China heads for Fed-style ZIRP as monetary policy continues to flail

(Originally published Sept. 15 in “What in the World“) It’s never a good sign for an economy when you can’t even give away money.

That’s the predicament China’s central bank finds itself in. It’s been offering more cash at lower costs to the country’s banks to stimulate growth and prevent bankruptcies in the heavily indebted property sector. But things have gotten so bad that banks are too nervous to lend and borrowers too pessimistic to borrow.

The People’s Bank of China tried again this week by lowering the portion of deposits banks must keep stashed in its vaults. The PBoC reduced the reserve requirement for commercial banks by a quarter of a percentage point to 7.4%, the second time this year it has cut the ratio. In theory that frees up more cash for the banks to lend to companies and consumers. If they want it. The problem the PBoC faces is that demand for loans is falling with China’s economic prospects. And more of the money being lent is being used merely to pay off existing debt rather than invest or spend it.

In times like these, some banks choose to keep even more money than required stashed at the central bank, which of course pays interest on these deposits. Central banks therefore raise and lower the interest they offer for reserves, and typically pay less for reserves banks deposit in excess of the requirement. It’s not clear if the PBoC also lowered its rate for reserves. In April it cut the rate on excess reserves for the first time in 12 years, to 0.35% from 0.72%.

Reserves are essentially a loan by banks are required to make to the central bank, which uses them to control the supply of money to an economy. Central banks also lend money to banks, and the PBoC on Friday expanded the amount of money it offers to lend for one year—its “medium-term lending facility”—by almost 50%, to 591 billion yuan ($81.9 billion).

Central banks also lend short-term cash using what’s known as a reverse repurchase agreement, in which the central bank buys a security from banks that includes a promise to sell it back to them later for the same price plus a percentage that represents an effective interest rate on the sales proceeds. The PBoC on Friday bought an additional 105 billion yuan worth of 7-day reverse repurchase agreements, thereby injecting that cash into the banking system. It also bought 34 billion yuan in 14-day reverse repos and reduced their effective annual interest rate to 1.95% from 2.15%.

The question is whether this additional cash will do any good. Last year, the PBoC offered six state-owned commercial banks 200 billion yuan in zero-interest loans if they would lend it, yuan for yuan, with their existing funds to companies with stalled property projects. To date, however, banks have borrowed less than 1% of the interest-free cash the PBoC offered. Why? Even with their funding costs cut in half, banks consider the property companies too risky to finance.

And no wonder. New home prices in August fell 0.1% compared to the same month last year even after many restrictions on property investment were eased.

China obviously isn’t the only country that has faced this problem. A similar predicament is what led the U.S. Federal Reserve to adopt its zero-interest rate policy, which was followed by its negative interest rate policy—when it effectively paid banks to borrow the money it was creating from thin air by buying newly issued bonds from the U.S. Treasury.

But it’s a particularly tricky time for China to be reprising the Fed’s Zirp routine, primarily because the Fed is now raising rates. With returns on dollars rising and returns on yuan falling, investors are sensibly trying to sell their yuan for dollars. That’s putting downward pressure on China’s yuan. The weaker yuan would normally boost export earnings, but demand for China’s exports abroad is weak, so whatever help it’s providing is meager. Instead, a weaker yuan boosts the price of imports, offsetting the impact of lower rates, while capital flight also tends to push up the real cost of funding by reducing domestic liquidity.