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UPDATED: April 1, 2015 NO. 11 MARCH 12, 2015
The Finer Details of Interest
Facing deflation risks and slower economic growth, China's central bank may continue cutting interest rates and reserve requirement ratios
By Wang Jun

Gao Yuwei, a research fellow with the Institute of International Finance under the Bank of China, said the rate cut this time indicates again that the "prudent" monetary policy should not only be understood literally. In fact, the monetary policy will be "gradually relaxed" this year and Gao estimated that the broad money supply (M2) will grow by 12.5 percent by the end of 2015, 0.3 percentage points higher than that in 2014.

Interest rate cuts may continue this year. According to Jia Shupei, an analyst with the Research Department of China Credit Rating Co. Ltd., considering a low inflation rate at the beginning of this year (which was 0.8 percent in January) and weak domestic demand, China Credit Rating Co. Ltd. has lowered its expected CPI growth for 2015 to 1.3 percent, which will be 0.7 percentage points lower than last year. "So, a lending rate that is 0.5 percentage points lower than the current level will be equivalent to the real interest rate last year," said Jia.

More RRR cuts will follow. A report by China International Capital Corp. Ltd. said interest rate cuts are still not enough, and more resolute RRR cuts are needed to address the capital outflow caused by currency depreciation. If the central bank does not input more liquidity by lowering the RRR, the market will face a shortage of capital. The central bank must actively guide the money market rate to drop so as to bring down the borrowing costs of banks, and then the overall interest rate will come down. Only when the money market rate falls significantly can the economic growth steady.

A policy mix

Since last year, monetary policy has been functioning to ensure stable growth and accelerate economic restructuring through tools such as targeted RRR cuts, pledged supplementary lending, medium-term lending facility, overall interest rate cut and overall RRR cut.

However, macroeconomic control must rely on both monetary policy and fiscal policy. Particularly, fiscal policy will be more effective in addressing some structural problems.

"The recent economic performance shows that marginal effect of monetary policy is decreasing, so we should not only rely on rate cuts to ensure stable economic growth," said Yang. "Currently, affected by shadow banking and Internet financing, the banking system faces an increasing outflow of capital. Market interest rate hikes make banks and companies victims of high borrowing costs, and the room for banks to lower loan rates is limited."

According to Yang, the PBC lowered the benchmark lending rate by 0.4 percentage points in November 2014. However, the loan prime rate, which reflects the real interest rate in the market, only dropped by 0.25 percentage points from 5.76 percent to 5.51 percent as of February 28.

While the appropriately "relaxed" monetary policy will continue, he expects a more relaxed fiscal policy will play a bigger role, where a tax cut is likely to replace expenditure expansion to be a more powerful tool of fiscal policy. Tax burden of small and medium-sized enterprises will be further alleviated, and taxes for real-estate transactions may be reduced or exempted.

According to a report from Minsheng Securities' Research Institute, proactive fiscal policy will include making good use of the government's fiscal resources and nurturing new growth points such as public facilities in the countryside, subway facilities in urban areas, healthcare, preschool education, culture and entertainment, sports, e-commerce and environmental protection.

Xie Yaxuan, an analyst with China Merchants Securities, said that in the future, both fiscal policy and monetary policy may be relaxed, but the relaxed fiscal policy will be different from before. The Central Government will take on the burden of more expenditure, leaving local governments with larger budgets, and such increases will be restricted by the budget.

Email us at: wangjun@bjreview.com

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