Three Clues for Starting Monetary Easing in the New Year

As the bond yields continue to hit new lows at the beginning of the year, the absence of a reserve requirement ratio (RRR) cut in the fourth quarter has not dispelled the market's expectations for monetary easing. Will there be an RRR cut and interest rate reduction in January this year? Given the economy's demand for a strong start despite external uncertainties, we believe the overall direction of monetary easing remains unchanged. The pace of implementation still needs to consider three factors: bank interest margins, the exchange rate of the renminbi, and bond issuance. Changes in these three factors also constitute three clues for observing monetary easing at the beginning of the year.

First, in terms of interest rate cuts, it is still necessary to generally maintain a match between the asset and liability side interest rates of banks, in simple terms, to maintain bank interest margins and create space for monetary easing. By the end of the third quarter of 2024, the net interest margin of commercial banks continued to narrow to 1.53%. Furthermore, the recent pressure on interest margins does not seem to have significantly eased:

On one hand, since the end of 2024, the pace of interest rates on the asset side has been somewhat overshot, with the decline in government bond yields outpacing the decline in the cost of interbank certificates of deposit on the liability side, leading to continuous compression of financial institutions' interest margins.

On the other hand, deposit rates are relatively rigid: First, since 2019, the pace of interest rate cuts for deposits and loans has not been symmetrical, with deposit rates only accelerating their decline since September 2022. Second, historically, the decline in banks' actual deposit costs lags behind deposit interest rate cuts by about a year.

A new round of interest rate cuts and RRR reductions requires matching interest rates on the asset and liability sides, stabilizing interest margins. We believe that the governance of banks' "manual interest supplementation" in the second quarter of 2024, as well as the strengthening of self-discipline on interbank deposit rates in December, reflect this idea.

Secondly, RRR cuts and interest rate reductions still rely on adjustments to the renminbi exchange rate to usher in a "window period." Recently, there has been considerable exchange rate pressure, reflected in the relatively strong onshore midpoint (the renminbi midpoint was raised by 5 basis points on the first trading day of the new year) and the tightening of offshore funding rates. Most intuitively, from the perspective of the China-U.S. interest rate differential, the Federal Reserve has signaled a pause in interest rate cuts, combined with the domestic bond market pricing in expectations for monetary easing in advance, resulting in the recent China-U.S. interest rate differential reaching a new low since 2002.

Historically, under exchange rate pressure, the central bank has delayed interest rate cuts and replaced them with RRR cuts: First, in the fourth quarter of 2023, the initial RRR cut was missed, replaced by the more expensive MLF and proactive management of the offshore market (3M-Hibor raised, foreign exchange trading volume tightened); Second, after the Politburo meeting in April 2024 mentioned "flexibly using policy tools such as interest rates and reserve requirement ratios," the central bank waited to improve the treasury bond trading tools, and only after the Federal Reserve's expectations shifted did it cut interest rates in July and September and reduce the RRR; For example, in November-December 2024, the central bank did not lower the reserve requirement ratio but instead used MLF reduction and renewal + government bond trading + reverse repos to hedge against the peak period of debt resolution and the liquidity pressure brought by the large amount of MLF maturing (Figure 7).

Furthermore, the fiscal stimulus at the beginning of the year is more critical, and monetary easing needs to be coordinated with it. There may be a reserve requirement ratio cut in conjunction with the two traditional bond issuance peaks around the Spring Festival and the third quarter. At the same time, interest rate cuts will further reduce local government debt interest rates, aiding in debt resolution.

At the same time, stabilizing expectations is also a consideration for the implementation of interest rate cuts and reserve requirement ratio reductions. For instance, the reserve requirement ratio cut after the market's continuous adjustment in January 2024, and the reserve requirement ratio cut at the end of June 2018 after the U.S. officially announced the tariff list on Chinese products. In the face of unclear subsequent situations, monetary policy needs to leave room for operational responses, playing a good role in "post-hand chess."

Looking ahead, the reserve requirement ratio cut may not wait too long, with the next window possibly in January. First, it will coordinate with the special bonds for debt resolution that may be issued early in January, as well as the significant funding demand around the Spring Festival; Second, after Trump officially takes office in January, there will be opportunities to hedge against potential impacts of tariff policies. Interest rate cuts may come later than reserve requirement ratio cuts, waiting for the "tolerance" of the exchange rate to be "recalibrated" and for interest rate spreads to stabilize, thus opening up space for monetary easing.

Article authors: Tao Chuan S0100524060005, Li Xiaoyu, source: Chuan Yue Global Macro, original title: "Three Clues for Monetary Easing at the Beginning of the Year (Minsheng Macro Tao Chuan Team)"

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