In 2024, a noteworthy trend emerged in the financial landscape of China: the central bank's balance sheet experienced a significant contractionThe total assets of the People's Bank of China (PBOC) dwindled from 45.7 trillion yuan to 44.1 trillion yuan, marking a reduction of 1.6 trillion yuanThis decline was the largest since 2016, indicating a pivotal shift in the operational strategies of the central bank.

Breaking down the timeline of this contraction reveals two primary phasesThe first phase took place between January and April, where total assets fell from 45.6 trillion yuan to 42.8 trillion yuanThe second phase occurred from September to December, with total assets shrinking from 45.5 trillion yuan to 44.1 trillion yuanThe major contributors to this reduction included a significant decline in the 'claims on other deposit-taking institutions' as an asset and 'deposits from other deposit-taking institutions' as a liability.

However, it’s crucial to understand that the PBOC's balance sheet reduction does not directly correlate with the monetary policy stanceThe bank has reiterated on numerous occasions that a shrinkage in the balance sheet does not equate to a tightening of monetary policyThe PBOC has emphasized that various seasonal factors play a substantial role in affecting the size of its balance sheetElements such as tax revenues, cash flow from economic activities, and government expenditures significantly influence the balance sheet's dynamics, rendering the analysis of its size at singular points in time somewhat superficial.

Furthermore, the fluctuations in PBOC’s balance sheet are subject to a myriad of complex factors, including foreign exchange reserves, the choice of monetary regulatory tools, seasonal variations due to festivals like the Spring Festival, fiscal spending, and changes in financial reform and regulatory approachesThe concept of a 'shrunken balance sheet' does not necessarily imply a contraction in the money supply; in some contexts, particularly during capital outflows, such a shrinkage could occur even while monetary conditions are being eased

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Thus, it is inappropriate to draw direct parallels with the balance sheet reduction strategies employed by foreign central banks.

Analysts have interpreted the reasons behind this contraction as primarily stemming from the two cuts in the reserve requirement ratio (RRR) in 2024, alongside the introduction of innovative monetary policy tools that do not appear on the balance sheetIn contrast to other methods of injecting liquidity through balance sheet expansion, the PBOC leaned more towards RRR cuts in 2024 to release medium- to long-term fundsThis strategy inherently invites a contraction in the balance sheetAdditionally, the introduction of a new tool for reverse repos replaced the liquidity provision previously offered by Medium-term Lending Facility (MLF) operations; however, it remains unclear if these tools have actually influenced the PBOC's balance sheet.

Looking ahead, experts anticipate further adjustments in the monetary policy frameworkAccording to Yang Yewei, chief fixed-income analyst at Guosheng Securities Research Institute, a continued downtrend in the RRR is expected in 2025 amid a backdrop of “moderate easing.” Should the PBOC persist with the significant implementation of reverse repos that do not reflect on the balance sheet, there may be sustained contraction pressures in the forthcoming fiscal periodFurthermore, Mingming, the chief economist at CITIC Securities, indicated that the transition from a quantity-based to a price-based control framework would likely see increased utilization of price-oriented instruments and non-balance sheet expanding toolsThis combination of 'loose monetary policy coupled with balance sheet contraction' is expected to remain prevalent.

Examining the implications of the RRR cuts reveals a unique dimension of the contractionWang Jian, chief analyst of the banking sector at Guoxin Securities, elaborated that the balance sheet contraction is closely associated with the RRR reductions, which delivered substantial liquidity post-decrease

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Banks often responded by repaying MLF obligations, which could explain the resulting shrinkage in the central bank's balance sheetNotably, the reductions in reserves do not intrinsically alter the total asset figure of the central bank; instead, they reformulate the structure of liabilitiesThe RRR serves as a robust policy tool; reducing it necessitates the PBOC's retraction of reverse repos and MLF operations to maintain sufficient liquidity in the banking system.

The underlying mechanics of these adjustments illustrate that when the RRR is lowered, a portion of the legal reserve requirements are 'unfrozen' into excess reservesThis maneuver promotes liquidity in the banking sector, fostering conditions conducive to money creation—while the overall scale of the central bank's balance sheet and base currency remains stableHowever, in the aftermath of RRR cuts, banks may use released funds to settle debts owed to the central bank, hence prompting a decline in claims on other deposit-taking institutions, ultimately reflected as a decreased balance sheet.

Throughout 2024, the PBOC executed two RRR cuts on February 5 and September 27, each by 0.5 percentage points, unleashing long-term liquidity exceeding 2 trillion yuan into the economyThis liquidity redirection corresponds with the balance sheet contraction occurring during the months between the cuts, further substantiating the argument that it was driven by banks utilizing the excess reserves to pay off MLF and related liabilities.

Wang Qing, chief macroeconomic analyst at Dongfang Jincheng, posited that the 2024 RRR reductions will lead to substantial decreases in commercial banks' deposits with the PBOC, approximately by 2 trillion yuanGiven the cheaper costs associated with these released funds, banks are likely incentivized to repay various debts to the central bank, resulting in noted balance sheet contractionCritically, if one takes these factors into account, it can be interpreted that the PBOC's balance sheet grew overall during 2024.

It’s imperative to emphasize that a shrinking central bank balance sheet and a constraining total liability and asset figure should not be misconstrued in the same light as the balance sheet contraction actions of the Federal Reserve (Fed). Key distinctions exist between the structures of the balance sheets of the PBOC and the Fed, with the former mostly exhibiting the dynamics of deposits and debts between the central bank and commercial banks

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