Blog Post

Backward guidance, Chinese style

Since early 2014, the People’s Bank of China (PBC), the Chinese central bank, has deployed multiple policy tools to loosen its monetary policy stance, including cutting its benchmark bank interest rates, relaxing mortgage terms, tinkering with the outdated loan-deposit ratio rule, selectively cutting some reserve requirements and injecting liquidity into the banking system via various new facilities.

By: Date: January 15, 2015 Topic: Global Economics & Governance

Since early 2014, the People’s Bank of China (PBC), the Chinese central bank, has deployed multiple policy tools to loosen its monetary policy stance, including cutting its benchmark bank interest rates, relaxing mortgage terms, tinkering with the outdated loan-deposit ratio rule, selectively cutting some reserve requirements and injecting liquidity into the banking system via various new facilities. Such concerted actions pressed both 10-year government bond yields and short-term interbank rates lower during most of 2014 (see Chart).

However, in response to the November interest rate cut, the 10-year Chinese government bond yield temporarily ticked up to 3.8 percent from 3.6 percent (see Chart), while interbank rates remained volatile. More puzzlingly, soon after the rate cut last November, the PBC in statements on its website and senior PBC officials rushed to repeatedly deny this policy move as a shift in the monetary policy stance. Many central banks in the advanced economies nowadays provide ‘forward guidance’ to reinforce and amplify the impact of monetary policy on the full market yield curve, by communicating to the public about the expected future path of the policy rate. In contrast, the PBC appears to have attempted to dilute what it did, by issuing confusing ‘backward guidance’, cautioning the market not to interpret its latest rate cut as monetary easing!

Chart: the Chinese government bond yield and stock market index

Source: Bloomberg.

Note: SHCOMP stands for Shanghai Composite Stock Market Index
Source: Bloomberg

For now, one can only speculate about the motives behind such confusing PBC signals.  Here, I put forward three possible motives, all related and not exhaustive.It will probably take some time to fully comprehend this baffling mix of monetary easing and tough talking. If we assume that the PBC wants to cushion the downside risks of economic growth without aggravating financial imbalances, then the best option would be to ease in a timely and measured manner while opening its big mouth to influence the longer end of the yield curve, which in the end matters most for both consumption and investment decisions. But these PBC ‘backward guidance’ statements instead appear to aim at dispelling expectations about further monetary accommodation on the horizon, potentially contributing to a higher yield curve and thus tightening Chinese financial conditions. One can only speculate about the motives behind such confusing PBC signals

The first motive could be that the PBC wants to convey the message that monetary stimulus, if any, will be minimal and fleeting, out of fear that the rate cut could stoke asset price bubbles before benefiting the real economy. In this view, the PBC “backward guidance” is really a disguised forward guidance. I am uncertain about the precise weight the PBC attaches to financial stability, but reasonably certain that the weightings of inflation and growth dominate, and both clearly call for meaningful monetary accommodation. Also, the asset price channel is part of the normal transmission mechanism for monetary policy, especially in light of a weak housing market. The latest surge of some 50 percent in Chinese stock market prices over the past few months (see Chart) could be a valid concern for the PBC; but the average Shanghai stock market valuation of some 10-time trailing and forward P/E appears manageable, and a buoyant equity share market could assist the tricky deleveraging process.

The second motive could relate to the concerns of the PBC about the moral hazard risk associated with China’s high level of local government debt. Local government officials have strong incentives to borrow, from both banks and shadow banks, to fund their pet investment projects, but then leave messy debts to their successors. These concerns make little sense to me. First of all, this is an issue of fiscal discipline facing local governments, whether the monetary policy bias is tighter or looser. Second, harder budget constraints are already gradually being imposed on local governments. This implies a de facto, sizable fiscal contraction and thus calls for reasonable monetary relaxation to partially offset the possible contractionary effects of reduced local government borrowing.

The third motive is the challenge of properly communicating the policy stance to the market under an emerging new monetary policy framework and in a more liberalised interest rate environment. The PBC used to principally target M2 growth while also setting benchmark loan and deposit rates. More recently, the PBC has introduced a few new policy tools, such as Short-term Liquidity Operations (SLO), the Standing Lending Facility (SLF), Medium-term Lending Facility (MLF) and Pledged Supplementary Lending (PSL), in an attempt to influence market-based interest rates. Maybe the PBC prefers to nudge the market to pay greater attention to these market rates rather than those still partially-regulated benchmark loan and deposit rates. This makes some sense but still does not justify sending out conflicting signals when a more accommodative policy stance is clearly warranted and desired.

