• PBOC assets have dropped as foreign-exchange reserves fell
  • China's credit and money supply have expanded nonetheless

Sometimes it helps to have a command economy.

While central bankers in Japan, Europe and the U.S. have struggled in recent years to stoke credit growth even as they grew their balance sheets to unprecedented size, the People’s Bank of China is succeeding, with a very different approach.

For all the Communist Party’s rhetoric about giving a decisive role to markets, China’s financial system remains dominated by state-owned lenders. That’s come in handy as policy makers loosened monetary policy since 2014 to shore up a slowing economy. Officials can direct banks to make new loans or roll over existing ones. The PBOC has also been expanding support for "policy banks" that support government objectives.

What’s perhaps most striking is China’s lending machine is humming even as the PBOC downsizes. Its balance sheet has been shrinking some as it sold off foreign-exchange reserves in the past year to shore up the yuan’s value.

The PBOC’s effectiveness is seen in the money multiplier, which was at 5.1 in March, according to a report from the central bank Friday. That means each 1 yuan the central bank pumps into the economy generates 4.1 more through the process of loans generating new deposits that then create further loans, and so on.

By contrast, developed-world central banks have found that while it’s easy to create money, it’s hard to get that money to be lent onwards. Much of the Bank of Japan’s money pumping has ended up right back at the BOJ, because banks have failed to find attractive borrowers to lend to. And democracies essentially can’t order banks to lend.

"It’s more powerful and effective, as the PBOC and State Council have more power over banks," said Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, referring to the central bank and the cabinet. "The money multiplier in China is under direct influence by the government and is much higher than other countries."

Besides relying on the multiplier effect, PBOC Governor Zhou Xiaochuan and his colleagues have had to adapt their money-creation strategy. Before 2014, when most investors and traders anticipated sustained long-term gains in the yuan, the PBOC used to limit its appreciation through purchases of foreign currency -- creating new yuan through the process. At the time, the challenge was more often how to mop up some of that new domestic liquidity, to prevent excessive inflation.

With bets on the yuan shifting, the reserves have fallen. They were $3.22 trillion yuan in April, down from just under $4 trillion in mid-2014, data released Saturday showed.

The PBOC has turned to the use of special loan programs for banks, including the policy banks, to inject liquidity. It’s also made more use of money market instruments to pump funds into the economy.

The problem is, this isn’t where the PBOC had really wanted to head in terms handling yuan devaluation and capital outflow pressure, though it was positive for the central bank’s shift of its monetary policy. The central bank’s stated objective has been to shift to a framework that, as in most developed nations in the past, uses measures of borrowing costs as the key policy tools -- a so-called price-based approach, rather than a quantity-based one.

As part of that transition, lending and deposit rates have been liberalized and a new money-market-linked interest rate corridor is falling into place.

"The way China manages its monetary policy is still different from the West," said Hao Hong, chief China strategist at Bocom International Holdings Co. in Hong Kong. "Despite the interest-rate liberalization, the Chinese economy still responds better to quantitative measures -- such as RRR, loan quota, money-supply growth target etc., than price-based measures, such as interest rates." RRR refers to banks required reserve ratio.

One reason for the desire to shift to a price-based policy was to move away from a volume-focused system that created the danger of too many loans going bad. While some of the lending -- especially through the policy banks -- can be targeted to desired goals such as shanty-town redevelopment and the upgrade of urban utilities, other lending can end up in undesirable places -- like stock or commodity-market speculation.

The current set-up still offers the PBOC one advantage: money-creation through the build-up of reserves was difficult to manage. Capital inflows largely determined how much the central bank had to buy in foreign currency, and how much to create in local currency. Now the PBOC has more control.

What’s less clear is whether the lending that’s being spurred is good for the economy. In developed nations, the practice of credit checks by banks is designed to limit the danger of bad loans -- though this famously failed to work in the subprime-mortgage disaster.

Efficient capital allocation is crucial given China’s total debt is now about 2.5 times annual economic output -- a level that’s in line with advanced economies and well below Japan but looks high given that China is still a developing market.

"As the Chinese economy develops and becomes more complex, the disciplining nature of independent financial-sector decisions becomes increasingly important -- and government-led credit stimulus is more likely to lead to bad debt," said Louis Kuijs, chief Asia economist at Oxford Economics in Hong Kong.

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