Liquidity is the real risk

China’s central bank has cut the reserve requirement ratio (RRR) twice in the last three months, and four times this year. The latest cut was the largest, at 100 basis points. Is this a shift to the PBOC’s “prudent and neutral” monetary policy stance? We are not convinced that the move aims to stimulate lending. And, even if so, a widespread acceleration in credit is unlikely because of the continued crackdown on non-bank financial institutions and the difficulties facing smaller banks.

The most reasonable interpretation is that the central bank rightly recognizes that the real risk facing the financial system is liquidity due to the ongoing de-risking campaign. Therefore, the central bank is (i) ensuring ample liquidity via reserve requirement cuts, and (ii) encouraging banks to continue to make use of longer-term funding sources. Already back in June, the PBoC’s deliberately altered its language around liquidity, saying that it would keep liquidity reasonable and “abundant”. Before this, the commitment was to keep liquidity “stable”.

The timing of this cut is not surprising given the high volume of medium-term lending facilities (MLF) maturating in the next few months and tax payment season being this month, both of which will drain liquidity. In fact, expiring MLF contracts alone will absorb nearly half the CNY1.2trn incremental addition to liquidity. Furthermore, the central bank anticipates an uptick in local government bond issuance this month and next, which banks are expected to buy.

Beijing is no doubt deeply uncomfortable with the confluence of the deteriorating external environment and the domestic economic slowdown. Also back in June, the PBoC was clear about watching closely how the trade war might negatively affect China’s already softening growth profile. And, of course, news flow since has become ever more concerning. Still, the central bank understands that more liquidity won’t necessarily lead to faster credit growth.

Indeed, we’ve not thus far yet seen any acceleration in lending growth. Total social financing (TSF) increased 1.04 trillion yuan in July, of which new yuan loans increased CNY1.29 trillion, while three shadow banking items, namely trust loans, entrusted loans and bank acceptance bills, declined by CNY488.6 billion. Year-to-date, TSF has increased by CNY9tr – down 27% y/y. At this juncture, commercial banks would rather hold extra reserves than lend money to the real economy; by the end of Q2:18, after three cuts the RRR, commercial banks still held 1.74% of extra reserves in the central bank. Another concern is that depressed credit growth also puts pressure on deposit expansion. Deposit growth expanded by a record low 8.3% y/y in August, from just 8.5% in July.

We expect another100 bps cut to RRR by year-end. Meanwhile, the PBoC is likely to tolerate further CNY devaluation. The risks facing the Chinese economy are tilted to the downside. The internal and external headwinds, and how they may play out, will likely shake China’s capital markets.

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