No More Flooding the Plains: The PBOC Opts for “Precision Irrigation”

The People’s Bank of China (PBOC) has taken an unexpected approach to monetary policy this year. As the Chinese economy has slowed, the central bank has refrained from using the “flood-irrigation” (大水漫灌) approach (credit-fueled stimulus) as in the past. Instead, it is pursuing what it refers to as the “precision drip-irrigation” (精准滴灌) method.[1] This “drip-irrigation” approach is more than just the adoption of a prudent monetary policy. It is trying to protect small banks against the risk of financial contagion.

China’s small banks are overly dependent on borrowing from other banks for their funding. However, their ability to access such funding can be disrupted during periods of stress in the financial system—which is what occurred when the central authorities took control of Baoshang Bank. Fears that Baoshang’s problems weren’t isolated made banks reluctant to lend to each other, particularly to small banks that are usually considered more vulnerable. That drove up borrowing costs and threatened to spread the distress more widely throughout the system—until the PBOC managed to calm the market by engaging in open market operations.

With officials signaling that more financial institutions will fail as the economy slows, it has not only become vital for small banks to reduce their dependence on interbank borrowing, but also for the central government to have readily available tools to handle future volatility.

In short, rather than bolstering growth, the PBOC’s monetary policy is currently focused on trying to strengthen the position of the country’s small banks. This report looks at why the central bank’s priorities have changed and outline the tools that the PBOC is using to direct funds to small banks.

Preventing Contagion

Generally speaking, China’s small banks (a group that includes city commercial banks—like Baoshang—rural commercial banks, and village banks), have long been the weaker links in China’s financial system. They have higher nonperforming loan ratios than large state-owned and joint stock banks and are also less ably managed.

In recent years, these subnational level banks have aggressively supplemented their deposit base—the primary source of funding for any bank—by borrowing heavily from their larger peers. Typically, that takes the form of short-term funding, which means that small banks are constantly borrowing to replace maturing loans or bonds. That became more difficult when the China Banking and Insurance Regulatory Commission (CBIRC) announced that Baoshang Bank presented a “severe credit risk” and proceeded to take it over.[2]

Markets were particularly spooked by the regulators’ insistence that creditors take a haircut, upending a widely held assumption that China’s banks were implicitly and wholly backed by the government. With the implicit guarantee now less of a guarantee, it became riskier to lend to small banks. As a result, the interest that small banks had to pay to borrow went up, and lenders demanded higher quality collateral in return for loans. Had the situation deteriorated further such that small banks were not able to borrow at all, other banks could have failed.

Consequently, as the International Monetary Fund (IMF) explained in a recent report, “interbank funding markets became strained as investors questioned the creditworthiness of weaker, smaller banks and nonbank financial institutions.”[3]

The Baoshang episode awakened the PBOC to the fact that as long as small banks are dependent on the interbank market to sustain their operations, disruptions in that market could exacerbate systemic risks. Reducing small banks’ interbank borrowing will not only make the overall system more stable, it will also give regulators more freedom to deal with banks like Baoshang without fear of triggering further financial distress.

PBOC Governor Yi Gang, in a statement to the IMF in October, characterized the effort as “preventing and mitigating major financial risks.”

“Since the beginning of this year…the authorities have…taken a number of targeted measures to improve its liquidity management tools,” Yi wrote. “The aim is to restore confidence in the interbank markets, mitigate liquidity risks of small and medium banks, prevent moral hazard, and ensure market stability.”

The “liquidity management tools” Yi refers to serve two distinct purposes. One involves redirecting liquidity to small banks so they can reduce their exposure to the interbank market. The other involves putting in place alternative sources of funding so that in an emergency, banks don’t have to rely on interbank borrowing. Both types of tools are explored below.

Replacing Interbank Liquidity

The Baoshang Bank takeover has made it more expensive for small banks to borrow from the interbank market (see Figure 1). That’s in large part due to the haircut forced upon Baoshang creditors. For the first time, banks are having to properly consider that, when lending to certain banks, there is a real risk that they may not get repaid in full.

Figure 1. Diverging Paths
Interest rate on newly issued 3-month Negotiable Certificates of Deposits, by bank type.
Note: Three-month NCDs are one of the most heavily issued NCD maturities. Circle denotes where interest rates diverged after the Baoshang takeover.
Sources: Wind; MacroPolo.

That has shown up in the widening spread on Negotiable Certificates of Deposit (NCDs), the dominant channel through which small banks borrow from the interbank market. In May, city commercial banks were paying, on average, 22 basis points (bps) more than large state-owned commercial banks on newly issued NCDs. By October, the gap was 68 basis points, significantly wider than at any point in the last four years.

