Caixin View: Reserve-Ratio Cut Has More Targets Than Lending

China’s banking system got a welcome New Year gift from the People’s Bank of China (PBOC) last week in the shape of a two-stage cut to the reserve requirement ratio (RRR), the percentage of deposits lenders have to set aside at the central bank, which can’t be used for lending — one 50 basis-point reduction on Jan. 15 and another of the same magnitude on Jan. 25. Yes, this should help bolster lending and economic growth, but there are other factors at play, including the PBOC’s efforts to restructure its liquidity management.

Unlike some of the PBOC’s previous RRR cuts, this one has a few strings attached — of the 1.5 trillion yuan released by the two reductions, a portion must be used by banks to repay loans maturing under the Medium-Term Lending Facility (MLF) in the first quarter, leaving a net liquidity injection of 800 billion yuan into the financial system, according to the PBOC. The changes will lower the RRR of large banks to 13.5% and that of smaller banks to 11.5%.

Adding liquidity to the financial system before China’s Lunar New Year holiday, which falls in either January or February each year, is not unusual. Demand for cash surges at this time of year as companies pay out year-end bonuses to staff, migrant workers get paid before trekking home for the annual holiday, and families splurge on food, leisure, travel and holiday gifts (mostly cash). In late December 2017, for instance, when it was still in tightening mode, the PBOC allowed some banks to temporarily lower their RRR by up to 2 percentage points for 30 days in the run-up to the festival in February 2018.

This latest RRR cut alone won’t be enough to satisfy seasonal demand — we estimate there is about a 1 trillion yuan liquidity shortfall for January through the Spring Festival period which ends in mid-February. More money will therefore likely be released in the next few weeks via daily open market operations and the MLF.

This year there’s the added urgency of supporting the real economy in the face of slowing growth and the deepening impact of the trade war with the U.S. The politburo, at a meeting in December, signaled greater efforts to support jobs, trade and investment this year to maintain economic growth in “a reasonable range.”

Economic headwinds

In an effort to downplay any overenthusiastic headlines about stimulus, the PBOC said the RRR cut "should be seen as a targeted adjustment, as opposed to flooding the financial system.” But it’s increasingly clear that lowering the ratio is going to play a role in providing support to the economy this year, especially when it comes to providing funds for smaller businesses.

Last year saw four RRR cuts in the face of economic headwinds, with one targeted specifically at boosting lending to small businesses. With growth challenges even more pronounced this year, we believe there could be a similar number of moves.

The PBOC is also tweaking banks’ eligibility for targeted RRR cuts to release more funds for lending to small companies. Last week, it relaxed the criteria banks need to meet for small business loans to qualify for a cut in the ratio.

But as we have said before, using the RRR as a tool to target more lending to small companies isn’t necessarily effective. Banks still have few incentives to lend to small, risky companies, many of which lack collateral. And with banks still under pressure to clean up their balance sheets, they don’t want to add more bad debt. More fiscal support for smaller businesses in the form of promised tax and fee cuts this year could be more helpful in the long run.

Looking beyond the headlines of the RRR cut, we think the move has other important aims. First, it should be seen in the context of more structural, long-term changes in the PBOC’s liquidity management. 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 a peak of 21.5% in 2011 for the biggest banks.

In the last few years, with the decline of China’s current account surplus, the PBOC has had to deal with the opposite problem — more capital outflows than inflows. 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. The MLF has ballooned in the last few years, peaking at 5.38 trillion at the end of September 2018. But the facility only provided temporary injections of liquidity, with loans carrying maturities of three months to one year, requiring the PBOC to actively manage it.

It’s now fairly evident that the days of surging capital inflows are long gone and that to replace the lost liquidity and to support the economy, the PBOC now needs to unwind the MLF and replace it with permanent releases of liquidity through RRR cuts. The outstanding MLF on the PBOC’s balance sheet is already coming down — it stood at 4.93 trillion yuan at the end of December.

We believe that several more RRR cuts are likely this year as part of the PBOC’s normalization of liquidity management and as part of government policy to support lending and economic growth.

Deluge of bonds

Second, it shouldn’t be forgotten that banks are by far the biggest buyers of local government bonds — some analysts estimate they hold as much as 80% of their outstanding debt. Consequently the PBOC will want to make sure that lenders have plenty of cash available to mop up an expected surge in issuance this year as fiscal spending increases to support flagging growth.

Although we won’t know until March what the local government bond quotas will be for 2019, initial signs are that they will be much bigger than they were in 2018. In addition, local governments will be able to start using their quotas far earlier than usual after the Standing Committee of the National People’s Congress passed a bill allowing them to issue 1.39 trillion yuan ($202 billion) worth of bonds before the legislature officially approves the 2019 quota in March. The amount is about 64% of the 2018 quota set by Beijing for new issuance of local debt and is likely to be issued in the first quarter.

Regulators have been preparing the ground for allowing banks to buy more local government bonds for months through a series of measures including scrapping restrictions on purchases by banks who underwrite bond sales. There are also plans to reduce the risk weighting lenders need to attach to local government bond holdings to zero from 20%, making it more attractive for banks to buy the debt because it won’t affect their capital adequacy ratio.

Third, reducing the use of the MLF by cutting the RRR will also help support bank profitability at the margins. Banks have to pay interest on their MLF loans at up to 3.3% and earn virtually zero interest on their reserve-ratio deposits held at the PBOC. This means repaying expensive MLF loans with funds released through an RRR cut will help reduce banks’ interest costs, which they could pass on to borrowers in the form of lower interest rates or keep the benefit and boost their net interest margin, a key profitability metric for investors.

Given the advantages of cutting required reserves to almost everyone and the still-high level of the ratio on a historical basis, we expect the PBOC to continue lowering the RRR this year not only to support growth, but to normalize its liquidity management and operation of monetary policy.