China’s Nervous Bank Reserve Cut

By | March 1, 2016

Serious Firepower
China surprised the markets Monday by cutting the Required Reserve Ratio by 0.5 ppt, injecting Rmb 700 billion into the market. This was a desperate measure. There are several reasons why the PBOC chose to do this now.

1) Short Term Injections Too Expensive. The PBOC had been relying on Short and Medium Term loans to the banks. They cost 0.6 to 1 ppt more than ordinary reserve deposits. The banks already are suffering from margin squeeze and rising NPLs. They can’t afford further reductions in profits.

2) Zombie Loans. Total system debt tops 300% of GDP. Many loans are to “Zombie” companies for which the government and various political actors would be too embarrassed to allow to fail. Rolling over even a portion of these loans requires massive liquidity — hence the RRR cut.

3) Capital Flight Pressure Eased? Capital flight continues to create monetary shortages domestically. With China’s forex dropping about $100 billion per month, the liquidity shortage is becoming acute.

4) Biggest Available Pool of Capital. This is the most important argument. The leadership already has used up the available pools of capital. These include: a) The stock market (an abject failure); b) Policy bank injections (about Rmb3 trillion); c) Local Bond Swap (3.2 trillion which only partly replaced debt and thus was stimulative, apart from also reducing interest costs for local governments; d) Insurance Firms (Rmb1 trillion mainly invested in local government projects and real estate).

5) Replace Bank Investments. The banks already have put an estimated Rmb8 trillion into investment products, in addition to loans. These are highly stimulative as they are direct purchases of corporate financial instruments. The banks can’t do too much more of this as they weaken the balance sheet.


Currency Devaluation is the Next Step

The banks have more than Rmb 20 trillion locked into the PBOC in reserves; what political leader can resist a cash pool this large? That’s why Zhou Xiaochuan at the PBOC and the State Council are tapping this pool of capital. But the reserves won’t last forever. As capital continues to leave the country, the PBOC will have to lower RRR several times. As political economist Victor Shih has noted, ” However with average monthly outflows,measured by banks fx sales, at 65 bln rmb, the rrr cut counteracted 1.5 months in high power money drainage.

At some point, probably when the RRR approaches global levels of 10% to 13% (lower than the existing 17% in China), the bank will have to face the music and do another significant devaluation of the currency. There’s no way around that.