China’s economy has shown signs of weakening since April after a decent first quarter, when GDP grew 4.8% year-on-year. The country’s GDP grew by only 0.4% in the second quarter, due to factors including COVID-related lockdowns in major cities and a deteriorating real estate sector.

Last month, the central bank, the People’s Bank of China (PBoC), surprised the market with a significant cut in interest rates: the one-year medium-term loan facility (MLF) and the reverse repurchase agreement. seven-day reversal were lowered by 10 basis points. . Another rate cut came a week later, when the five-year and one-year loan prime rates (LPR) were each cut by 15 and 5 basis points.

Restoring business confidence is the key objective

The recent Chinese rate cut has been unexpected by most analysts given that the world’s major central banks have experienced a cycle of interest rate hikes in recent months and China’s consumer price index rose 2.7% year-on-year in July, indicating stronger inflationary pressure. The market expected the central bank to favor structural monetary tools, such as additional liquidity or rate cuts for certain sectors, rather than a more general reduction in interest rates.

We think the rate cut is reasonable as it helps restore business confidence after the release of discouraging macro data for July. The company’s total funding (i.e. total excluding financial institutions) was down 30% year-on-year, from 1.080 billion yuan to 756 billion yuan (108 billion dollars), a new monthly record in six years.

This implies that willingness and effective borrowing remain low despite prior policy efforts by the monetary authority.

Growing mortgage boycotts

Another sign of economic difficulties is the rapid spread of mortgage boycotts in July, involving projects in 26 provinces and municipalities, raising fears of widespread risk in the financial sector.

In July, house prices in China fell for the 11th month and since the outbreak of the mortgage strike, the decline is further accentuated. Lower rates served as strong policy support for the struggling real estate sector.

At the same time, the central bank maintained its cautious stance on expanding liquidity, while taking steps to reduce household and corporate funding costs. By August 15, when 600 billion yuan ($86 million) of MLF loans matured, the PBoC operation had resulted in a net withdrawal of funds of 200 billion yuan from the banking system.

A decline in borrowing activity

Weak social finance is underpinned by insufficient investment and consumption demand, resulting from uncertainties about corporate profits and income prospects for the population.

In July 2022, M2, a broad measure of money supply, fell 337 trillion renminbi ($48 billion) month-on-month, compared with an average increase of 3.3 trillion renminbi in the first half of the year. . The reduction in new loans, by households and businesses, is the main reason for the decline in the M2 balance.

Meanwhile, the risk is increasing that funds and liquidity will sit idle within the financial system, due to deteriorating demand for credit from the real estate sector. Funding of short-term bills of the four public banks and major national banks increased by 148.0% and 102.7% year-on-year in July 2022, while the growth rate of short-term and long-term loans of these banks has decreased. During the same month, loan growth also slowed significantly (negative) for small and medium banks, indicating a further weakening in demand for credit by small and medium enterprises.

The fiscal injection from the central bank’s earnings presentation will soon be exhausted, and the local government bond issuance quota will soon be exhausted.

Reduced cost of borrowing and more targeted support to keep going

We expect the central bank to accelerate the implementation of existing structural policies, such as additional liquidity in specific sectors, increased targeted credit expansion for SMEs, especially low-carbon ones, linked to agriculture and focused on technological innovation.

For example, the State Council executive meeting in June decided for the first time to earmark 300 billion yuan ($43 billion) for policy-based development financial instruments (PDFI) to accelerate the funding for local government projects. In August, the government announced an 800 billion yuan credit increase to strategic banks to support infrastructure construction. Another increase of more than 300 billion yuan was added later in the month.

China’s monetary policy will likely continue to aim to stimulate borrowing demand and help financial institutions increase the supply of credit to targeted borrowers.

Financial support for local governments

In March 2022, the PboC announced that the PBoC would make profits of over 1.1 trillion renminbi to the central government. The amount will be used to accelerate the implementation of policies, including VAT refunds and other expansionary tax policies. By the first half of 2022, it had generated more than 900 billion renminbi ($129 billion), equivalent to a liquidity injection resulting from a 0.45 percentage point reduction in the reserve requirement ratio, according to the estimate of the PBoC.

Profits remitted by the central bank can directly reach the recipients without going through the traditional money creation cycle. More importantly, the injection helps rebuild local government finances without increasing their debt levels, allowing local governments to pursue tax reduction and job protection policies and add cash flow essential to the real sector.

A recent innovation is the use of the PDFI (Policy Based Financing and Development Instruments), a new monetary policy tool first announced in June, which aims to provide rapid financing to infrastructure projects supported by the government. In particular, the PDFI provides start-up or transition funds through infrastructure funds, which can be considerably faster than issuing local government bonds.

At present, the PDFI mainly focuses on the construction of network infrastructure for transport, energy and irrigation, while other local projects such as those on scientific and technological innovation were to be financed by special bonds from local governments.

In the coming months, the government must provide more funds to help reverse the economic downturn of the past few months. The fiscal injection from the central bank’s earnings presentation will soon be exhausted, and the local government bond issuance quota will soon be exhausted.

The impact of lower rates has yet to materialize and the financial risks associated with a depressed real estate sector are far from resolved. We expect more monetary easing measures to be announced, particularly those aimed at strengthening the fiscal expansion for the rest of the year.