China’s monetary policy to sail out of the ‘reefs’ and into smoother waters ahead in 2019
The year 2018 saw China’s monetary policy carefully sail through the “reefs,” as economic slowdown and surging exchange rate risk left little room for adjustment. However, since the beginning of this year, major internal and external changes have broken the dilemma.
From the internal perspective, in January 2019, the “loose credit supply” saw improvement in terms of both volume and structure, barriers to implementing monetary policy removed, which is expected to guide the Chinese economy to stabilize in the first quarter.
First of all, China’s outstanding broad money supply, or M2, grew 8.4 percent year-on-year in January, while new yuan loans and social financing both soared to historic monthly highs at 3.23 trillion yuan ($478 billion) and 4.64 trillion yuan, respectively. The figures showed that “loose fiscal policy” has had a positive effect on credit supply to the private sector, thus pushing up the growth rate for total social financing. It is expected that in the first quarter of 2019, with the gradual implementation of “loose fiscal policy,” the volume of “loose credit supply” will remain at a high level.
Moreover, in January, financial data continued its trend of structural optimization from the previous month, which is reflected by the pickup in medium and long-term lending and the continuous increase in bond financing. Looking ahead, such structural improvement is likely to continue, further boosting the supportive role of “loose credit supply” in “stabilizing growth.”
From the external perspective, the following three factors are expected to support the Chinese yuan’s exchange rate to regain long-term stability, thus enhancing the autonomy of China’s monetary policy.
First, developed economies have slowed their pace of tightening. Since the end of 2018, due to the stalling global recovery and signs of a returning crisis, central banks of various developed economies have become more cautious toward the normalization of monetary policy. The European Central Bank, the Bank of England, and the Reserve Bank of Australia successively lowered their forecast for economic growth. In the US, the dovish voice inside the Fed has gradually increased. Because of this, since late January, the yield inversion of short-term government bonds in China and the US has been eased. Thus, despite the monetary policy differentiation between China and other major developed economies, the degree of divergence is expected to decline, weakening the long-term pressure on the yuan’s exchange rate.
Second, capital outflow pressure has been gradually alleviated. Since October 2018, emerging markets have once again gained favor from international capital. In this context, the MSCI expansion of A shares and the inclusion of A shares into the FTSE Emerging Markets Index will likely happen in 2019, with foreign investment attracted by such major international opportunities. Latest data showed that in the fourth quarter of 2018, net inflow of direct investment by overseas financial institutions soared to $2.14 billion, marking the highest level since the third quarter of 2015. Thanks to the overseas investment inflow, China’s capital outflow pressure is expected to continue to be eased in 2019, thus reducing the restraint on its monetary policy.
Third, the yuan’s exchange rate continued to return to its normal valuation. In the long run, the yuan’s rate reflects changes in China’s economic fundamentals, with two-way fluctuations surrounding its equilibrium exchange rate. In the third quarter of 2018, the effective exchange rate of the yuan was greatly lower than the equilibrium rate. In the fourth quarter, the yuan’s rate rebounded slightly, indicating the effective exchange rate had started to return to its equilibrium level. Due to the still existing gap between the effective rate and equilibrium rate, there is room for the yuan’s rate to return to its valuation, conducive to further buffering of the external exchange rate risk.
In short, thanks to changes in the internal and external environment, China’s monetary policy is expected to sail out of the “reefs” in 2019, becoming more flexible in maintaining its prudent, neutral, and marginally loose stance.
We believe that comprehensive and targeted cuts to reserve requirement ratios, reductions in open market rates, and increased use of targeted mediumterm lending facility will become the main policy tools of China’s central bank in 2019. Only when extreme changes happen in the internal and external environment (for example, the Chinese economy fails to stabilize in the middle of 2019 and the Fed doesn’t raise interest rates), will the possibility of lowering the benchmark deposit and lending interest rates rise significantly.