China's Intent Behind Interest Rate Freeze... 'Zero-COVID' Policy as an Obstacle (Comprehensive 1)

[Asia Economy Beijing=Special Correspondent Jo Young-shin] The People's Bank of China, the central bank of China, has kept the benchmark interest rate unchanged. On the 15th, the People's Bank of China froze the Medium-term Lending Facility (MLF) loan rate, while lowering the reserve requirement ratio (RRR).

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Some expected the Loan Prime Rate (LPR) to remain unchanged based on past cases where the MLF rate and the benchmark interest rate, the LPR, showed synchronization.

The People's Bank of China announced on the 20th that the 1-year LPR for April was recorded at 3.7%, the same as the previous month. This marks the third consecutive month of no change since a 0.1 percentage point cut in January. The 5-year LPR also remained steady at 4.6% as in the previous month.

Since March, as COVID-19 spread across China, the prevailing view was that the Chinese government would cut interest rates to stimulate the economy. There were also predictions that Chinese financial authorities could use all three available monetary policy tools (MLF, RRR, LPR), but with this freeze, analysts suggest that the People's Bank of China is adjusting the pace of interest rate changes.

China's Interest Rate Pace Adjustment

Regarding the LPR, the market was divided between calls for a rate cut and for maintaining the current rate. Some argued that due to the decline in growth momentum caused by the resurgence of COVID-19, interest rate cuts were necessary to boost the economy. Others contended that since lockdown measures reduce the effectiveness of rate cuts, a pace adjustment was needed. This freeze appears to reflect the People's Bank of China siding with the pace adjustment argument.

First, with the 0.25 percentage point cut in the RRR on the 15th, about 600 billion yuan (approximately 117 trillion KRW) will be injected into the market starting from the 25th. Additionally, considering that 600 billion yuan of the profits earned by the People's Bank of China last year will be transferred to the national treasury and fiscal funds will be released starting this month, the effect is equivalent to the 0.25 percentage point RRR cut.

Chinese media such as Caixin reported that the People's Bank of China will allocate 1.1 trillion yuan of this year's profits to the national treasury for use in tax reductions and other measures, indicating that Chinese authorities will combine monetary policy with fiscal policy.

Above all, it is presumed that the People's Bank of China considered that consumers are confined at home due to lockdowns, which diminishes the effect of interest rate cuts. They likely judged that cutting rates would be more effective once COVID-19 is under control. In fact, last month, China's retail sales fell by 3.5% month-on-month. This negative retail sales figure is the first in 20 months since August 2020 (0.5%).

Chinese media also mentioned the past synchronization between MLF and LPR, reporting that the People's Bank of China would adjust the pace of rate cuts. There were six instances (October and November 2019, January, March, and May 2020, and July 2021) where the LPR remained unchanged after MLF was frozen and RRR was cut. Conversely, there were only two cases (September 2019 and December 2021) where the LPR was cut after MLF freeze and RRR cut, leading to expectations of a freeze. A cut in the MLF rate lowers banks' funding costs, and it is argued that LPR can be managed solely through MLF rate adjustments.

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The Complex Intentions Behind China's Interest Rate Freeze

It is also analyzed that the People's Bank of China considered the abundant cash in the market. As of the end of March, the M2 (broad money supply) balance, indicating cash liquidity in the market, increased by 9.7% year-on-year to 249.77 trillion yuan (approximately 4,841.1 trillion KRW). In the first quarter, new yuan loans amounted to 8.34 trillion yuan (about 1,616.3 trillion KRW), an increase of 663.6 billion yuan compared to the same period last year, marking the largest quarterly increase on record.

Given that the Chinese government is maintaining its existing zero-COVID policy involving lockdowns, there are concerns that money will be injected into the market but may not translate into consumption. This reflects concerns that inflation could be stimulated, which might be counterproductive.

Additionally, the interest rate gap with advanced countries such as the United States was likely taken into account. Analysts suggest that if the interest rate gap widens further, capital outflows could occur (although the Chinese financial market is closed, so the possibility of dollars flowing overseas due to the interest rate gap is low). Considering the yuan-dollar exchange rate and other factors, the decision was made to keep rates unchanged.

However, the possibility of rate cuts remains open. To offset the adverse effects of lockdowns in major cities such as Shanghai, there is sufficient room to cut rates as early as May or at the latest before the start of the second half of the year.

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