The PBoC released its 2Q17 monetary policy report on August 11. We highlight the key messages as follows:

Overall speaking, monetary conditions tightened moderately in 2Q. More specifically, monetary conditions tightened more visibly in April-May, while loosened on the sequential basis since late-May. According to the report, weighted average lending rate picked up by 14bp in 2Q to 5.67%, with increase in short term bill financing rates continuing to outpace the real-economy funding rate by a wide margin. More specifically, weighted average rate of bill financing increased further by 62bp in 2Q to 5.39%; while interest rate of general loans only edged up by 8bp to 5.71% and mortgage financing rate picked up by 14bp to 4.69%. The PBoC highlighted in the report that while regulatory tightening triggered worries over liquidity conditions in April-May, the PBoC has started to release more liquidities via OMO since late-May and steered market expectations towards an orderly financial deleveraging process. Consequently, short-term interest rates started to moderate in June after spiking up in April-May. Overall speaking, the weighted average funding cost remains conducive to growth, considering nominal GDP growth of 11.1% YoY in 2Q2017. Meanwhile, excess reserve ratio edged up in 2Q by 10bp but remained relatively low, which PBoC explained as more of a “structural change” with the efficiency of liquidity management improving, rather than a cyclical phenomenon. Apart from the “price” signals, monetary aggregate growth in terms of adjusted TSF growth and M2 Proxy also moderated further in 2Q, signaling continued monetary tapering in 2Q2017. It is also worth noting that similar to our earlier analysis, the PBoC sees the slowdown in M2 growth as a structural trend, while also noting that the representativeness and relevancy of M2 statistics has declined.

The PBoC came across relatively positive in regards to the assessment over domestic and global macro outlook. The central banks sees continued recovery in global growth and muted inflation, while China growth remained robust in 2Q, property market stabilized, and consumer price inflation was largely benign. The report noted that the domestic economic growth has become more stable and balanced in 2Q, with household income and corporate profitability staying on the path of recovery. Furthermore, both manufacturing and private investment growth was on the mend, while consumption and export growth also remained robust. The PBoC saw consumer price inflation largely benign, and the gap between PPI and CPI narrowing going forward, partially driven by the high base of PPI towards year-end. The PBoC also characterized the property market in 2Q as “largely stable”, with the growth of both transaction value and mortgage loans moderating. From a global perspective, the central bank has become more affirmative on global growth recovery (esp. in EU, Japan, and the emerging market economies) and stays relatively relaxed on inflationary pressure. In regards to risks, the PBoC will continue to be on the look-out for potential asset price volatilities triggered by monetary policy normalization, as well as potential geo-political tensions.

In regards to monetary policy conduct, the central bank will likely maintain a “prudent and neutral” stance, and continue to keep the liquidity conditions smooth. Furthermore, the PBoC has stressed the importance of “preemptive policy fine-tuning” against the current macro backdrop. Meanwhile, the PBoC will also continue to develop the MPA framework, in the spirit of preventing financial risks and promote healthy financial deleveraging. The report has detailed the continued diligent OMO management of the central bank in 2Q in order to stabilize market expectations and liquidity conditions. Since the central bank maintains that the current challenges facing China’s economy is more “structural” than “cyclical”, cyclical management by the central bank will maintain a “prudent and neutral” stance. In addition to prompt liquidity management, the central bank has also vowed to become more “preemptive” in fine-tuning monetary policy conduct in response to changes in growth and inflation trajectories going forward. In terms of longer term policy mechanism for risk management, the PBoC will continue to develop the MPA framework. More specifically, starting from the 1Q2018 MPA, the central bank will include all interbank certificate of deposit with duration no-longer-than 1 year as part of interbank liabilities for all banks with assets over Rmb 500bn. Meanwhile, the PBoC will continue to monitor the interbank CD issuance by other banks before making further amendments to the current regulations.

On the structural reform front, we have noticed the following highlights in the report:

Monetary policy will continue to support direct financing, especially bond financing. It has been mentioned in the report that net bond financing has declined visibly YoY in 1H2017, especially that of local government bonds and credit bonds. In addition, we have witnessed a notable pick-up in net bond issuance since July, echoing with the emphasis over “direct financing” by both the Financial Working Conference and the 2Q PBoC Monetary Policy Report as part of the effort to improve the overall “funding structure” of the economy.

Deleveraging in the real economy will likely focus on the (state-owned) enterprise that have not seen improvement in spite of the ongoing economic reflation, especially the “zombie companies”. Once again, these statements from the Monetary Policy Report are highly in sync with those from the National Economic Working Conference. In addition, the PBoC has specified that SOE and zombie enterprise deleveraging should follow a market-oriented process.

To further develop the CNY exchange rate mechanism, to promote RMB internationalization, especially that of cross-border investment in the bond markets. The report has elaborated on the introduction of the “counter-cyclical coefficient” as part of the USD/CNY central parity formula since May and characterized it as a “step-forward” in developing the CNY exchange rate price-discovery mechanism and increasing CNY exchange rate volatility.  Meanwhile, the PBoC has characterized CNY exchange rate expectation as “stable” in the second quarter. Furthermore, the central bank has put more emphasis on detailing the progress made on bond market internationalization in 2Q2017, including the commencement of the Northbound trading of the “Bond Connect” since July 3. It appears that the PBoC will continue to push forward with bond market internationalization, including the commencement of the Southbound trading of the Bond Connect.

Looking forward, we expect monetary policy to operate in a relatively narrow “range”, with continued diligent liquidity management to balance the immediate task of maintaining market stability and the long term goal of deleveraging. In addition, we cannot rule out potential policy “fine-tuning” if growth trajectory continues to improve, and commodity and food price sees further upside. In the near term, we expect weighted average lending rate to continue rising moderately, but the structure of funding cost movements will likely change. More specifically, with the period of most pronounced impact from deleveraging behind us, bill financing rate may start to “normalize” while medium-long term lending rate may continue to trend up with further recovery in profitability and investment returns.  As mentioned previously, monetary policy may become more “pre-emptive” in managing volatilities in market liquidity, as well as potential excess in deflationary or inflationary expectations. We expect 3Q cyclical momentum to be on the strong side, while we have witnessed another round of commodity price run-up since June. Given the policy emphasis by the PBoC on “preemptive policy adjustments”, we would continue closely monitor the changes in the “price” and “quantity” indicators of market liquidity, in order to gauge the potential fine-tuning on the front of monetary policy conduct and financial regulations in response to changes in cyclical momentum.