When the People’s Bank of China (PBOC) cut its reserve requirement rate (RRR) by 1% for China’s banks recently, the central bank said its “prudent and neutral policy stance” remained in place, since the overall quantity of excess reserves would not change much. Indeed, the PBOC will maintain a relatively high reserve requirement for China’s banks.
Still, the move caused China’s entire yield curve to drop by 15 basis points (bps) and raised interesting questions about the PBOC’s policy intent.
We believe the action sent an important signal that China’s policymakers will be careful not to overtighten ahead of an expected growth slowdown in 2018. Although it is too early to call this the beginning of an easing cycle, the RRR cut confirms the end of 18 months of continuous liquidity tightening by the PBOC, and thus makes the PBOC’s policy stance not only more neutral but also more flexible.
Lower reserve requirement: a form of monetary easing
Announced on 18 April, the PBOC’s cut lowers the reserve ratio for large Chinese banks to 16% from 17%, effective on 25 April.
According to the PBOC, the 1% reduction will release CN¥1.3 trillion ($206 billion) in excess reserves. While the PBOC will require banks to use the funds to repay CN¥900 billion to its mid-term lending facility (MLF), the remaining CN¥400 billion in reserves will be released to the banks, with the goal of increasing loans to small companies, in particular.
Effectively, this is a loosening of monetary policy by the PBOC. The impact on interbank funding costs are clearly accommodative; banks currently pay an annual rate of 3.30% to borrow from the PBOC’s one-year MLF, so the release of CN¥1.3 trillion in deposit reserves (the PBOC pays 1.62% on required reserves and 0.72% on excess reserves) will lower interbank borrowing costs. We estimate wholesale funding costs should drop by 15 bps – 20 bps after the RRR cut. So the market’s knee-jerk reaction of driving down the yield curve in the days after the announcement was in line.
Tighter conditions no longer needed
For Chinese policymakers, the incentives to avoid further tightening financial conditions are increasing.
First, China’s hard economic data have been mixed so far this year. Although headline GDP growth of 6.8% in the first quarter was in line with market expectations, credit growth slowed further and the property market cooled, indicating that growth has peaked and is slowing toward the official GDP target of “around 6.5%” for 2018, with some downside risks.
Also, while China’s focus on curbing systemic debt risk will remain at the top of its agenda, smooth deleveraging via further regulatory curbs on the shadow banking system require stable wholesale liquidity markets. So policymakers will likely act at a measured pace to avoid any hawkish policy errors.
Currently, Chinese policymakers are focusing on trade negotiations with the U.S. Rising uncertainty on trade could be seen as a potential macro headwind warranting some pre-emptive policy protection; the synchronized global trade recovery has been a key support to China’s sustained growth over the past 12 months.
It remains to be seen whether the PBOC has actually ended its interest rate hiking cycle. PBOC Governor Yi Gang has explicitly stressed the need for China to maintain an interest rate differential with the U.S. of around 80 bps – 100 bps and a stable yuan as the Federal Reserve raises U.S. policy rates. But with the new cut in reserve requirements, the PBOC may have already made a stealthy policy shift to a more neutral stance that offers flexibility going forward.
For more on China and our macroeconomic view, please see our Cyclical Outlook, “The Beginning of the End.”
Isaac Meng is an emerging markets portfolio manager with a focus on macroeconomic and financial analysis of China. He is a frequent contributor to the PIMCO Blog.