China's Monetary Shift: PBOC Unlocks New Pathways to Market Revival
On Christmas Day, the People’s Bank of China (PBOC) delivered a timely present: a $300 billion RMB issuance of 1-year bonds under its MLF (Medium-Lending Facility) instrument. The value of the present does not lie in the amount of debt issued, but in understanding the directional shift in financial engineering that underlies such an intervention.
Due to sustained lethargy in its economy after the pandemic, the government has continually cut rates to stimulate greater credit growth. However, it is necessary to have a contextual knowledge of Chinese monetary policy, which works very differently from other global economies. In China, unlike market-oriented economies in the West, interest-rate setting assumes a more centralized, administrative, and top-down connotation. This means that the most powerful monetary tools are often quite limited and have longer time horizons, since stability is prioritized over flexibility. Main instruments for maintaining liquidity fall under two categories: supply-side and demand-side.
The main supply-side policy would be Central Bank deposit rates and Reserve Requirement Ratios. As per Article 32 of the Law of the People's Republic of China on Commercial Banks: "Commercial banks shall place a deposit reserve with the People's Bank of China and maintain sufficient provision for payment, in accordance with the regulations of the People's Bank of China." Liquidity implications would be influenced therefore by 1) the deposit rate and 2) Reserve Requirement Ratios (RRR). This is an easy instrument to apply: hike up the RRR or the deposit rate when you want to cool the economy down and dial down the two measures if you want to heat the economy up. Such simplicity is also indicative of the lack of flexibility, and consequently, the importance of stability to the PBOC. Unlike the Federal Reserve, which has phased out the legal necessity for central bank reserves in 2020, the Chinese government prefers to have greater oversight over its financial system, since mandatory reserves would make financial engineering more effective.[1]
On the demand side, the Chinese government has two main policies: MLFs (Medium-Lending Facilities) and 7-, 14-, and 28-day Repos. MLFs are 1-year loans issued to large, qualified banks, which often have a controlling-stake by the government. This is to ensure that the capital is deployed strategically in particular sectors, rather than the market-centric approach utilized by the Federal Reserve with its 24 large, primary dealers. The MLF also serves as a benchmark for the Loan Prime Rate (LPR), another key credit indicator that represents the lending rate at which commercial banks lend money to their most creditworthy clients. The MLF thus becomes the single most important financial lever that the PBOC can exercise, since it directly influences the LPR, which is the actual interest rate in the economy. On the short-term, Repo operations are also conducted. The sheer size of the Chinese economy (1st in terms of Purchasing Power Parity) and the heavy bank-centric nature of its financial system have resulted in an economy dependent on short-term liquidity measures.[2] Total turnover for repo contracts exceeded 1600 trillion yuan in 2023, with roughly 90% being 1-day term contracts.[3]
Therefore, we need to be precise when we hear the phrase “The PBOC has cut rates.” Did it reduce the RRR, or maybe there was a reduction in MLF or Repo rates? This is unlike the Federal Reserve, which incentivizes its primary lenders and Money-Market Funds to adjust to the Federal Funds Rate through a slew of Open Market Operations (OMOs) and Repo operations. However, recent changes in China’s monetary policy indicate a shift from its dirigiste, state-administered philosophy to a more market-oriented approach that still places a premium on the state’s macro-control capability. This is further corroborated by the MLF operation on December 25, which was mentioned at the start; the issuance of $300 billion RMB paled in comparison to previous issuances in 2023 (1.5 trillion RMB) and 2022 (650 billion RMB). [4] [5] While a chunk of it can be attributed to the PBOC’s desire to retain more dry powder for a challenging 2025, the trend is indicative of greater diversification of the PBOC’s monetary toolkit. In the 15th Lu Jiazui Conference that was held in June 2024, Pan Gongsheng, the governor of PBOC, claimed that there will be a paradigm shift from a quantity-focused monetary policy to a price-based monetary framework, widely adopted by Western institutions.
The fundamental reason was explained in the same speech: “When the growth of money and credit has pivoted from supply constraints to demand constraints, it obviously runs against the law of economic performance if the emphasis remains on quantitative growth, or even "the obsession with aggregates" exists.” The growing pain of excess liquidity in an environment of sluggish demand cannot be addressed by blunt instruments that inject greater volume into the economy. It would be more prudent to rely on market forces through short-term liquidity measures such as repo operations, since a shorter time-horizon of debt-like securities would incentive more efficient capital allocation by financial institutions, reducing over-reliance on speculatory or low-productivity activities. More importantly, the problem within the Chinese economy is not liquidity; rather, it is excess liquidity. YoY M2 Growth in the first quarter stood at 7%, noted by Pan Gongsheng, exceeding the first quarter GDP YoY growth rate (4.2%).[6] This is not an idiosyncratic event, as demonstrated below.
Fig 1. M2 growth rate has always outpaced GDP growth rate, but this has become especially obvious in recent months. The narrowing at the end can be attributed to exports growth. However, rapidly falling credit growth rate demonstrates how even M2 supply is increasing steadily, the money is not properly utilized. Source: LSEG Workspace
The growth rate of nominal GDP has consistently lagged behind the expansion of M2, notably in 2023, before showing modest improvement in 2024. This pattern reflects substantial net injections into the economy through MLF in 2023, followed by robust 2024 export performance that buoyed GDP growth rate and increased net withdrawals via MLF in 2024 which closed the spread. More tellingly, a plummeting credit growth rate in 2024 suggests that demand for money was not stimulated by consecutive liquidity injections. More targeted, short-term horizon tools are crucial to ensure greater utilization efficiency of capital. In essence, more stringent and market-based lending operations by the PBOC would encourage higher-quality lending and investment activities, which veer from the traditional growth drivers of long-term infrastructure developments that have cratered in value due to the property market bust. The larger context is also helpful to understand the policy shift. As the Chinese government seeks to increase fiscal and monetary stimulus in 2025 to address lagging consumption after the recent conclusion of the Central Economic Work Conference, it must ensure an affordable cost of debt-financing. A greater reliance on securities with near-term maturities would load off some financial pressure from the government, since yield rates for their securities will be lower.
