Oct 08, 2018 08:44 PM

Caixin View: Reserve-Requirement Cut Cements Bleak Outlook

China's central bank likes to make announcements when markets are closed to avoid panic, and its latest monetary policy action followed that pattern. On Sunday, as the country prepared to return to work after a week-long public holiday, the People’s Bank of China (PBOC) said the reserve requirement ratio (RRR) for most commercial banks and all foreign banks will be reduced by 1 percentage point from Oct. 15. The cut — the fourth of 2018 — will release around 1.2 trillion yuan ($174.7 billion) of liquidity into the banking system, although a 450 billion yuan chunk of that is mandated to be used to repay loans made by the PBOC via its medium-term lending facility (MLF), leaving a net injection of 750 billion yuan.

The market reaction in China on Monday was brutal – stocks fell sharply, with the benchmark Shanghai Composite Index closing over 3.7% lower. The Shenzhen Component Index lost 4.05%, and Hong Kong's Hang Seng benchmark index closed 1.39% lower.

The market is seeing the move as a clear sign Chinese policy makers are concerned that economic growth is slowing too steeply and that they are trying to inject confidence amid a deepening conflict with the U.S. that's moving way beyond trade tariffs. But we think there are other, more nuanced factors at play. These include a continuation of the shift in the PBOC's management of liquidity and monetary policy, efforts to lower funding costs for banks, providing them with additional liquidity to buy local government bonds, and continued, but likely futile, attempts to channel funding into the real economy.

When foreign money was pouring into China in the 2000s, the PBOC had to mop up the excess inflows to prevent the yuan from appreciating too rapidly and stoking inflation. That sent the RRR up to an extremely high level of 21.5% in 2011 for the biggest banks, and kept trillions of yuan locked up at the central bank. Now, with the PBOC having to deal with the opposite problem – more capital outflows than inflows – it needed to bring down the RRR. However, fearful that cutting the RRR would send too strong a signal of easing and put pressure on the yuan to depreciate, the PBOC turned to other money-market instruments to manage liquidity and introduced tools such as the MLF. But these were temporary, targeted loans and needed active management where as the RRR is a permanent injection of liquidity into the financial system. So in one sense, cutting the RRR is merely a normalization of monetary policy to bring the RRR back down to a reasonable level.

The latest move brings the RRR for the biggest banks down to 14.5% and for smaller banks to 12.5%. That's still high, so we expect more cuts at a measured pace over the next year.

The PBOC also appears to be confident it can manage the potential pressure on the yuan to depreciate, pressure that is increasing given the trajectory of higher interest rates in the U.S. and slowing economic growth in China. The central bank is able to manage the currency in a variety of ways both onshore and offshore through intervention of state-owned commercial banks and raising short-term interest rates in Hong Kong to ward off short sellers. It has also tightened scrutiny of capital outflows. So we don't think the RRR cut will have much of an impact on the currency.

On the domestic front, the RRR cut appears to have several objectives. As with the three previous reductions this year, the move is aimed at encouraging more lending to cash-starved smaller companies and private firms to support economic growth. In its statement, the PBOC said more liquidity can help boost credit to small businesses, privately owned enterprises and innovative companies. This has been a long-standing priority for the government, and one which is becoming increasingly urgent amid signs of a deepening economic slowdown.

But we are not optimistic this latest RRR cut will do much to incentivize banks to lend to these companies. This is because the basic problem is not that the banks lack liquidity. As we've argued before, many of these smaller businesses are simply just too risky to lend to, and often lack adequate collateral. Furthermore, banks are still under pressure to reduce risk and clean up their balance sheets — they don't want to add more bad debt. On Sept. 28, Premier Li Keqiang said that banks should treat both private and state-owned firms equally. But facing the conflicting demands of de-risking and lending to more risky sectors, banks can be led to water with an RRR cut, but can't be made to drink.

That's not to say banks won't lend more, but it's likely to be marginal. Where the banks will benefit, however, is through a lowering of their own costs, which the PBOC hopes they'll pass on to business customers. Banks have to pay interest on their MLF loans and get virtually zero interest on their reserve-ratio deposits held at the PBOC. The logic is that repaying expensive MLF loans with funds released through an RRR cut will help reduce banks' interest costs which they will then pass on to borrowers through lower interest rates to support the real economy.

The RRR cut also gives banks more cash to buy local government bonds. The State Council and Ministry of Finance have told local governments to speed up bond sales to raise money to fund infrastructure and other investments. This is part of a pledge by the government to implement a more pro-active fiscal policy to shore up slowing economic growth. In an interview with the official Xinhua News Agency released on Sunday, Finance Minister Liu Kun said the government is studying more tax cuts on top of those already implemented this year, and is taking measure to help companies impacted by the trade war with the U.S. Banks are the biggest buyers of local government bonds so their firepower matters.

So, what's likely to happen next. The PBOC has reduced the RRR four times this year, and for the reasons outlined above, we think it may well not stop here. The need to keep normalizing monetary policy and ensure the financial system has adequate liquidity to shore up confidence and prevent too much stress amid the economic slowdown, means it's possible that more measured cuts will come.

China has been reluctant to move in lockstep with the U.S. Federal Reserve as the latter has raised interest rates. The Fed raised interest rates in December 2017, and in March, June and September this year. But the PBOC has only followed the Fed twice in the current cycle – in December and March. And even then, the PBOC only raised interest rates in the money market without increasing benchmark savings and lending rates. That's both a sign of caution amid slowing economic growth and also a reflection of the central bank's interest-rate liberalization policy which involves shifting benchmark interest rates to a system based on market rates rather than bank savings rates.

We think the chances are relatively high that the PBOC will actually cut money-market interest rates to help companies and banks lower their cost of funding and ease pressure on their debt burdens as the economy slows and trade war pressure intensifies. The latest manufacturing PMI surveys show weakening export orders and job shedding, and data to be released later this month is expected to show continued depressed growth in fixed-asset investment. The National Bureau of Statistics is due to release a deluge of data on Oct. 19 – third-quarter gross domestic product (GDP), fixed-asset investment for the first nine months, September retail sales and industrial output data. Any further move by the PBOC ahead of that date could indicate bad news is on the way.


Oct. 12: The General Administration of Customs releases trade data for September

The People's Bank of China may release money supply and total social financing data for September this week

The Ministry of Commerce may release foreign direct investment (FDI) data for September this week

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