How will the Monetary Policy Change the Chinese Economy
China’s counter-cyclical policy is very cautious when it comes to the implementation. Despite continuous significant economic downturn and noticeably negative output gap，China maintains its prudent monetary policy. The implementation of monetary policy has many considerations，including further pressure on the renminbi (RMB) exchange rate and cross-border capital flows due to the Federal Reserve raising interest rates. However，more importantly are the scepticism towards the effects of accommodative monetary policy and the concerns over its side effects. Specifically，first is the doubt over the effects of accommodative monetary policy in the context of weakened expectations，the impact of the pandemic and supply shocks. Second is that although the monetary authority has slightly adjusted policy rates and reduced lending rates，the economy has failed to pick up substantially，leading to scepticism towards the efficiency of accommodative monetary policy. Third is that between monetary and fiscal policies，the latter produce instant results，which should be given priority. Fourth is the possible side effects that come with accommodative monetary policy，such as inflated asset bubbles，widening gaps in income and wealth inequalities，the hampering of the market’s voluntary competitiveness-based elimination and the emergence of zombie companies.
The academia’s scepticism towards accommodative monetary policy is deep rooted. Classical economists and Real Business-Cycle theorists believe in the market’s ability to repair itself and find monetary policy useless. Monetarists and neoclassical economists，in contrast，oppose discretionary policy and stress the imposition of rules on monetary policy. Even Keynesian economists specify the limitations placed on monetary policy by liquidity traps. Despite the many doubts its face，high hopes were pinned on accommodative monetary policy to counter economic downturns. In modern monetary economics，monetary policy has various channels to interact with real sectors through the financial markets. Policy interest rate cut imposes a number of influences，including changing the intertemporal price of expenditure，the balance sheets of household sector，corporate sector，and government，and the exchange rate. As a result of those changes，total expenditure increases. Over the last three decades，whether it was the Great Moderation before the financial crisis in 2008 or afterwards，the operational frameworks and policy instruments of monetary policy have continued to innovate while the importance of monetary policy in countercyclical policy is further foregrounded.
In this paper，we estimate how will policy rate cut in China change the cash flow of household sector，corporate sector，and government，and therefore boost overall expenditure. The estimation is based on the following logic:
The parameters used in the calculations came from historical evidence and may not fully reflect the current situation. They do，however，serve as reference for the effects of policy rate cut. The effects that following changes – brought about by lowered rates – have on aggregate demand are not considered here: wealth and asset-valuation effects，intertemporal substitution in consumption and changes in the risk appetite of capital markets.
From Policy Rate to Market Rates
The seven-day reverse repo rates have been adjusted downwards twice since 2015. The first time was between January and October 2015，when the rates of open market operations (OMO) lowered ten times，adding up to a total of 185 bps. The second time was from 2019 till now，when OMO rates were reduced five times，coming to a total of 55 bps. With the 20 trading days before and after the downward adjustments of OMO rates as the observation period，the seven-day Depository-Institutions Repo Rate (DR007) fell more than twofold than the OMO interest-rate cuts. The People’s Bank of China (PBC) has lowered OMO rates five times since 2019 by 55 bps in total. The DR007 also reflected the effects of the OMO interest-rate cut and fell even more.
Since 2016，the medium-term lending facility (MLF) has become the policy instrument that guides the medium-term interest rates. In 2019，the PBOC developed a model for controlling the medium-term interest rates known as the MLF-Loan Prime Rate (LPR)-Borrowing Rate. Since 2016，the PBC has cut the one-year MLF rate five times，and the latest adjustment was on 15th August 2022. On average，the average interest rates of financial institutions’ RMB loans are in a position to fully reflect the impact of a lowered MLF rate. However，significant differences are seen in the interest rates of different types of loans. After each downward adjustment of the MLF rate，the average lending rates of financial institutions will drop on average 1.5 times that of the MLF rate. The drop of interest rates of general loans is 1.64 times that of the MLF rate，whereas that of notes financing and residential mortgage loans are 1.11 and 1.47 times.
Policy-rate cuts will also cause deposit rate and wealth management-product rates to fall. During the rate-cut cycle in 2015，OMO dropped by a total of 185 bps and the benchmark deposit interest rate dropped by 150 bps. During the rate-cut cycle between 2019 and January 2022，OMO rates dropped by a total of 55 bps，whereas the average yield of seven-day wealth management products fell from 3.7% to 3.2%，down by 50 bps. Meanwhile，the weighted average interest rate of structured deposits fell by 55 bps from 3.55% to 3%. Consequently，the transmission rate of policy-rate cut to terminal deposit rates was about 90%. In other words，each time the policy rate drops by 100 bps，the deposit rates and the yields of wealth management products of the household sector will fall by 90 bps.
From Market Rates Adjustment to Cash Flow Changes
Cash Flows of Household Sector
As of August 2022，the debts of China’s household sector amounted to 73.2 trillion yuan，amongst which17.9 trillion yuan was short-term loans and 55.3 trillion yuan mid- and long-term loans. Out of the mid- and long-term loans，38.9 trillion yuan was residential mortgage loans. Policy-rate cut impacts the cost of debts with different terms via different mechanisms. For short-term debts，it directly reduces the interest payment for the current period，whereas for mid- and long-term debts，the effects will depend on the average duration and the repayment methods.
With reference to the calculations in Studies of International Finance，we set the average duration of a mortgage at 15 years. The repayment method is the set of the same amount of principal and interest to measure the impact of interest rate decline on the cost of resident debt. The results show that with a 100 bps cut in the policy rate，the household sector’s short-term borrowing rate would fall by 164 bps，reducing debt interests by 301.5 billion yuan. The household sector’s mid- and long-term borrowing rates will drop by 147 bps，reducing the payments for principals and interests by 479.7 billion yuan，amounting to a total reduction of 774 billion yuan.
As of August 2022，the savings of China’s household sector amounted to 114.2 trillion yuan，amongst which 35.6 trillion yuan was current deposits and 78.6 trillion yuan fixed deposits. An additional 6.2 trillion yuan was money-market funds and about 27.3 trillion yuan was invested in wealth management products. A drop in the policy rate does not affect the deposit interest rates but mostly the returns on some fixed deposits and other assets. Suppose new additions to fixed deposits and their renewals (accounting for half of the fixed deposits)，around 39.3 trillion yuan，are impacted by deposit-rate cut，both money-market funds and wealth management-product investments will be affected. A 100 bps drop in the policy rate will see a 90 bps drop in the household sector’s return on assets and 655.2 billion yuan reduction in its interest income.
Cash Flows of Non-financial Enterprise Sector
Firstly，we worked out the debt distribution in four non-financial corporate sectors，with the total being 78.5 trillion yuan for real property and urban-development investment platforms，36.2 trillion yuan for industrial enterprises and 53.1 trillion yuan for other enterprises.
Two conditions affect changes in the debt interests of property and urban-development investment platforms. One is their debt types. The issuance rate of corporate bonds is fixed while the loan contracts of most companies also have a fixed interest rate. Under such circumstances，to enjoy the benefits of a rate cut，companies would need to buy back their bonds and reissue them or apply to pay off their bonds ahead of maturity and resign contracts. Consequently，the replacement ratio of enterprises’ stock debts determine how much they will enjoy the rate drop brought about by a cut in the benchmark interest rate. Second is the transmission efficiency of benchmark interest rate to the terminal financing rate.
Based on the calculations above，when policy rate drops by 100 bps，enterprises' short- and long-term financing rates will drop by 111 bps and 164 bps. Based on the assumption that half of the companies’ debts are replaced by lower-cost debts，the short- and long-term debts of all the companies will amo