We studied the transformation of China’s monetary policy framework in a report published on March 9, 2015 (Searching for the new normal of how money is supplied in China). Two years on, what progress has been made? What remain to be done? What are the implications for the economy and the market?

We once described the PBoC’s balance sheet as “peculiar,” because of its rapid expansion and foreign assets-dominated structure.

Behind were continual FX inflows and the inflexible exchange rate, but things have  changed much in two years. China started to see huge FX outflows and entered a monetary easing cycle. The PBoC’s balance sheet experienced profound changes:

Balance sheet expansion decelerated. Total assets increased only 1.6% from 2014 to 2016 and shrank 6.0% in 2015.

The size and share of foreign assets declined sharply. Foreign assets held by the PBoC dropped 17.5% in the two years, with the share in the total assets falling from 82.4% to 66.9%.

Claims on depository corporations expanded rapidly, by 2.4x from 2014 to 2016, with the share from 7.4% to 24.7%.

These reflect a change in how money is created. As FX outflows drained domestic liquidity, the PBoC replenished funds via open market operations (OMO) and various relending facilities, and a series of RRR cuts lifted the money multiplier. Broad money growth was mainly driven by RRR cuts in 2015 and OMO and relending operations in 2016.

The new way of supplying money has lent stronger support to domestic demand. In the past, issuing money as external credit was to lend to the issuers of foreign assets. Now, creating money as internal credit allows domestic entities to increase spending. This was labeled by some as China’s QE, but it is a sensible option for China to restructure the public sector balance sheet, reduce the fiscal burden and boost economic activity.

Looking ahead, China will need to continue improving its money supply mechanism backed by domestic credit. Even if FX inflows resume, China should not return to the past mode of money issuance. Rather, it should take the opportunity to push forward exchange rate reforms, reducing the need for central bank intervention and sterilization. The PBoC will also need to sharpen its new tools for money supply in the aspects such as relending rules and collateral requirements. Further, we believe the PBoC should increase its purchases and holding of government bonds, with a pressing need to roll over the maturing special treasury bonds it holds. We do not expect the PBoC to cut the RRR in 2017, but it will eventually need a reasonable and stable RRR, which we think should be around 10%. RRR normalization will lower the implicit burden on banks and unleash their growth potential. Last, to better coordinate fiscal and monetary policies, China will need to establish a target-based treasury operating system and improve local government finance.