While the PBOC's balance sheet appears to have shrunk over the past two months, the Chinese central bank has already returned to, and will maintain, an easing stance. In our view, the recent balance sheet contraction and monetary tightening resulted from pre-emptive measures in Q1 2025. The central bank absorbed liquidity to defend the RMB exchange rate ahead of the US "Liberation Day" on April 2nd. It withdrew RMB 462 billion through open market operations in Q1 and issued RMB 120 billion worth of bills in Hong Kong to tighten offshore liquidity and support the offshore CNH exchange rate. On entering Q2 2025, RMB 712 billion in OMO injections, along with benchmark and reserve requirement ratio cuts, signal a return to easing. Short-end interest rates (R007/DR007) are falling rapidly.
Weak inflation and subsequently elevated real interest rates are the key drivers of easing, as they disincentivize credit growth and economic activity. Both consumer and producer prices have contracted since the start of the year amid overcapacity. On the supply side, ongoing trade tensions are exacerbating domestic price war. Manufacturers are cutting prices for front-loaded exports, which in turn, curbs domestic prices. On a 12-month moving average basis, China’s PPI and exports show a correlation of +0.71 over the past two decades. The automobile industry is a prime example. Auto PPI is underperforming the already-falling headline PPI amid a diverging trend between rising automobile production / investment versus tepid domestic sales / exports.
Intense domestic competition among internet platforms and many other sectors has capped consumer goods prices. Meanwhile, consumption demand remains weak. Household sentiment is under pressure from weak job prospects, slowing income growth, and the negative wealth effect from the property market. This nationwide supply-demand imbalance is weighing on both CPI and PPI. As a result, May’s real interest rates remain elevated at 5.7% and 3.1% in PPI and CPI terms, respectively.
On a positive note, the weakening USD allows the PBOC more room to ease. USD/CNY has already returned to 7.20. After the recent cuts, we expect an additional 20bps cut in the 1-year LPR and a 50bps reduction in the RRR in the second half of the year. The PBOC will also likely resume the government bond buying programme that was halted in January 2025. Thus far, its claims on government only accounts for 2% of GDP. This compares to 6.0% during the Global Financial Crisis.
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