There had been market concerns that the monetary policy stance might turn tighter in the past few weeks. Indeed, the representative 7-day repo rate climbed to 3.21% as of last Friday from the recent low of 1.94% on May 15. It is also reported that in the recent weeks, the People’s Bank of China (PBoC) conducted repo operations to drain spare liquidity from selected financial institutions and did not roll over some Medium-term Lending Facility (MLF) loans matured.

The PBoC’s decisive move over the weekend to cut the benchmark interest rates by 25bp and the reserve requirement ratio (RRR) by 50bp for designated banks should have dismissed all doubts about monetary easing. Were the policy stance to change, it would be in the direction of an increased pace of loosening. Besides the weekend’s formal reassurance, the PBoC resumed reverse repo operations last Thursday, injecting liquidity of Rmb35bn at a rate of 2.7%, after 10 weeks of suspension, partly to alleviate seasonal liquidity squeeze.

We believe that monetary policy will stay on the easing path until a more sustained recovery is underway. We continue to expect three 50bp RRR cuts in the remainder of 2015. Short-term rates will need to stay at a relatively low level, because:

Long-term borrowing costs remain high. The transmission of policy easing to long-term rates in the banking system or the bond market seems slow, and an adverse liquidity environment would hinder the previous actions from fully exerting their influences. The PBoC may extend extra Pledged Supplementary Lending (PSL) to financial institutions or buy long-term government bonds from the open market to guide the long-term rates down, but these operations are only effective under appropriate liquidity conditions.

M2, the PBoC’s intermediate policy target, still grows below the targeted rate. As foreign exchange (FX) inflows – a main engine of base money issuance – subside, the PBoC will have to lower the RRR significantly and hence increase the monetary multiplier in order to keep M2 growth on track. Liquidity needs to be released on a continuous basis to sterilize the effects of the FX slowing.

Economic growth is still under pressure amid deflation risks. Although the price indices weakly stabilized in May, it is still too early to confirm a recovery. Despite a typical policy lag of six to 12 months, to better achieve the objectives on growth and inflation, monetary policy tightening should come only after more recovery signs emerge.