China’s monetary policy loosening is a sign that the central bank is gearing up for a fight
Aidan Yao says the People’s Bank of China looks set to do some heavy lifting in the coming months and investors can expect tough times ahead
The People’s Bank of China’s decision to cut the reserve requirement ratio by 50 basis points suggests the central bank has finally started to fine-tune monetary policy in response to growing pressure on the economy and rising risks to financial stability.
The reserve requirement ratio cut will release around 700 billion yuan (US$105.1 billion) of liquidity into the banking system. While the size of the cut was half of that in April, the net liquidity injection will be almost twice as large, as the previous reduction was used partly to offset the maturity of the central bank’s medium-term lending facility loans.
The latest cut sends a much clearer signal that the central bank is prepared to safeguard the economy against rising internal and external risks. This is curiously reflected in the timing of both the announcement on June 24 – merely one week after the soft economic activity data in May – and its implementation on July 5, one day before the first batch of US tariffs is supposed to go into effect.
Fundamentally, some monetary easing is warranted at the moment, as the overall conditions in China have become suffocating for growth. The tightening effect of deleveraging and new asset management rules have led to a persistent decline in the growth of M2, a broad measure of money supply, while the shrinking of shadow banking credit has driven down total social financing.
Overall, monetary conditions have become much tighter than the “neutral” setting desired by the central bank.
Given that the economic slowdown is partly policy driven, some easing of liquidity to counteract the tightening effect from other policies is clearly justified, as economic and financial market stress becomes apparent.
But while past reserve requirement ratio cuts were unconditional liquidity injections, the latest move has strings attached insofar as how banks can use this windfall of cash.
The central bank has designed the cut so that the liquidity is “encouraged” to support corporate deleveraging and lending to small and medium-sized enterprises (SMEs).
In particular, the 500 billion yuan unleashed to large banks is earmarked to support the debt-to-equity swaps programme, which has progressed sluggishly since its debut in 2016, due to a lack of enthusiasm from banks amid concerns over capital erosion.
The remaining 200 billion yuan will be disbursed to small and rural banks for them to lend to SMEs. The latter have suffered disproportionally from the shrinking of shadow banking credit, leading some companies to default on their bond payments lately.
It’s worth noting that a number of previous reserve requirement ratio cuts were guided to support SME lending too, albeit with unsatisfactory results. The fact is that, once the liquidity is out of the central bank and into commercial banks, it is entirely up to those banks to decide to whom they want to lend.
SMEs, given their smaller sizes and often lack of quality collateral, are riskier bets that banks try to avoid, particularly during an economic downturn.
Looking ahead, the latest cut is only the beginning, not the end, of policy fine-tuning to foster macro stability. With domestic growth facing stronger headwinds and external conditions turning less supportive, both monetary and fiscal policies should be deployed to safeguard the economy. This is particularly true if Beijing continues to press ahead on deleveraging and local government debt consolidation.
Further cuts to the reserve requirement ratio are expected – at least one more in the second half of the year is likely – while the fiscal authorities step up on-budget spending to put a floor on infrastructure investment growth. Beijing’s “policy put” remains in place to ensure the economy achieves its 6.5 per cent growth target this year.
One wild card is the currency, which has reacted significantly to the diverging growth and interest rate paths between China and the US. The latest reserve requirement ratio cut, to the extent that it signals the central bank’s willingness to ease policy, has exacerbated the depreciation pressure on the renminbi since its announcement.
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Although a weaker currency can help China counter the potential effects of tariffs, Beijing will have to carefully monitor the side effects of a rapid depreciation on capital flows and asset prices. If the recent foreign exchange moves continue and start to threaten financial stability, Beijing may have to take precautionary measures by either intervening in the market and/or tightening capital controls.
In that environment, the central bank may also refrain from cutting the reserve requirement ratio, to avoid sending a too-strong easing signal. Instead, it may resort back to short-term liquidity measures. Fiscal policy could also be tapped for more heavy lifting for the economy, as in 2016-2017.
All in all, investors need to be prepared for tougher times in the second half of 2018.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers