and regulatory needs. After 2011, despite significant periodic changes and fluctuations in economic operations, the flexibility of the monetary policy stance has been notably insufficient, with the "prudent" stance continuing for 14 years. In fact, over these 14 years, China's economy has experienced a series of fluctuations. For instance, the economic downturn and capital outflow in 2015-2016; the U.S. trade war against China in 2018-2019; the impact of the pandemic from 2020 to 2022, and so on. However, the overall monetary policy stance has remained unchanged. This is clearly not conducive to monetary policy conducting countercyclical adjustments based on the needs of the real economy. Of course, the spillover effects of the Federal Reserve's monetary policy have imposed certain constraints on China's monetary policy, but over these 14 years, the Fed's monetary policy has already undergone several major adjustments.

It Is Both Necessary and Feasible to Adjust the Monetary Policy Stance to "Moderately Loose"

Firstly, from the domestic perspective, macroeconomic and financial indicators are relatively weak, urgently requiring further monetary policy support. In August 2024, China's Manufacturing Purchasing Managers' Index (PMI) was 49.1%, down 0.3 percentage points from the previous month. The manufacturing sector's vitality continued to decline, falling below the expansion-contraction threshold for the fourth consecutive month. Since the beginning of this year, the manufacturing PMI has only briefly exceeded 50% in March and April, remaining below 50% for the other 6 months. Similarly, in 2023, it was above 50% for only 4 months and below 50% for 8 months. In other words, China's manufacturing sector has been in a state of contraction for most of the past two years.

Looking at financial data, the year-on-year growth rate of the broad money supply (M2) balance in August was 6.3%, marking the fifth consecutive month below 8%. The narrow money supply (M1) balance decreased by 7.3% year-on-year. In July, new RMB loans increased by only 260 billion yuan. If we exclude the 558.6 billion yuan in bill financing, the actual new loan increase was negative. Although new RMB loans in August rebounded to 900 billion yuan, this still falls short compared to the 1.22-1.36 trillion yuan in the same period from 2021 to 2023. Examining the breakdown, both short-term and medium to long-term loans for residents and businesses have significantly declined. The factor of insufficient demand leading to credit decline may outweigh seasonal factors. Additionally, indicators such as prices, real estate, and consumption remain in a persistently sluggish state.

Secondly, there is a notable gap between the current "prudent" monetary policy stance and market psychological expectations. From 2020 to the present, even in the face of major external shocks like the COVID-19 pandemic and insufficient domestic demand, the monetary policy stance has only slightly shifted from a "prudent and neutral" stance towards a more accommodative direction, described as "flexible and appropriate", "flexible, precise, and reasonably appropriate", or "precise and effective". However, the overall stance remains "prudent". Since 2023, the central bank has made several adjustments to the LPR (Loan Prime Rate). For instance, the 1-year LPR was reduced by 10 basis points in June 2023, August 2023, and July 2024. The 5-year LPR was cut by 10, 25, and 10 basis points in June 2023, February 2024, and July 2024, respectively. Except for the relatively larger reduction of the 5-year LPR from 4.2% to 3.95% in February 2024, the other rate cuts have been minimal.

Compared to European and American countries, which often reduce interest rates by 25-50 basis points consecutively, or even up to 100 basis points in a single cut, these small reductions have more symbolic than practical significance. This creates a clear discrepancy with market expectations, making it difficult for these minor rate cuts to significantly impact the market. From the perspective of strengthening expectation management and effectively guiding market expectations, making a reasonable and appropriate adjustment to the monetary policy stance as soon as possible would help boost market confidence and change the current generally weak market expectations.

Thirdly, from the perspective of policy coordination, to enhance the effect of countercyclical regulation, monetary policy needs to better complement fiscal policy by implementing a "dual easing" combination. In the process of countercyclical adjustment, governments typically use expansionary fiscal policies to stimulate aggregate social demand through measures such as borrowing, deficit spending, tax cuts, and increased government expenditure. However, expansionary fiscal policy inherently has the side effect of a "crowding-out effect". This means that as government spending increases, monetary demand grows correspondingly. With a fixed money supply, interest rates rise, leading to suppressed private sector investment. At this point, it's often necessary to pair this with expansionary monetary policy, increasing the money supply to curb interest rate hikes.

In recent years, China's fiscal policy stance has been clearly positioned as an "active fiscal policy", with calls to "increase strength and improve efficiency", generally leaning towards expansion. In 2023, the national fiscal budget deficit was initially set at 3%. In October 2023, the budget was adjusted, adding 1 trillion yuan in ultra-long-term national bonds, ultimately bringing the fiscal deficit ratio to 3.8%. For 2024, China's budgeted deficit ratio continues to be set at 3%, with local government special bond issuance planned at 3.9 trillion yuan, further increasing from last year. Additionally, it was decided to issue large-scale ultra-long-term special national bonds for several consecutive years starting this year.

As fiscal policy stance significantly expands, monetary policy must necessarily provide active support, including increasing liquidity supply and further lowering interest rate levels. At this juncture, it's very necessary for the monetary policy stance to make a corresponding adjustment, shifting from "prudent" to a substantive "moderately loose" stance.

