China's Central Bank Faces Policy Bind Over Debt, Growth Goals

(Bloomberg) -- China's central bank is caught in a bind, as it seeks to tighten monetary policy for some parts of the economy while loosening it for others.

Already engaged in the mammoth task of wringing bad debts out of China's $40 trillion-plus financial system, the People's Bank of China is now attempting to achieve that while simultaneously being asked to bolster flagging growth and rescue falling stock markets.

That would be a tough enough feat for any central banker, but the outlook for PBOC Governor Yi Gang just a few months into his new job is even more complicated: A growing trade war with the Trump administration coupled with rising borrowing costs in the U.S. has prompted investors to sell the yuan heavily, raising the prospect of the central bank having to defend it.

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“The pressure of monetary policy to balance domestic and external stability is big, and room to maneuver is becoming even smaller," Xu Zhong, director general of the PBOC Research Bureau, said at forum in Beijing last week. “Monetary policy can't do everything, especially under conditions where external shocks are constantly increasing.”

That's quite a change of outlook from the first few months of this year when trade and the economy looked strong, with growth in 2017 having accelerated for the first time since 2010. That had put gradual tightening of PBOC policy on the agenda. Now, an economic slowdown has deepened -- a gauge of June export orders tumbled into contraction even before the U.S. imposes additional tariffs -- putting the brakes on those plans.

Stocks had their worst quarter in more than two years in the three months through June, and the yuan is falling as the Federal Reserve is stepping up the pace of interest rate hikes, leading a global tightening cycle that's pushed the dollar up.

And on top of that, China's drive to curb indebtedness at state firms and local governments remains a policy priority -- though even that edifice may be cracking. Late Tuesday, a senior PBOC official signaled that China may need to ease back to some degree and focus efforts while confidence recovers.

The PBOC is, nevertheless, busy. Since April, Yi has announced plans to cut banks' reserve requirements twice, widened the collateral pool for liquidity operations, and held off from a widely anticipated increase in inter-bank borrowing costs that would have paced the Fed's June rate hike. As both the RRR cuts had specific purposes attached to them, economists still can't agree whether the PBOC is easing policy in general or not.

Record Defaults

With household and corporate indebtedness high, corporate bond defaults heading for a record year amid slower growth, the risk is that the PBOC may be trying to do too much. It may either struggle to balance debt risks with growth threats, or just focus on one problem to the exclusion of the others.

The PBOC's room for maneuver is also limited by the plunging currency, as that will put a cap on how far officials can loosen domestic policy to assist in a slowdown. According to Nie Wen, an economist at Huabao Trust Co. in Shanghai, that fact risks forming a "vicious cycle" if left unaddressed by officials, as slower expansion will weigh on the yuan, which in turn hurts purchasing power of the economy.

Fiscal Room

Part of the focus on the PBOC is because policy makers are trying to keep the fiscal purse strings tight. The government adopted a lower budget deficit target for this year, though they have hinted that there's room for more public spending should the economy run into difficulty.

For now, officials want to avoid reviving the old stimulus favorites, such as splurging on government-backed infrastructure projects or loosening property purchase curbs. Instead, it has slashed taxes for imported goods to encourage domestic consumption.

The PBOC is now expected to hold the seven-day reverse repo rate, which guides inter-bank borrowing costs, unchanged at 2.55 percent till the end of 2018, according to a Bloomberg survey on economists from June 15 to June 21. That's a significant dialing back from expectations of tightening just a month earlier.

One Mistake

Meanwhile, economists also expect the central bank to come up with more targeted tools, in an attempt to aid parts of the economy without flooding the financial system with cash. The bigger the slowdown, the more the PBOC's political masters will be tempted to open the taps. On the flip-side, keeping financial policy tight in order to gain ground in the deleveraging campaign risks hurting the economy.

“Pipelining these priorities is a tricky game,” said Ding Shuang, chief economist for Greater China and North Asia at Standard Chartered Bank Ltd in Hong Kong. “One mistake could cause big risks, and it's just easy to make mistakes.”

--With assistance from Xiaoqing Pi and Jeff Kearns.

To contact Bloomberg News staff for this story: Yinan Zhao in Beijing at yzhao300@bloomberg.net

To contact the editors responsible for this story: Jeffrey Black at jblack25@bloomberg.net, James Mayger

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