China’s central bank cut the required reserve ratio (RRR) for its banks as it stepped up efforts to counter the impact of capital outflows and encourage banks to boost lending amid fresh data showing a weakening economy.  With the news, Macquarie Equities Research (MER) released a report late Wednesday (04/02/15) on the impact.  Excepts of the report can be found below…
 

• Another positive surprise for the market: The People’s Bank of China (PBoC) announced a cut in the (RRR) of 50bps. This would bring the RRR to 19.5% for larger banks and 17.5% for smaller banks. The PBoC also made additional RRR cuts for qualified banks to support SMEs, agriculture and infrastructure projects. To the market, the cut is an unexpected but exciting move, as investors had been disappointed by the absence of an RRR cut following last Nov’s rate cut. It’s also the first time the PBoC has made a broad RRR cut since May 2012. MER estimates that the cut would release around RMB600bn of loanable funds into China’s banking system.

• Why the cut? More importantly, the cut is meant to compensate for the shortfall in capital inflows. Compared to 2013, FX purchased by China’s banks fell by RMB2tn in 2014. Such a slump in capital inflows, along with contracting shadow banking lending, caused tight liquidity conditions last year. In 2014, the PBoC stuck to targeted easing, which turned out not to be very effective. The rate cut last Nov and the RRR cut today suggest that the PBoC is changing its mind. As such, MER expects more cuts. Specifically, MER reiterates its view that China will cut the RRR four times and interest rates twice in 2015. The next move is likely to be a 25bp interest rate cut after the CNY holidays, given the weak economy and price disinflation.

• Policy mix: Stable currency + loose liquidity. At this stage, given the weak economy and capital outflows, MER believes the most likely policy mix to be adopted by the PBoC is a stable exchange rate and accommodative monetary policy. Specifically, MER expects the PBoC will continue to resist the temptation to depreciate the RMB sharply, in order to stabilize capital. In addition, it is likely to use various measures including today’s RRR cut to keep liquidity ample, in order to meet the liquidity spike around the CNY holidays and support the real economy.

• Positive for both bond and stock markets: The RRR cut would increase liquidity supply in the interbank market, and thereby benefit the bond market. Probably more importantly, today’s cut will rekindle expectations on further policy easing. As a result, risk appetite should increase, prompting more money to flow into the equity market. Usually with such macro policy moves, large caps tend to outperform smaller ones. Banks in particular will benefit from the cut of RRR, which is essentially a tax on banks (the PBoC pays a lower rate on bank reserves than banks’ funding costs).

• Long term outlook: At least 20 RRR cuts ahead! RRR in China was only 7.0% a decade ago. During the go-go years of global imbalances, a huge amount of money flew into China. In response, the PBoC raised the RRR 19 times between 3Q06 and 2Q08, then 12 times between 1Q10 and 2Q11. Given muted capital inflows in recent years, the course is reversing now. In the next five years, MER believes there would be at least 20 RRR cuts (50bp each) and the RRR will be lowered to below 10%, which is still too high compared to countries, many of which have zero RRRs nowadays. From a structural point of view, MER finds it a shame that RRR cut are seen by some as politically incorrect - an indicator of turning on the monetary taps. In MER’s view it is just a normal monetary policy tool, which should be lowered on falling capital inflows.

Source: Macquarie Research - 6 Feb 2015