Finally, changes in the external environment have provided a time window for adjusting China's monetary policy stance. On August 23, Federal Reserve Chairman Powell spoke at the global central bank governors' meeting, officially confirming that 'the time for policy adjustment has come.' The market generally believes that a rate cut announcement by the Fed in September is a foregone conclusion. We predict that this round of the Fed's rate cut cycle may last 14-16 months, with 6-8 rate cuts, accumulating to a total reduction of 150-200 basis points.

Undeniably, in recent years, despite increasing downward economic pressure and deflationary pressure, China's monetary policy stance has remained unchanged. A significant reason for this is the constraint imposed on China's economy and financial system by the Fed's high interest rate policy. Currently, the Fed's new round of rate cuts is imminent. Against this backdrop, China's monetary policy stance has gained a rare adjustment window, providing room to push for a new round of reserve requirement ratio cuts and interest rate reductions.

It cannot be denied that in recent years, even as downward pressure on the economy and deflationary pressures have continued to increase, China's monetary policy stance has remained unchanged. A crucial reason for this is the constraints imposed on China's economy and finance by the Federal Reserve's high interest rate policy. Now, with the Fed's new round of rate cuts on the horizon, China's monetary policy stance has gained a rare window for adjustment, providing space to promote a new round of reserve requirement ratio cuts and interest rate reductions.

A "moderately loose" monetary policy stance lies between "prudent" and "loose". Implementing it under current circumstances has three positive implications:

First, compared to a "prudent" monetary policy stance, it is more proactive and aggressive. It allows for greater use of quantitative, price-based, and structural monetary policy tools, injecting ample liquidity into the market and driving real interest rates significantly lower.

Second, compared to a "loose" monetary policy stance, it is relatively more cautious. As the degree of easing is relatively moderate, it can avoid side effects such as "flooding the economy with liquidity" and severe inflation.

Third, compared to the current nominally "prudent" but actually leaning-loose monetary policy stance, its greatest positive significance lies in its ability to send clearer and more explicit policy signals to the market. This allows market participants to better understand the easing intent of the policy and form consistent positive expectations for subsequent policies, thereby enhancing confidence in economic recovery and improvement.

Given that reserve requirement ratio cuts, interest rate reductions, and structural tools have frequently been adjusted towards easing in recent years, and that the direction of continued counter-cyclical adjustment will not change in the coming period, why can't we realistically adjust the "prudent" stance to a "moderately loose" stance in a timely manner? Considering various aspects, the conditions for implementing a truly "moderately loose" monetary policy stance have now matured.

Related Policy Recommendations

1: Develop a more scientific and reasonable definition of monetary policy stance. Policy makers should comprehensively review and standardize the monetary policy stance system and related definitions, especially the boundaries between "loose" and "moderately loose", "tight" and "moderately tight". They should explain what specific changes will occur in monetary policy targets and operational tools under different policy stances, how to refine the triggering conditions for entering and exiting various policy stances, and how to match monetary policy stance with fiscal policy stance.

2: Further strengthen expectation management and convey clear monetary policy signals to the market. While establishing a standardized monetary policy stance system, it is recommended that monetary authorities adopt a more rigorous, accurate policy stance that better reflects current needs. This would allow market participants to better understand the orientation of monetary policy and form positive feedback in resonance. As pointed out by central bank leadership, "When the transparency of monetary policy increases, the policy's comprehensibility and authority will be enhanced. The market will spontaneously form stable expectations about future monetary policy trends, reasonably optimize their own decisions, and monetary policy regulation will achieve twice the result with half the effort."

3: Adjust the monetary policy stance to "moderately loose" to create a suitable policy environment for implementing larger-scale reserve requirement ratio (RRR) cuts and interest rate reductions. Regarding the possibility of RRR cuts, the weighted average deposit reserve ratio for small banks in China is already around 5.0%, leaving relatively little room in the short term, but this does not mean it cannot be further reduced. The weighted average deposit reserve ratio for medium-sized banks is 6.5%, and for large banks, it's 8.5%. If monetary authorities implement a new round of RRR cuts, they could consider focusing on targeted cuts for large state-owned commercial banks and national joint-stock commercial banks. Given that these banks account for 60% of deposits in China's banking industry, a targeted 0.5 percentage point RRR cut is estimated to release over 600 billion yuan of liquidity into the market.

Given that current domestic real interest rates remain relatively high, further interest rate cuts are also necessary. It is recommended to concentrate policy resources to implement a relatively large interest rate cut of about 50 basis points in one go at the end of this year or early next year. At the same time, considering that structural monetary policy tools such as the carbon emission reduction support tool, inclusive small and micro loan support tool, and inclusive elderly care special re-lending will all expire at the end of this year, additional quotas for relevant structural monetary policy tools could be added at the beginning of next year. The interest rates for re-lending supporting agriculture, re-lending supporting small enterprises, and rediscount could each be reduced by 0.5 percentage points to complement efforts in green finance, inclusive finance, and pension finance.