Fig 2. December 2024 noted a record net withdrawal in liquidity through MLF policy. This indicates a gradual shifting from MLF tool since 2023 after noting its effectiveness decline (see fig 1). Source: PBOC, Bloomberg.
Reducing reliance to MLF is only one side of the equation; the PBOC has also been active in other efforts to diversify its economic toolkit. In October, the PBOC introduced $500 billion RMB of outright reverse repos with a 6-month maturity date that could be traded on the secondary market.[7] This has two key advantages: 1) Acting as an intermediate-maturity date liquidator between short-term repos and MLFs 2) Greater margin for price discovery and thus a more market-oriented monetary approach by allowing a secondary repo market.[8] This financial instrument allows for banks to assume a more implicated role in capital allocation, hopefully increasing efficiency along the way. Such greater flexibility is also seen in the adjustment of MLF to reflect market conditions through a bidding process. After July, an auction-based system began to replace the administrative-heavy nature of the MLF rate, following an increased divergence between MLF rates and National Certificates of Deposit (NCD) rates. The latter is the inter-bank lending rate of the highest creditworthiness and can be translated as the FFR in western contexts. MLF policy transmission is effective insofar as MLF acts as an interest-rate floor for NCD, or when the spread between MLF and NCD is small—this began to fall apart by July 2024, when NCD rates (1.9642%) were much lower than MLF rates (2.50%). Excess liquidity in the system meant that government mandated monetary policies are no longer that effective. A market-based approach would be more efficient instead.
Fig 3. Using SHIBOR (Shanghai Interbank Offered Rate) as a proxy for NCDs, we see a persistent differential since 2021. This can indicate the deteriorating effectiveness of MLFs as policy transmission tools. Source: LSEG Workspace
What does all this mean for upcoming fiscal/monetary stimulus?
These policy adjustments indicate two major trends. Firstly, the greater need of monetary policy flexibility in light of the economic crisis enveloping the country. In his December 17 speech at the CEWC, Chinese Premier Li Qiang emphasized the importance of improving the efficiency of "capital deployment and investment." [9] Allowing for greater modernization and dynamism in their monetary policy—even at the cost of less oversight—is crucial for the upcoming rounds of financial stimulus in 2025. More emphasis on short-term security operations will permit greater financial efficiency in the system. Additionally, any large-scale financial stimulus, like the 10 trillion RMB package proposed in September, risks creating another asset bubble. Repo operations and market-based MLF rates act as safeguards against such risks, since long-term assets with excessively low rates are often culprits for systemic financial collapse (cue SVB in 2023). This has already been warned by the PBOC in July 2024, when 10-year government bond yields have been pushed down to unprecedented levels, sparking immediate OMOs to push up the rates by controlled sell-offs.
Secondly, the need to create more favorable conditions for counter-cyclical fiscal measures. A day after, the CCP announced a 3 trillion RMB special-purpose bond package that will be allocated to local governments. These bonds will then be tasked to utilize such capital to boost consumption, buy unfinished real-estate projects, or build new, high-quality infrastructure.[10] Such capital deployment must cooperate with a suitable monetary environment. The spread between the loan prime rate and 10-year sovereign bonds has increased to its largest in 4 years; while this might spur greater lending, this also indicates weaker bank profits, which can ultimately backfire if loan demand does not keep up.
Fig 3. LPR/10-year spread has increased to its greatest in years as policy cuts rates to stimulate the economy. Source: LSEG Workspace
Data already show struggling profit margins as interest rates continue their descent.[11] A manageable, controlled spread will be crucial for both bank health and proper capital allocation. This can be achieved through strategic short-term financial interventions by the PBOC, which protects bank profitability by prioritizing market sentiment, ensuring smoother capital transmission.
References
[1] Board of Governors of the Federal Reserve System. (). Reserve requirements.
[2] S&P Global. (2024, October 12). China bond market reforms: Key to growing with less debt.
[3] South China Morning Post. (2024, October 31). China to widen access to US$23.2 trillion repo market with transformative signalling impact on interest rates.
[4] People’s Bank of China. (2024, October 15). Overview of monetary policies.
[5] People’s Bank of China. (2024, November 8). Key monetary policy actions.
[6] Pan, G. (2024, June 19). China's current monetary policy stance and evolution of monetary policy framework in the future. Keynote speech at the 15th Lujiazui Forum, Shanghai.
[7] State Council of the People's Republic of China. (2024, October 10). Ministry briefing.
[8] State Council of the People's Republic of China. (2024, October 28). China issues new government policies.
[9] State Council of the People's Republic of China. (2024, December 17). Policy adjustments in December.
[10] Reuters. (2024, December 24). China to increase budget deficit, ramp up government bond issuance to support growth.
[11] S&P Global Market Intelligence. (2024, December 15). Chinese banks face profitability pressure amid falling margins, slow loan growth.
