Written by Kevin Yao
BEIJING (Reuters) – China's central bank is expected to use its most aggressive monetary tactics in a decade this year as it tries to stimulate the economy and cushion the blow of impending U.S. tariff hikes, but in doing so it risks quickly sapping its strength.
The People's Bank of China (PBOC)'s announcement on Friday that it has halted purchases of Treasury bonds due to asset scarcity highlights the constraints on its resources as it faces an increasingly difficult economic environment.
Analysts say policy implementation is complicated by various factors. There is the risk of currency and capital outflows, weak demand for domestic credit, and diminishing scope to cut interest rates and inject liquidity by lowering reserve requirement ratios (RRRs) – the amount of cash banks need to hold on hand for rainy days.
All of these restrictions are interconnected. Further bond purchases, interest rate cuts or liquidity injections may put downward pressure on the yuan, which could cause funds needed for domestic growth to flow out.
The restrictions were evident even before the suspension of bond purchases.
In September, People's Bank of China Governor Pan Gongsheng, in rare forward-looking comments, indicated the possibility of cutting the reserve reserve ratio again by the end of the year, depending on market conditions, but the cut did not happen, despite a more flexible policy stance.
More monetary easing could support the economy in the near term, but will fuel asset bubbles in the longer term.
The People's Bank of China has repeatedly warned that a bond rally that has pushed yields to record lows could undermine financial stability when markets turn.
“Short versus long, internal versus external, exchange rate versus interest rates – these are multiple conflicts,” said Xing Zhaoping, chief strategist at ANZ Bank.
Facing deflationary pressures and mounting headwinds to already faltering growth, China's top leaders in December abandoned their 14-year-old “prudent” monetary policy stance in favor of a “moderately accommodative” stance.
But the room to cut interest rates and bank reserve requirements is smaller than the scope of easing implemented during the “cautious” era, implying that the People’s Bank of China may in practice have to be more cautious than before, analysts say.
The People's Bank of China's seven-day reverse repo rate, the new benchmark interest rate since last year, is 1.5% after a total of 30 basis points of cuts in 2024. It is 203 basis points lower than in May 2012, the data point The first. Available to the public.
“In theory, the lower bound for interest rates is zero, as we have seen in the United States and Japan,” said Larry Hu, chief China economist at Macquarie. “However, I do not think interest rates in China will fall to zero.”
He expects interest rates to be cut by 40 basis points, which would still be the strongest annual cut since 2015.
“If credit demand does not rebound, further cuts in interest rates may not only lead to increased lending, but could create bubbles in the financial market,” Hu said, adding that this would also hurt banks' profitability and increase the risk of capital outflow from banks. During the weakening of the currency very quickly. Reducing confidence in the economy.
Business confidence is weak and consumer sentiment is near record lows. Banks' net interest margins, a key measure of lending profitability, contracted to an all-time low of 1.53% in the third quarter of 2024.
However, most analysts expect a cut in the reserve requirement ratio this month and a cumulative cut of up to 100 basis points throughout 2025 from a weighted average of 6.6%. This would bring the average required reserve ratio closer to the 5% threshold – the current requirement for the smallest banks, and widely viewed as the minimum.
Difficult transition
The shrinking space available to reduce interest rates and the required reserve ratio may put a wrench in the work of central bank reforms.
The People's Bank of China's stated goal – to reduce its “quantity-based” practices of relying on banks to expand credit and to rely more on interest rates to transmit policy so that markets can play a more prominent role in financing the economy – is becoming increasingly difficult.
“A moderately loose monetary policy will include interest rates and quantitative measures,” said Xu Hongcai, deputy director of the Economic Policy Committee at the state-backed China Association for Policy Science.
Xu, who also expects cuts of 40 basis points, warns that the pace of monetary easing needs to be balanced with exchange rate concerns.
“Excessive devaluation could destabilize financial markets, affect expectations and cause panic,” Xu said.
Some analysts, including Hu Jing and Xing, feel that the suspension of purchases of Treasury bonds indicates that the People's Bank of China is uneasy about the damaging effects of the rapidly weakening yuan.
But not all economists are so concerned about a softer currency. In theory, it could make exports more competitive and mitigate the impact of US tariffs, which incoming President Donald Trump has threatened to raise to 60% on all imports of Chinese goods.
“Sacrificing monetary policy flexibility to maintain exchange rate stability would be like putting the cart before the horse,” Zhang Ming, chief economist at the Chinese Academy of Social Sciences, said in a January 2 article on his WeChat account.
He said that if lowering interest rates boosted growth, the exchange rate might rise rather than fall.
($1 = 7.3317)
