Has China’s monetary policy lost its power to move the economy?
Leading economist says Chinese businesses and households are still mending balance sheets.
Concerns have arisen in China that efforts to boost the economy via monetary loosening will prove ineffective, or even heighten risk for a banking sector struggling to boost profits.
A leading Chinese economist argues that this is because households and private businesses remain reluctant to borrow for spending or investment purposes, with many still dialling back leverage in a situation much akin to a “balance sheet recession.”
Other policy concerns that may have led to tighter monetary conditions include the narrow net interest margins of Chinese banks, as well as the need to maintain the renminbi exchange in tandem with purchasing power for domestic consumers.
Beijing has shifted to looser monetary policy
Since the end of last year, Beijing has signalled plans to energise the Chinese economy via a robust fiscal and monetary stimulus package.
At the Central Economic Work Conference held in December, policymakers made unprecedented reference to the need for “even more active fiscal policy.”
They also revived the term “moderately loose monetary policy” - a phrase last seen 14 years ago in the immediate aftermath of the Global Financial Crisis.
This messaging has remained consistent across the first quarter. The all-important Two Sessions congressional event reiterated these policy settings, with the Chinese central bank also committing to reductions in the reserve ratio and policy rate “when opportune,” in a bid to bolster liquidity in the banking system and reduce borrowing costs.
Monetary conditions tighten despite policy signals
Since the start of 2025, however, monetary conditions have shown a trend of tightening that runs contrary to the official signalling sent over the past two quarters.
Zhang Tao (张涛), currently the head of financial markets at China Construction Bank (CCB), notes that the 10-year Chinese Treasury yield has risen from under 1.6% at the start of 2025 to as high as 1.9%, for an increase of 30 basis points.
At the same time, the renminbi spot rate has risen from 7.33 at the start of the year to under 7.22, for an increase of 1.6%.
In theory, loosening of monetary conditions should bring about an increase in demand for funds by reducing interest rates. This should also cause the value of the renminbi to come under pressure, due to declines in the returns on renminbi-denominated assets
China has instead seen longer term interest rates rise, and the value of the renminbi post an increase.
China’s economy still busy repairing balance sheets
Zhang argues that the Chinese economy has lost its sensitivity to monetary policy loosening, due to the precariously leveraged state of many businesses and households.
“Under current actual conditions, the real economy is currently in a phase of intense adjustment of balance sheets, and the sensitivity of demand for finance to monetary conditions has greatly fallen,” Zhang writes in a recent opinion piece (张涛：如何理解支持性货币立场下货币条件的收紧).
These conditions were already evident in 2024, when Chinese economists speculated over the prevalence of “balance sheet recession” conditions created by the slump in the property market that kicked off in 2021.
In 2024, the Chinese central bank reduced policy rates by 30 basis points, while the interest rate on standard loans provided by financial institutions fell 53 basis points to 3.82%.
Instead of spurring accelerated growth in lending, however, 2024 saw a sizeable slowdown in the extension of credit to actors in China’s real economy.
Loans to enterprises increased just 18 trillion yuan, while medium-and-long term household lending increased 2.7 trillion yuan, for contractions of 2 trillion yuan and 2.5 trillion yuan compared to 2023.
Government borrowing picks up the slack
While Chinese businesses and households no longer show a positive sensitivity to reductions to interest rates, Zhang notes that the government is “by its very nature insensitive to monetary conditions.”
This is because government spending is determined by shot-calling officials seeking to achieve economic policy objectives, as opposed to self-interested actors on the market hoping to increase profits or preserve the health of their balance sheets.
For this reason, Beijing is ramping up credit-fuelled government spending, to pick up the slack of lacklustre ailing private sector borrowing.
“Financial demand from the government continues to rise,” Zhang writes.
As of the end of February, government sector financing in China had reached an annualised rate of 12.8 trillion yuan, for an increase of 3.5 trillion yuan compared to the same period last year.
In the first two months of 2025, government financing accounted for a quarter of 9.3 trillion yuan in total social financing - a broad measure of credit extension in the Chinese economy.
This is an especially urgent point to consider, given China has launched a large-scale stimulus plan to bolster demand, by increasing the narrow deficit ratio to a record 4% in 2025 and the broad deficit ratio to as high as 10%
The immediate purpose of this increase in debt-fuelled government spending is to ride out the short-term headwinds for demand - chief amongst them Trump’s trade protectionism.
