PBoC makes a smart move
Jeremy Stevens
Last week, the People’s Bank of China (PBoC) cut the reserve requirement ratio (RRR) by 100 basis points (bps). This, the first cut since February 2016, is in contrast to tightening financial conditions in mature economies.
Some have, incorrectly, argued that the move implies that China will use credit as a countercyclical policy tool to smooth growth. But, put plainly, the move was (i) not about boosting overall lending, (ii) is consistent with de-risking the financial sector, and (iii) aims to ensure that the smaller banks have sufficient liquidity.
The RRR cut will inject CNY1.3 trillion into the banking system. The vast majority – some CNY 900 billion – will be used to repay medium-term lending contracts that are due on 25 April. The remainder will go to city and rural commercial banks for small business lending.
Granted, the cut reduces financing costs, substituting more expensive medium-term funding (currently 3.25% for one-year) with lower cost reserve requirement funds (currently 1.62%). That said, given the strong Q1 economic growth reported last week – GDP expanded by 6.8% y/y – the monetary policy focus isn’t on supporting the real economy.
In fact, a case can be made that on some metrics monetary policy will tighten in 2018. The resilient recovery in global economy is coexisting with monetary normalization actions across the major central banks. The PBOC is likely to follow this trend – albeit to a lesser degree. Even though the benchmark interest rate has remained unchanged since October 2015, it has already tightened twice in the past five months – most recently raising the seven-day reverse repurchase interest rate by 5 basis points, from 2.50% to 2.55%, in March.
These two, seemingly contradictory, moves are easy to misinterpret. However, note that the RRR is focused on bank funding. Financial de-risking remains front and centre of policy. Leverage at the corporate sector is not about to reverse the downward trend of the past four quarters.
Instead, the tightened financial regulation has put pressure on the funding sources, especially interbank borrowing, for small and medium banks. These smaller banks have been reporting for many months that reducing their reliance on interbank borrowing and other financial products (to supplement soft deposit growth) is proving near impossible.
Given that China’s RRRs are unusually high (at 17% for large commercial banks and 15% for smaller ones), a structural downtrend in RRR is a potentially potent tool to ease the funding environment. The latest move shows that the central bank will maintain the pressure on the banking sector but without overwhelming it. This is smart. We therefore expect more of these cuts throughout this year.
Related to this, the RRR cut aids interest rate liberalization. Cutting the reserve requirement ratio will force down market rates, thereby facilitating a liberalization of deposit rates.
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