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Impact Of China 0.5% RRR Cut Is Equivalent To RMB 630 Billion Liquidity Injection, Goldman Finds

To say that the PBOC is confused at this moment is a very big understatement: on one hand, yesterday the PBOC moved its reference rate for the yuan outside the daily trading band for the first time in 21 months, forcing the currency to strengthen as authorities seek to limit volatility in capital flows. And then just hours later, as reported first thing this morning, the same PBOC announced its broad RRR cut - the first one since May 2012 -  an attempt to ease ongoing, and thus tightening, capital outflows, and pushing the currency lower in the process. In short: unlike other central banks who hope that institutional and retail investors figure out their FX intentions and help them out by "frontrunning" their moves (which may never come) in what is now a clear and global currency war, China is certainly not making it easy for FX traders to figure out what will happen next.

However, when it comes to the actual RRR-cut, there is little confusion: the impact of the PBOC's latest action is the functional equivalent of a roughly RMB 630 billion liquidity injection as Goldman has calculated.

The rest of Goldman's take below:

PBOC cut RRR on accumulating signs of weakness in the economy; more easing measures likely to follow in the coming months

PBOC just released an announcement that it will lower RRR (reserve requirement ratio) for all financial institutions by 50 bps, effective February 5th (Thursday), which is in line with our expectation. In addition to the broad cut, an additional 50bp targeted RRR cut has been announced for city and rural commercial banks with sufficient exposure to SMEs, and the RRR for Agricultural Development Bank will be lowered by 450 bps. This is the first broad RRR cut since May 2012; the most recent (targeted) cut was in June 2014.

The total implied liquidity injection is about 630bn RMB, by our estimates: the overall 50bp cut implies around 570 bn RMB, and targeted cuts involve roughly 10% of deposits, accounting for roughly another 60bn RMB.

The main rationale for the cut was likely the accumulating signs of weakness in the economy which include:

  1. official and HSBC manufacturing PMI data both weak at sub-50 level,
  2. industrial profits data fell from -4% to -8% in December,
  3. falling CPI and PPI inflation which indicate deflationary risks (it is not clear if the government has seen the official reading of the January CPI already, but we expect a drop to 1% yoy, the lowest reading since the GFC),
  4. significant FX outflows which have contributed to tighter domestic liquidity conditions, and
  5. NPL and default concerns.

Many of these were contributed by tight financial conditions as a result of elevated real interest rates and rapid appreciation of the REER. The softer equity market performance in recent days likely made this decision easier too, as the November-December run-up was probably viewed as excessive by policymakers.

The move will release a significant amount of liquidity which will help to ease financial market tightness. Equally important it sends a very strong signal of policy loosening. A full RRR cut is generally viewed as the most blunt tool in the monetary policy tool box. This will provide a boost to confidence which is likely positive for short term demand growth, and should also help reduce the risks of a protracted period of undesirably low inflation. We expect the 7-day repo rate to ease back down, perhaps to the 3.6%-3.8% range based on behavior following previous RRR cuts. Both the repo rate fix and CNY fix will be important clues to potential further moves and policymakers’ intentions.

We expect further moves in the coming months, as Chinese policymakers often ease along multiple dimensions simultaneously:

  • More RRR cuts are likely. With policymakers having demonstrated a willingness to use broad RRR cuts, we expect to see more, though the next may come with a significant lag (likely Q2). If the government wants to offset the effects of FX outflows on domestic liquidity, another 50-75bp per quarter will be needed (by our rough estimate).
  • With inflation falling there is also a case to lower benchmark interest rates to bring down high real interest rates. The last cut in November was asymmetric (a bigger cut in lending rates than deposit rates), although we don’t think that would necessarily be the case again. The timing of any benchmark rate cut will be data-dependent, but a cut before the end of the quarter is quite possible.
  • The government may allow the CNY fix to depreciate against the USD to ease pressures on exports growth, though we have only a very modest move (to 6.20 on a six-month horizon) in our baseline. A widening of the CNY band to ease the currency (under current circumstances, the spot would probably trade quickly towards the weak side of the band) is a real possibility but is not our baseline at this point.
  • Finally, other administrative measures supporting the property sector and infrastructure investments are also often used to as a part of the broad package.

* * *

So while China is worried about capital outflow and a declining Renminbi, it appears to be even more worried about the stock of liquidity within China's banking system. It remains to be seen which concern will prevail.

For now, however, the market is delighted no matter the final outcome:

China's 700 pt rip-roaring 5-minute rally up close

pic.twitter.com/VdlXnEFDE1

— Eric Scott Hunsader (@nanexllc)

China's monster rally was sparked down under by Australian $, which sparked world-wide reaction: pic.twitter.com/yCI1Oj41Gl

— Eric Scott Hunsader (@nanexllc)