It also has the goal of paving the way for more sustainable long-term growth, by using deficit spending to create the conditions for greater domestic consumption and investment in capacity expansions.
Monetary loosening could have negative effects
Zhang frets over the negative distortionary impacts of China’s efforts to ramp up credit growth, by boosting government spending to compensate for lacklustre demand from a non-state sector still preoccupied with balance sheet repair.
“Continuing to loosen monetary conditions could bring about the negative impact of reductions in the efficiency of the allocation of financial resources,” Zhang writes.
He points in particular to the negative impact on commercial banks, which continue to dominate the Chinese financial system and are currently in a hampered condition due to meagre net interest margins and profits.
According to Zhang, ongoing efforts to reduce interest rates have put heightened pressure on China’s commercial banks, without leading to commensurate growth in their balance sheets or asset scale that would presage a greater boost for the real economy.
Bank profitability has declined, with the contraction in net interest margins reaching its greatest level in recent years.
The average net interest margins of China’s commercial banks stood at 1.52% as of the end of 2024, for a drop of 0.17 percentage points compared to the end of 2023.
For the big commercial banks that account for a disproportionate share of credit creation, net interest margins shrank 0.18 percentage points to 1.44%.
In order to ensure that interest rates remain low for the real economy, China’s financial regulators have also stepped up their scrutiny of the banking sector - in particular covert methods for bumping up borrowing costs as well as inter-bank borrowing.
All of this appears to have contributed to a slowdown in the growth of bank balance sheets, whose rate of expansion fell from 37 trillion yuan/ year at the start of 2024 to 27 trillion yuan at the end of February.
According to Zhang, any continued monetary loosening could have adverse risk impacts for the financial system if banks are still constrained by narrow net interest margins and struggle to grow their balance sheets by regular means.
It could also undermine the effectiveness of monetary policy when it comes to transmission of short-term rate adjustment by the Chinese central bank to longer-term rates.
“China’s financial system remains dominated by indirect financing made by banks,” Zhang writes.
“Once the banking system sees a contractionary trend, further loosening of monetary conditions not only will change the environment so that it begin to be unfavourable to policy rate transmission, it will also further reduce the risk resistance capability of the financial system.”
Key policy drivers for China to tighten monetary conditions
In light of the hampered condition of the Chinese banking system and the potential risk created by further monetary loosening, Zhang highlights several key factors driving a tightening of monetary conditions.
“From these points, we are essentially able to understand at the policy level why there has been a tightening of monetary conditions amidst supportive monetary policy,” Zhang writes.
The first is the all-important imperative of preserving the health of the commercial banks, that continue to comprise the mainstay of the Chinese financial system.
“In an indirect financing system, a key precondition for support of the real economy is to maintain the health of the banking system” Zhang writes.
“With fiscal subsidies in place, however, the banking system is able to transform monetary tightening into a restoration of its own profitability, by stabilising net interest margins.
“It’s only when net interest margins are stable, that the banking system then has the ability to continue to strengthen support for the real economy, by increasing the pace of growth in its balance sheets.”
Zhang also highlights the need to keep exchange rates stable - especially amidst the uncertainty of a Trump-led trade war, while also maintaining healthy yield curves across Chinese debt markets.
“Given the need to stabilise exchange rates externally, tightening of monetary conditions can only rely more heavily on changes to the interest rates environment,” he writes.
“Given the macro-prudential need to prevent the empty circulation of funds, it is necessary to steepen the money market and bond market yield curves, as this will help to stabilise net interest rates in the banking system.
“For this reason, since the start of the year the Chinese central bank has not only strengthened guidance via policy rates, it’s also strengthened execution and supervision of its interest rate policies.
“Recent changes in the yield curve are markedly influenced by these policy demand.”
The final key factors include China’s drive to increase domestic consumption - as part of the long-term objective of re-balancing sources of demand within the economy, as well as raise returns on investment.
Despite China’s extremely tepid levels of inflation, in Zhang’s opinion this too will require preserving the stability of the yuan and holding off on excessive cuts to interest rates.
“The chief macro-economic missions this year are to ‘vigorously stimulate consumption, raise the efficiency of investment, and comprehensively expand domestic demand,’” Zhang writes.
“Spurring consumption will objectively require stabilisation of the purchasing power of the currency, while one of the requirements for raising the efficiency of investment is restraint in the use of funds.
“For this reason, tightening of monetary conditions isn’t completely in opposition to [current] macroeconomic adjustments.”