China and the yuan have become hot topics in the financial world over the past 12 months as the country tries to rebalance its economy and devalue the yuan to help domestic consumers.

The world is also closely watching the actions of China’s financial policymakers as the country grapples with a mountain of legacy debt built up over the past decade.

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The Peoples Bank of China second-quarter monetary policy report released last weekend failed to bag any more color to the PBOC policy stance to legacy debt, but it did contain a warning on the depreciation impact of Reserve Ratio Requirement cuts on the CNY. The report also mentioned concerns about upside risk to CPI emerging from further rate reductions.

These revelations are notable for the crucial reason that they underscore the constraints of major monetary easing. China’s policymakers have been heavily reliant on easing to keep the country’s economy growing ever since the financial crisis and policymakers are leaning more and more on this strategy as they try and ease the financial burden for firms saddled with high levels of debt.

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The PBOC is worried about developing trends 

Goldman Sachs’ China economics analysts MK Tang, Yu Song, Zhennan Li and Maggie Wei, believe that the overall tone of report from the central bank is in line with recent officials’ comments, on the intention to restrain banks’ off-balance sheet credit extension (using the tool of the central bank’s macroprudential assessment framework).

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Also, the report highlights the potential of RRR cuts in exerting depreciating pressure on the yuan through lowering market interest rates and boosting easing expectations as this action is believed by the market to be a strong signaling mechanism. The report goes on to note that there are upside risks to CPI inflation due to unstable inflation expectations, delayed transmission of the past fast increases in housing prices and damages to agricultural products caused by the recent flood. Jul CPI inflation eased to 1.8% year-on-year from 1.9% in Jun on lower food inflation. PPI deflation narrowed to -1.7% year-on-year from -2.6%. Softer headline CPI inflation points to subdued inflationary pressures and still sluggish aggregate demand.

Overall, it’s clear that the PBOC is worried about a number of factors in China’s financial system. The report indicates that the weighted average interest rate of general bank loans was 5.58% in June, a further 9bp decrease from March. Excess reserve ratio was 2.1% at end-June, flat vs. end-March.

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On the topic of the yuan depreciation, Goldman’s MK Tang and team report that the PBOC:

“Further emphasizes that the change in USD/CNY between the fixing vs. the close price of the previous trading day depends on the movement of the basket of currencies, while the intra-day CNY change reflects market demand and supply conditions. Such an explicit distinction on the nature of forces relevant for the CNY change over previous close vs. fixing and over fixing vs. close first appeared in the Q1 monetary policy report in May…and the Q2 report clearly reiterates this approach. While it still leaves uncertain how CNY would behave over a long horizon, in our view this approach has at least improved the transparency of the CNY fixing mechanism and greatly reduced market fear of a sudden large devaluation.”

And on a final note. According to the PBOC, that massive increase in M1 over the past year was partly related to temporary idle cash from the municipal bond swap program, as well as the pickup in housing transactions. See more: China’s Banking System Is Beginning To Show The Strain