Monetary conditions continued to tighten notably in 2Q18 despite relatively muted pick-up in interest rates. The “funding gap” widened further for the real economy amidst regulatory tightening. According to the 2Q MPR, weighted average lending rate only edged up by 1bp in 2Q18 to 5.97%. More specifically, weighted average rate of bill financing declined by 47bp in 2Q18 to 5.11%; average interest rate of general loans picked up by 7bp to 6.08%. Meanwhile, average mortgage rate rose further by 18bp to 5.60% in 2Q18. Although the pace of interest rate pick-up has slowed visibly in 2Q18, “quantity” indicators, which in our view are more telling of overall financial conditions than the “price” indicator alone, point to continued tightening of financial conditions. Adjusted TSF growth slowed further to 11.2% YoY in June 2018 compared with 12.2% YoY in March, meanwhile, “M2 proxy” growth also slowed to 9.9% YoY from 10.6% YoY. In our view, the main constraint for credit expansion was regulatory tightening and to a lesser extent, the consequent financial market turmoil that deterred corporate bond and equity financing. The dichotomy between notable decline of short term rates vs. slowing broadly-defined money and credit growth highlighted that the obstacles for credit expansion is not overly tight liquidity conditions. Regulatory tightening on multiple fronts has dampened the supply and demand of funding at the same time since late 2017, including the implementation of the new asset management guidelines, regulatory tightening over local government financing, heightened pressure for NSA “standardization”, accelerated NPL realization, as well as continued scrutiny over property developer and household mortgage financing. The impact was most visible on the compression of net credit issuance via NSA channels, which came in Rmb3.7trn lower in 1H18 vs. 1H17 and contributed to most of the slowdown in headline adjusted TSF growth. Meanwhile, the PBoC highlighting in the MPR that the excess reserve ratio rose to 1.7% in June from 1.3% in March, which echoed the falling short-term interest rates. Notable pick-up of the excess reserve ratio indicates that the central bank has effectively loosened interbank liquidities. However, regulatory scrutiny and restrictive fiscal policy continued to depress credit growth in 2Q.

In its assessment for the global macro conditions in the 2Q MPR, the PBoC toned down the optimism further for both domestic and international growth. Domestically, the central bank pointed out that rapid deleveraging weighted on infrastructure investment growth, while rising trade friction clouds the external demand outlook. Meanwhile, global growth outlook diverged further. The central bank sees CPI being largely contained and PPI remaining “sticky” in China. The PBoC has shifted from focusing on the overall global reflation trend, to emphasizing global growth divergence (underneath a stable headline). Growth momentum in the developed countries and the emerging market economies both diverged further – among the G3, US growth picked up while Europe and Japan both saw softened cyclical momentum; while EM growth also diverged, with systematic risk rising in selected EM countries amidst a stronger dollar and the global rate hike cycle.

Meanwhile, the Central Bank listed global trade tension as the biggest risk to China and global growth at present. On the domestic demand front, the PBoC hinted on the overlapping effect from deleveraging-related policies on multiple fronts and highlighted the rapid decline of infrastructure investment growth. Meanwhile, the central bank emphasized the rising external demand uncertainties and its potential contagion via stronger dollar and volatile financial market reactions.

On the cyclical management front, the Central bank will likely keep liquidity conditions accommodative, in order to safeguard the real demand growth and financial stability amidst rising uncertainties. We see further room for RRR cuts in the rest of the year. In light of the changing domestic and external demand trajectory, the PBoC has clearly move further towards policy fine-tuning – while maintaining the long-term goal of deleveraging, the subtext has been reedited to focusing on “structural deleveraging” rather than overall deleveraging. The central bank has highlighted their efforts towards liquidity easing in 2Q and indicated the intention of keeping short-term interest rate at relatively low levels. Meanwhile, the central bank dedicated the first “box” in the 2Q MPR to explaining the difference between base money growth and liquidity provision, pointing out that high RRR is unique to China and potential RRR reduction slows base money growth but props up interbank liquidity at the same time (as it happened in 2Q). As we have analyzed in previous reports, RRR cuts push up money multiplier and help support money supply growth. In July-August, further reduction in RRR, combined with continued PBoC injection & potential decline in fiscal reserves sent short-term rates notably lower, signally further loosening of liquidity conditions. Looking forward, it appears that the central bank may continue to favor RRR reduction over large-scale OMO as the policy tool to replenish interbank liquidity, since the former is also in line with the longer-term policy goal of “unblocking” monetary policy transmission mechanism.

Over the medium-long term, the central bank will continue to focus on improving the monetary policy transmission mechanism, while promoting the flexibility and relevancy of the “price” signals of money – the interest rate and CNY exchange rate. In our view, the shift of focus towards “structural deleveraging” is in line with the central banks’ longer term policy goal of “unblocking” the monetary policy transmission via adjusting the “price signals” of funding – the interest rate and the effective exchange rate. Going forward, structural deleveraging may include more efforts towards cleaning up the liabilities of the “zombie firms” and “formalizing” local government financing. It is worth noting that the central bank has been relatively successful (so far) in managing exchange rate expectations, given the stable FX flows despite accelerated currency depreciation. The central bank reiterated in the MPR that while there is no policy intention to push down the CNY in face of rising trade tensions, more CNY exchange rate flexibility will be encouraged (– so long as it does not trigger “panic” over CNY one-sided depreciation and FX outflows/base money deflation, in our view). It is also worth mentioning that the central bank continued to call for improved policy coordination from fiscal and regulatory policy to stabilize growth and asset price expectations.