Background to China's Cut in Banks' Reserve Ratios

(This commentary was written for the Shocks & Surprises Global Weekly Summary before the announcement of Monday's cut in reserve ratios. It has not been altered, because it gives what I believe is useful background to that decision.)

If Chinese monetary policy is to be continued consistently in the practice of the last few years, an early policy relaxation achieved by cutting banks’ reserve requirement ratio is to be expected, with each 1 percentage point cut gifting banks approximately Rmb 1.25tr in deposits available for lending, but probably also draining money from government bond markets in similar amounts.
Just as reserve ratios were raised to limit the monetary consequences of the huge inflow of capital during the last eight years, so now as capital exits China (despite a frenzied stockmarket boom), banks’ liquidity needs boosting.

The week’s economic data leaves no room for doubt that the economy continues to weaken: early in the week it was revealed that March’s exports fell 15% yoy, cutting the month’s trade surplus to just US$3.1bn.  Later came the news that M1 growth had slowed to 2.9% yoy and M2 growth to 11.6% in March, and that aggregate new financing was weaker than expected at Rmb1.18tr. Still later, there were disappointments for industrial production (up just 5.6% yoy), for retail sales (up just 10.2% yoy) and for urban investment (up just 13.5% yoy ytd).  Taken together they reveal that the underlying loss of momentum intensified, perhaps dangerously, in the industrial sector, in domestic demand, and in monetary conditions.

The fact that 1Q GDP growth was reported to have slowed only very modestly, to 7% yoy, was undercut by the fact that nominal GDP growth had slowed to just 5.8% yoy. Worse, when one excludes the positive impact of a 1Q trade surplus equivalent to 5.4% of GDP, the resulting nominal domestic demand growth slumped to just  0.9% yoy (or 5.3% on a 12ma).

Consequently, policy-loosening is needed, and soon. What form should it take? When in early February PBOC cut reserve ratios, it it claimed the cut was to offset capital outflow, rather than open the gate for monetary easing. As the chart shows, this was China’s consistently applied policy between 2007 and the middle of 2013: as China’s reserve rose from US$1.1tr in January 2007 to US$3.55tr by July 2013, so the reserve ratios required of banks rose from 9.5% of deposits to 20% of deposits. During periods when the reserves build-up slowed or faltered in 2H2008 and again in 2011-2012, PBOC responded by cutting RRRs.

So far, however, it has not responded significantly to the far sharper falls in reserves seen during the last six months. In 3Q14 reserves fell by US$106bn, in 4Q14 they fell by a further US$45bn, and in the first three months of 2015 they fell by a further US$113bn.  1Q’s fall is the most worrying, since it indicates a heavy flow of capital out of the country. During 1Q, we know that China recorded a trade surplus of US$123.8bn, and that it attracted US$38.4bn in FDI whilst overseas direct investment out of China came to US$25.8bn - these flows add up to a net inflow of US$136.4bn. However, we know that foreign reserves fell by US$113bn, which means that the combination of the balance of services and net capital movements produced a deficit of US$249.4bn.  This is an extraordinary development, given the background of surging domestic stockmarkets, which one would normally expect to attract capital into China.

One explanation has it that the capital has merely migrated to Hong Kong in order to capture the profits from arbitraging between the different stockmarket prices of A-shares in China and Hong Kong. No-one doubts that this arbitrage has been enthusiastically pursued, but since Hong Kong’s foreign reserves rose only US$3.7bn during 1Q, such investment cannot be more than a footnote in the larger story of capital flight from China.

Now let us look at the impact these capital outflows have made on the cashflows of China’s banking system, counted as the change in deposits minus the change in loans. In this analysis, we also have to include one other policy initiative - the widening of the definition of deposits made in January 2015 which added approximately Rmb8.3tr to January’s deposit total. For the purposes of the chart below, these are excluded.

The chart shows how successful this flexible movement of reserve ratios has been in muting the financial repercussions of China’s foreign exchange build-up - typically during the heavy inflow years it halved banks’ net cash inflow, whilst in 2011 it engineered a genuine liquidity tightening.  However, it also shows that the huge capital outflows from China during the last year has completely changed banks’ cashflow situation: before changes in reserve ratios, the picture changed from a net cash inflow of Rmb2.02tr in the 12m to March 2014, to a net outflow of Rmb3.52bn in the 12m to March 2015. 

With PBOC having cut RRRs so far by only 50bps, the situation is hardly improved: the net cashflow moves from a Rmb214bn shortfall in the 12m to March 2014, to a Rmb4.395bn shortfall in the 12m to March 2015. Still, at this point, every percentage point cut in RRRs would free up approximately Rmb 1.25tr, potentially available for lending. 

It is in this context that the widening of the definition of deposits, which resulted in a book entry inflow of an estimated Rmb8.3bn deposits in January, and a positive cashflow for that month of Rmb 6.53bn, becomes so crucial. Looked at in the light of the pressure capital outflow is putting on China’s bank liquidity, this re-definition looks like a useful holding tactic of a central bank hoping to avoid significant cuts in RRRs (perhaps because of the negative impact cuts would make on government bond markets?).  If capital outflows continue to pressure banks’ cashflows - and it's difficult to believe it won’t, given the deterioration in China’s economic data - more and deeper cuts to reserve requirements will be expected and needed.