The PBoC released its 1Q17 monetary policy report on May 12. We highlight the key messages as follows:

Monetary conditions started to tighten in 1Q17, but remained conducive to growth. According to the report, the weighted average lending rate picked up to 5.53% in March 2017 from 5.27% in December 2016. However, the “relative” financial conditions remained accommodative as the acceleration in nominal GDP growth in 1Q17 has outpaced the increase of the weighted average lending rate by a wide margin. More specifically, we saw the most notable pick-up in short-term interest rates – the weighted average rate of bill financing increased by 87bp to 4.77% in 1Q17. Meanwhile, the rates of general loans picked up by 19bp to 5.63%, while mortgage rates edged up by only 3bp to 4.55% compared with December 2016. On the other hand, the excess reserve ratio of financial institutions fell by 110bp to 1.3% at end-March 2017. The decline in the excess reserve ratio was partially driven by the seasonal factor – the 1Q excess reserve ratio declined by an average 100bp vs. the preceding 4Q in the past 15 years. However, the lower excess reserve ratio, slower M2 and adjusted TSF growth in 1Q17 vs. end-2016 suggest that not only have the absolute financial conditions tightened on a higher “price” of money, the growth for the “quantity” of money has also been decelerating.

Overall speaking, the PBoC has become more positive on domestic and global macro outlook. Meanwhile, the central bank sees reduced deflationary pressure globally, and moderated PPI inflation in China going forward. The report had noted that the domestic economy is now on a stronger footing, with higher growth, improved corporate profitability, and continued industrial upgrade. On the domestic inflation front, the PBoC sees PPI inflation moderating, CPI inflation trending higher but staying at a benign level, while the pressure of property price inflation remains elevated. Meanwhile, the central bank has become more positive on the global growth outlook, but it remains cautious on the sustainability of the global recovery and stays alert on the potential risks such as populism, geopolitical risks, as well as the potential financial market volatility driven by the potential “QE exit” in the major economies. Furthermore, the PBoC has acknowledged the challenges to domestic monetary policy conduct posted by the potential spill-over effects of monetary and fiscal policies in other major economies. In regards to the domestic economy, the central bank expressed concerns over the structural issues that may stand in the way of a more sustainable recovery, including the rising share of infrastructure investment in 1Q17 and the dichotomy between faster recovery of the SOEs vs. the SMEs during this round of reflation.

Monetary policy may stay “prudent” and “neutral”, while the main focus of policy execution may be to balance between maintaining stable liquidity conditions and promoting financial deleveraging. The report noted that since the main challenges to China’s economy currently is more “structural” (rather than “cyclical”), monetary policy is likely to maintain a prudent and neutral stance. Furthermore, the PBoC had emphasized the efforts made to keep liquidity conditions relatively stable (i.e. to “smooth out the peaks and troughs”) amidst the more complex interplay of seasonality, financial deleveraging, asset price movements, and the buoyant loan demand driven by economic reflation. In regards to the exchange rate, the central bank appears to have grown more confident on the RMB’s rising global status, and indicated the intention to continue promoting RMB internationalization. It is worth noting that the PBoC has made extensive explanations over the popular market notion of PBoC balance sheet “contraction” – i.e., the decline in 1Q was largely driven by the seasonal factors and the decline in fiscal deposits (which in itself is expansionary), and it does not symbolize an overly tight monetary policy stance. Furthermore, going forward, the PBoC noted in the report that it will use 7-day reverse repo and 1-year MLF as the main instruments of open market operations, when needed.

While financial deleveraging may continue to be the policy focus in the near term, we expect the central bank to maintain a stable market liquidity condition and remain overall supportive over the financing need of the real economy. The PBoC started to guide the market rates higher since August 2016, as the policy emphasis began to shift from supporting growth to preventing financial market risks and financial deleveraging. Although the central bank has grown more confident on the cyclical strength, both domestically and abroad, it remains uncertain about the sustainability of the recovery. Therefore, we expect monetary policy to maintain a neutral stance. While financial conditions may tighten further from here, our baseline assumption remains to be a manageable monetary tapering relative to the strength of China’s current economic cycle. Furthermore, policy coordination has improved markedly in this round of financial deleveraging, and the tightening of financial conditions for the real economy may continue to be more moderate than that for the financial markets. Therefore, while we may observe a “soft-patch” of growth numbers in the coming months driven by adjusted inflation expectations and liquidity tightening, it is unlikely that we witness a repeat of the tightening episode of 2013 this time around.