China Flash:China cut RRR,Beginning of the beginning

Another positive surprise for the market: The PBoC announced a cut inthe Reserve Requirement Ratio (RRR) of 50bps. This would bring the RRR to19.5% for larger banks and 17.5% for smaller banks. The PBoC also madeadditional RRR cuts for qualified banks to support SMEs, agriculture andinfrastructure projects. To the market, the cut is an unexpected but excitingmove, as investors had been disappointed by the absence of an RRR cutfollowing last Nov’s rate cut. It’s also the first time the PBoC has made abroad RRR cut since May 2012. We estimate that the cut would releasearound RMB600bn of loanable funds into China’s banking system.

Why the cut More importantly, the cut is meant to compensate for theshortfall in capital inflows. Compared to 2013, FX purchased by China’s banksfell by RMB2tn in 2014 (Left Chart). Such a slump in capital inflows, alongwith contracting shadow banking lending, caused tight liquidity conditions lastyear (for more details, see the liquidity section in Nine lessons from 2014, 8Jan 2015). In 2014, the PBoC stuck to targeted easing, which turned out notto be very effective. The rate cut last Nov and the RRR cut today suggest thatthe PBoC is changing its mind. As such, we expect more cuts. Specifically, wereiterate our view that China will cut the RRR four times and interest ratestwice in 2015. The next move is likely to be a 25bp interest rate cut after theCNY holidays, given the weak economy and price disinflation.

Policy mix: Stable currency + loose liquidity. At this stage, given the weakeconomy and capital outflows, we believe the most likely policy mix to beadopted by the PBoC is a stable exchange rate and accommodative monetarypolicy. Specifically, we expect the PBoC will continue to resist the temptationto depreciate the RMB sharply, in order to stabilize capital outflows (Don’tworry about RMB, 30 Jan 2015). In addition, it is likely to use variousmeasures including today’s RRR cut to keep liquidity ample, in order to meetthe liquidity spike around the CNY holidays and support the real economy.

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

Long term outlook: At least 20 RRR cuts ahead! RRR in China was only7.0% a decade ago. During the go-go years of global imbalances, a hugeamount of money flew into China. In response, the PBoC raised the RRR 19times between 3Q06 and 2Q08, then 12 times between 1Q10 and 2Q11.Given muted capital inflows in recent years, the course is reversing now. Inthe next five years, we believe there would be at least 20 RRR cuts (50bpeach) and the RRR will be lowered to below 10%, which is still too highcompared to countries, many of which have zero RRRs nowadays. From astructural point of view, we find it a shame that RRR cut are seen by some aspolitically incorrect - an indicator of turning on the monetary taps. In our view itis just a normal monetary policy tool, which should be lowered on fallingcapital inflows.