The PBOC sounds less hawkish but significant easing unlikely

In the just-released Q4 2013 Monetary Policy Report, the People's Bank of China seems to have very subtly softened its tone on the issue of liquidity management.

Instead of repeating the phrase "strengthen the role of liquidity control to guide the smooth and appropriate growth of money, credit and total social financing" used previously in the Q3 2013 report, the central bank is now saying that it will "maintain an appropriate liquidity environment to achieve reasonable growth of money, credit and total social financing".

This may have come about as a result of the PBOC's liquidity tightening in recent months that sent short-term rates higher.

Starting from a tighter liquidity conditions baseline, we could imagine the PBOC slightly easing its stance as markets head into spring. However, we do not expect any significant easing of liquidity or credit conditions this year, even if it may be pressured by other parts of the government to do so.

The central bank made clear that it considers the overall liquidity conditions achieved in 2013 as "reasonable and appropriate", and thinks that credit "continues to grow rapidly". This suggests that despite the liquidity tightening markets experienced in 2H 2013, the central bank still considers the current pace of credit growth relatively fast.

The PBOC also recognized that "the role of the liquidity gate (monetary aggregates) is becoming ever more important against a backdrop of rapid financial deepening and innovation".

More importantly, the central bank reiterated that structural issues in the real economy continue to hamper the effectiveness of monetary policy. The PBOC points out that: "local governments-led large-scaled construction and financing have further strengthened in recent years"; "growth has become increasingly dependent on investment and debt accumulation"; "Under this investment-intensive growth model, resources continue to be allocated towards sectors such as property, which pushes up debt levels, crowds out other enterprises (especially SMEs), and limits or imposes higher costs on other's access to financing". As a consequence, "such structural problems have undermined the effective impact of aggregate monetary policy".

We concur with the PBOC's view on the dented effectiveness of monetary policy. Nevertheless, the central bank may face increasing pressure from other parts of the government to ease liquidity and credit conditions to support growth, something that often seems easier and less painful than proceeding with much-needed restructuring and reforms.

In addition, the government has reportedly set a 7.5 percent growth target for 2014, keeping stable growth atop its list of priorities. This means the PBOC will unlikely aggressively tighten overall credit growth.

Bottom-line

We see a somewhat more neutral stance from the PBOC going forwards, with neither a major relaxation nor further tightening of liquidity conditions from here onwards. We expect the 7-day repo rate to average 4 to 4.5 percent for this year.

A stable policy tone, coupled with the PBOC's efforts to establish an effective "interest rate corridor", should all help to reduce the risk of interbank rates surging again to excessively dangerous levels. Volatility in China's money market, therefore, will likely be reduced somewhat, although moderate swings will persist as interest rate liberalization proceeds and the international liquidity environment becomes more complicated on the back of QE tapering in the US.

Nonetheless, we still see volatility in China's overall credit conditions, especially within the shadow credit system, as a key risk to monitor this coming year.

The author is Chief China Economist at UBS. This article is co-authored with UBS economists Donna Kwok, Harrison Hu and Ning Zhang.

The views do not necessarily represent those of China Daily.