The 50bp reduction in China’s reserve requirement ratio (RRR), effective on 5 February, is less of a policy easing than it appears, says Fitch Ratings. The measure compensates almost exactly for liquidity destroyed by cross-border capital outflows during 2014. Accompanying targeted-easing measures are in line with the authorities’ practice in this easing cycle, going back to 3Q14. Latest data from the State Administration of Foreign Exchange (SAFE) indicates that net capital outflows in 2014 totalled USD96bn (CNY575bn).
We estimate the 50bp RRR cut by the People’s Bank of China (PBOC) to release around CNY570bn into the economy. Therefore, the liquidity effect of the broad-based RRR cut roughly balances out against the impact of capital outflows. Also notable is the PBOC’s continuing with targeted-easing measures to lower borrowing costs in certain sectors of the economy, on top of the broad-based easing. The PBOC announced an additional 50bp RRR cut for smaller financial institutions focused on micro enterprises and agricultural lending, as well as a 400bp RRR cut for the Agricultural Development Bank of China (ADBC).
We expect these measures to release approximately CNY101bn (USD16bn) in liquidity – CNY85bn for the smaller institutions and CNY16bn for ADBC. The measure follows further evidence that the economy is slowing. The official manufacturer Purchasing Manager Index (PMI) dropped below 50 in January (49.8).
A move in this series below 50 coincided with the previous phase of RRR reductions beginning in November 2011. The non-manufacturing PMI also dropped in January to 53.7. This is the weakest reading since April 2009, barring a single month in January 2014. The authorities’ reluctance to reduce RRRs or otherwise loosen policy more aggressively reflects awareness of the risks to systemic stability from rapid credit growth. Fitch expects the authorities will continue to engage in targeted-easing measures to maintain growth at a rate of about 7% over 2015. However, RRRs may be reduced further if substantial net capital outflows continue.
Evidence that the authorities were abandoning their focus on rebalancing the economy and resorting to very aggressive monetary easing to sustain growth would be negative for Fitch’s assessment of systemic stability – and, therefore, for sovereign and bank credit profiles. Conversely, signs that the economy can grow at an acceptable rate (from the perspective of social and political stability) without reliance on sharply rising debt, would boost confidence that China can manage its debt problem. Structural reforms which would help to develop economic activities less reliant on credit are key for China to rebalance its economy.
For the banking sector, the RRR cuts should result in a higher reinvestment yield which will alleviate some pressures on net interest margins. However, Fitch estimates the positive earnings impact at only around 1%. Furthermore, uncertainty remains as to whether the recent easing measures by the PBOC (including the earlier rate cuts in November 2014) will actually result in increasing credit to targeted sectors, such as small and micro enterprises. If banks utilise the monetary loosening to continue expanding credit in sectors which are already highly leveraged, it would exacerbate vulnerabilities in the system and be credit negative.