Faced with higher funding costs, city and rural commercial banks have subsequently seen their net outstanding volume of NCDs decline 11% since the peak in March 2019 (see Figure 2).[4]

Figure 2. Small Banks Becoming Less Active Interbank Borrowers
Net outstanding NCDs issued by small banks (in billion yuan)
Sources: Wind; MacroPolo.

As small banks gradually reduced their interbank borrowing, the PBOC has simultaneously allocated funds directly to small banks to ensure they have sufficient liquidity to continue operating. This has been achieved using targeted cuts to the reserve requirement ratio (RRR). Between May and July, the PBOC significantly reduced the RRR for the 1,000 county-level rural commercial banks and credit cooperatives with assets less than 10 billion yuan. It also cut the RRR for city commercial banks by an additional 100 bps, spread over October and November. Combined, these cuts meant an additional 380 billion yuan of liquidity was released into the banking system, according to the PBOC.

But it would be inaccurate to characterize these RRR cuts, along with a 50 bps cut in September for all banks, as the PBOC reverting to stimulus. These cuts merely represent a replacement of liquidity that the PBOC had drained from China’s largest banks.[5] This has been done through retrenching the Medium-term Lending Facility (MLF)—a major channel through which the PBOC injected liquidity into larger, more sound banks before September 2018. But this year, the PBOC has effectively loosened monetary conditions for small banks and tightened them for larger banks, while keeping the overall liquidity situation fairly neutral.

Direct Line to the PBOC

The PBOC’s recent actions haven’t been about simply releasing liquidity, but also ensuring that in an emergency, small banks are able to quickly access the liquidity they need. Access to capital isn’t equal, since most of the PBOC’s tools for pumping money into the financial system are available to large banks only. Small banks typically need to have good quality collateral, which they may lack in times of financial trouble, to access credit. In recent months, however, the PBOC has been trying to address this imbalance.

Specifically, the PBOC has made it easier for small banks to exchange assets for cash from the central bank itself. That initially started in the second half of 2018 when the PBOC increased its rediscounting and relending quota three times by a combined 400 billion yuan. In June this year, it raised the rediscounting quota an additional 200 billion yuan.

Rediscounting allows banks to sell discounted bankers’ acceptances (which I’ve written about here) to the PBOC. Similarly, relending allows banks to exchange loans made to small businesses, poor communities, and the agricultural sector, for cash from the PBOC. This allows small banks to reserve high-quality collateral—like Ministry of Finance or policy bank bonds—for borrowing from other commercial banks, but can tap funds from the PBOC using less tradable assets that they are likely to have readily on hand.

Additionally, in June, the PBOC said that it was willing to accept NCDs as collateral for borrowing via the Standing Lending Facility (SLF). The SLF is an emergency facility through which the PBOC makes very short-term loans to banks in return for collateral. Previously, the central bank had demanded relatively high-quality collateral, which small banks may not have in sufficient volume. In its second quarter monetary policy report, the PBOC referred to the rediscounting quota and the SLF as part of its drip-irrigation arsenal.


When the PBOC launched its deleveraging campaign in 2016, one of its first priorities was to reduce interbank lending. It was an effort specifically aimed at unraveling the complicated network of loans between banks and non-bank financial institutions that fed a ballooning shadow banking sector. The campaign proved successful, with interbank borrowing volumes declining sharply. Now, with the Baoshang takeover, the PBOC has again turned its attention to the interbank market, albeit with the aim of inoculating small banks from potential disruptions to their funding.

It will likely take another period of stress—for example, when the banking regulator takes over another bank—to determine whether current efforts to bolster China’s small banks are sufficient to protect them against contagion. And even if they are, it’s uncertain whether the current approach of directing liquidity to small banks is a band-aid or a permanent solution.



[1] In the PBOC’s second quarter monetary policy report, published in August, it warned against “flood irrigation”—a warning repeated by Governor Yi at a press conference a month later—and argued that “precision drip-irrigation” is needed to better manage small banks’ liquidity. “Flood irrigation” refers to the approach that the PBOC took last year, when it cut the RRR massively, “flooding” the banking system with liquidity. In theory, those actions should have resulted in more lending, more investment, and more growth. However, the approach failed to meaningfully stimulate the economy.

[2] Grace Zhu and Chao Deng, “China Takes Over Bank Linked to Missing Financier,” The Wall Street Journal, May 24, 2019,

[3] “Global Financial Stability Report: Lower for Longer,” International Monetary Fund, October 2019,

[4] NCDs are a type of unsecured bond issued by banks and sold in the interbank market, with a maturity of less than a year.

[5] Between February and the end of September 2019, cuts to the MLF have drained 1.33 trillion yuan worth of funds from the banking system. We estimate that RRR cuts (both targeted and system-wide) have injected about 1.11 trillion yuan over the same period.


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