In any case, the best course of action for the PBC at this juncture, in my view, is to pursue a sensible and accommodative monetary policy in a confident fashion, with the aim of a lower and steadier domestic interest rate and less-managed currency. Just as forward guidance by some major central banks at the zero lower bound can help depress their yield curves further out, a clear and firm PBC policy signal could also help flatten and stabilise the Chinese yield curve, which in turn would cushion economic growth, pre-empt deflation risk, facilitate structural adjustment and support financial liberalisation. As a minimum, the PBC should avoid diluting the signalling effect of its own new policy moves.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Global income inequality is declining – largely thanks to China and India

Income inequality among citizens of 146 continues to fall, though at a somewhat reduced pace, according to the updated Bruegel dataset. Income convergence of China and India accounts for the bulk of the decline in global income inequality from 1988-2015.

By: Zsolt Darvas Topic: Global Economics & Governance Date: April 19, 2018
Read about event More on this topic

Upcoming Event

Apr
25
12:30

Central banking in turbulent times

This event will look at fundamental questions about the central banking systems and how the Great Recession might have prompted a reassessment of the old central banking model.

Speakers: Maria Demertzis, Paul De Grauwe, Marianne Nessén and Francesco Papadia Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More by this author

Podcast

Podcast

Director's Cut: EU risks US tariff pain in standing by the WTO

As global trade war continues to unfold, Bruegel director Guntram Wolff is joined for this Director's Cut of 'The Sound of Economics' podcast by Bernd Lange MEP, chair of the Committee on International Trade (INTA), to discuss Europe's options.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Global Economics & Governance Date: April 18, 2018
Read article More on this topic More by this author

Opinion

US Tariffs Aim to Contain China’s Technological Rise

While tension increases with each of the imports listed under the new tariffs, it now seems clear that the US are trying to slow down China's technological advances. Though such a protectionist attitude represents an obstacle, China should consider it an opportunity to strengthen relations with its Asian neighbours and the EU.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 10, 2018
Read article More on this topic More by this author

Opinion

What Are the Targets in the US–China Trade War?

Following the US announcement of new, high tariffs on imports, China is answering the Trump administration by applying its own series of tariffs. In this article, the author identifies the list of products that each country will be targeting, going beyond purely trade issues as each attempts to weaken the other.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 10, 2018
Read about event More on this topic

Upcoming Event

May
25
08:30

Where is China’s financial system heading? Implications for Europe

An event on the Chinese Banking Sector.

Speakers: Alicia García-Herrero and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More by this author

Opinion

How Should the EU Position Itself in a Global Trade War?

It is high time for the EU to work on more than just wishful thinking in response to the US challenge to global trade. With the first cracks appearing in the multilateral system, it will be difficult for the EU to maintain a middle course between the US and China.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance, Global Economics & Governance Date: April 5, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: A global trade triumvirate?

In this week’s Director’s Cut of ‘The Sound of Economics’ podcast, Bruegel director Guntram Wolff hosts a discussion with Bruegel fellows Alicia García-Herrero and André Sapir on where Europe will position itself between the two major trading powers of China and the United States if relations continue to cool.

By: The Sound of Economics Topic: Global Economics & Governance Date: March 27, 2018
Read article More on this topic

External Publication

Capital Markets Union and the Fintech Opportunity

Fintech has the potential to change financial intermediation structures substantially. It could disrupt existing financial intermediation with new business models empowered by intelligent algorithms, big data, cloud computing and artificial intelligence.

By: Maria Demertzis, Silvia Merler and Guntram B. Wolff Topic: Finance & Financial Regulation Date: March 26, 2018
Read article More on this topic More by this author

Opinion

Will U.S. tax reform lure U.S. companies away from China?

What will be the results of the changes to the U.S. tax system in China? Will the new U.S. corporate tax rate cause Chinese firms to shift their operations to the U.S. to enjoy the new tax benefits? Read Alicia García-Herrero's opinion on President Donald Trump’s tax reform.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: March 26, 2018
Read article More on this topic More by this author

Blog Post

Central banks in the age of populism

Two years of elections have shown that we live in an age of increasing political and economic populism. What are the consequences of that for central banks? We explore opinions about it, from both 2017 and more recently.

By: Silvia Merler Topic: Finance & Financial Regulation Date: March 19, 2018
Read article More on this topic More by this author

Opinion

Reading The Tea Leaves on China’s Constitutional Amendments

The recent amendments of the Chinese Constitution have stimulated much attention, focusing on the power consolidation of President Xi. Though the four key amendments do not mention direct economic reforms, indirect impact should be considered even if clear-cut conclusions are difficult to draw.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: March 12, 2018
Load more posts