China leads in precision-guided central banking. Does it work?

IN ECONOMICS TEXTBOOKS, central banks wield power by raising or lowering interest rates. That depiction, always a little simplistic, is now badly out of date. Since the financial crisis of 2007-09, and especially since the onset of the covid-19 pandemic, central bankers have dramatically expanded their arsenals. They have bought trillions of dollars in assets—mostly government bonds—to keep economies and financial systems from freezing up. And they have become more hands-on, trying to steer cash to “real” businesses, not just to markets. These actions reflect both the severity of the economic shock and the constraints on monetary policy in rich countries, where short-term policy rates are already at or below zero. But when it comes to unconventional interventions, it is a central bank in a very different situation—managing the world’s strongest major economy—that is by far the busiest.

In contrast with other central banks, the People’s Bank of China (PBoC) has refrained from expanding its balance-sheet. Yet it is ever more determined to guide money flows. Since 2014 it has introduced at least ten separate targeted tools to that end, and tweaked them constantly. There have been credit facilities for small businesses and farmers, new money for the construction of affordable housing, adjustments to banks’ required reserves if they lend to favoured sectors, plus caps on loans to risky industries from property to steel. Such is the scope of activity that economists in China now distinguish between two kinds of monetary policy: “aggregate policies”, like interest rates, that affect the whole economy and “structural policies” that support this or that sector. As central banks elsewhere gravitate towards more targeted actions, China’s record with structural monetary policy deserves attention.

The pandemic has illustrated the merits of targeted monetary policy. Back-stopped by central-bank facilities, Chinese banks deferred loan repayments for millions of companies and issued credit to those on the frontlines, such as makers of medical supplies. A similar response has been seen in the rich world. But in China the point of targeting goes beyond emergency relief. It is used to achieve other goals: in a report published on February 8th the PBoC said structural policies were like “drip irrigation” for the economy, helping channel financial support towards technological innovation and environmental protection.

The big attraction of structural monetary policy for China is that, in theory, it tackles a dilemma at the heart of the financial system: credit growth is needed to sustain rapid economic growth, but overall debt levels are already very high, particularly among state-owned companies. In explicitly encouraging banks to lend to less-indebted companies in promising sectors, policymakers have a set of three objectives: generating more growth, with less debt, while also modernising the economy.

To hear it from the PBoC, the experience has been a resounding success. It says it has catalysed 15.1trn yuan ($2.4trn) in “inclusive loans” (credit to very small businesses), more than double the amount three years ago, reaching some 32m firms in all. The average interest rate on these loans in December was 5.1%, not much higher than the interest rate on government debt. Small businesses, left to fend for themselves, would never enjoy such good terms.

But a closer look at the data raises questions about the efficacy of targeting. The overall shape of the economy has changed little. The liability-to-asset ratio for state firms—a measure of their indebtedness—is only slightly lower than it was five years ago, when the PBoC ramped up its structural policies. Moreover, the jump in “inclusive loans” is misleading. Small firms, broadly defined, account for just a quarter of overall bank lending, little changed over the years. Without targeting, perhaps the imbalances would have been even worse. But it is hard to escape the conclusion that the practice has had a marginal impact on financial flows.

Despite the PBoC’s official bluster about structural monetary policy, many economists who work in its regional branches are more sceptical. They have started to crank out research papers, mostly in Chinese, on the topic. Fu Hongrui and Zhong Zhenzhen argue that communication is a stumbling block. For central banks to hit their mark, it helps if companies and investors understand their intent, so that they have the confidence to push in the same direction. The PBoC, however, provides only basic information about its targeted operations, with scant details about who actually receives its credit. This, argue the researchers, blunts the benefits. In another paper Yin Xingshan and two other PBoC economists argue that structural monetary policies do not get at the roots of China’s problems. True solutions would include transforming state-owned companies into profit-focused entities and increasing competition in the banking sector. The central bank on its own will struggle to cure the economy’s “chronic disease”.

Structural weaknesses

The PBoC, which lacks formal independence, cannot very well say no when the government wants it to be more activist. It has taken to describing “precision” as one of the core aims of its policies. But some of its economists worry about the consequences. Chen Ge, a central-bank researcher, enumerates a series of risks. To obtain special loans from the PBoC, banks need to post collateral. There is little to stop them throwing ineligible loans into the mix. The central bank thus faces balance-sheet hazards if some of the dodgier assets go bad. Moreover, it is hard to monitor whether banks use the credit as promised. And if companies and banks become more reliant on the PBoC for direct support, it will grow progressively harder to unwind the interventions.

The answer, Mr Chen concludes, is for the government to step in and do more with its fiscal space, taking weight off the PBoC—a prescription that will sound wearily familiar to central bankers elsewhere. The PBoC may be following a different path. But it is arriving at a similar destination. ■