That leaves interest rates, which are not a main means of transmitting monetary policy in China. It’s that simple. Monetary policy is managed by managing liquidity provisioned to banks, which then affects outright lending and then interbank/onshore interest rates (I think looking at onshore IRS rates tied to the benchmark 7-day repo are the best signal) and then filters through to the cost of capital in other parts of the economy. China’s mostly fixed bank deposit rate regime speaks to a monetary policy constrained by the Impossible Trinity: while still controlling the exchange rate and the Swiss cheese-style capital account, China via the PBOC manages liquidity as best it can to manage onshore lending AMOUNTS, and by virtue RATES. On the liquidity front, hot money flows matter BIG. Hot money inflows/outflows affect both the FX side of the equation and the liquidity side. Over the past decade, we’re ultimately talking about inflows. Inflows add to onshore liquidity, unless sterilized by the PBOC. Therefore the surge in Chinese FX reserves is a combination of sucking up the USD coming into the country via the trade surplus and hot money inflows, and then provisioning as much RMB in return as it sees fit under the economic circumstances. That’s why bank RRRs have also been linked closely to monetary policy: to manage liquidity in a country that receives so much foreign exchange from its trade surplus, high RRRs ultimately tie up the liquidity that is swelling foreign reserves. Thus RRR changes still are the main policy signal. When deposit rates are sticky, well, most interest rates are sticky. Minor cuts here are there do not feed through into big changes of saving/investment/spending that would really change the economic picture. China’s massive wealth management product (WMP) and shadow banking industry has grown out of the forced low returns on savings imposed by low, fixed deposit rates (shadow banking being a result of financial repression in many ways, US financial crisis included). When WMPs became an easy way for out-of-favor sectors to roll over loans for dodgy investments borne out of the 2009 stimulus plan and offer returns that could not be offered elsewhere (certainly not in China’s until-recently listless stock market, the property market is obviously another issue), well the PBOC had little choice but to act – it was losing control of monetary policy. Bank deposit rate liberalization was one of the underlying motives of the last rate cut and is the NEXT BIG THING in China’s financial evolution, beyond a nearly open capital account. (UPDATE: The draft rules on a bank deposit insurance scheme issued Sunday are setting the stage for further liberalization of deposit rates next year). Just to reinforce the point, banks in China have never had to compete for funds via deposits, only having done so recently and indirectly via their sponsorship of WMPs. The WMP problem would probably disappear it banks could offer competitive bank deposit rates. But of course, competitive bank deposit rates might mean some banks go out of business or that market interest rates could be much higher than the PBOC wants, all potential problems the PBOC/CBRC don’t really want to deal with now. The result: as Stephen Jen of SLJ Macro Partners and others have argued, China’s interest rate regime has played a prime role in the misallocation of resources and needs to change. Thus, rate moves do not necessarily have a clear cut monetary policy impact in the way most folks are used to thinking about with major economies and even some of the bigger EM ones. Liquidity provisions are more important. Which is why the reaction among some Chinese FX traders to the PBOC rate cut this month was not “Great a rate cut!” but “Shucks, why not a bank reserve requirement (RRR) cut?”. Welcome to monetary policy with Chinese characteristics. Those buying AUD/commodities on the rate cut headlines clearly don’t understand this interplay.
The piece is from late 2014 but still of interest more generally.