China bank reserve cut deepens divergence

A clerk counts Chinese currency Image copyright AP

China has just cut its reserve ratio requirement (RRR) - the amount of cash banks have to hold as reserves - by 0.5% to 19.5%, in the first industry-wide move since 2012.

This follows cuts in its benchmark interest rates in November, which was also the first cut since 2012.

China's move further widens the divergence in rates among major economies, as the US and UK are expected to move towards "normalisation" of rates.

Stimulus measures

In other words, raising interest rates for the first time since the financial crisis is on the cards for these economies, while other central banks enter an easing cycle.

China seems to be joining the latter group that also includes the European Central Bank embarking on cash injections or quantitative easing for the first time next month and the Bank of Japan raising the amount of their QE for this year and beyond.

Others also easing include Australia, which cut rates to a record low 2.25% on Tuesday, in the first move in 18 months.

For China, the economy isn't as dire as the eurozone's or Japan.

But, its GDP growth of 7.4% last year missed its 7.5% target, and projections going forward see growth slowing further to potentially below 7%. The World Bank even sees India outpacing China within the next few years.

The concern of growth slowing too sharply has triggered this round of easing. The property market also seems to be cooling, and prices may be dropping too much, which opens up more room for the People's Bank of China (PBOC) to ease monetary policy.

Image copyright Reuters

Money management

Besides, the RRR is very high still - banks have to set aside nearly one-fifth in reserves. The PBOC will hope that easing reserve requirements will mean more lending, since cutting rates in November didn't boost lending as expected.

In December, new loans came to 697.3bn yuan, which was considerably less than the 852.7bn expected. Worse, the residual portion of credit attributed to shadow banking rose to the highest in nearly a year.

The latest figures for M2, the monetary aggregate, grew by 12.2% in December, which was also below expectations. This is despite the government having cut reserve requirements for selected banks and urging them to lend to small enterprises and in rural areas.

Plus, money is leaving China. Their considerable foreign exchange reserves fell for the last six months of 2014, to $3.84 trillion.

Greater capital account opening, which has been a key reform alongside the internationalisation of the RMB, though, means that it may be harder for the PBOC to manage the money supply since cash can now leave more easily than before.

It's still not completely open and the yuan isn't freely convertible, so monetary policy in China is still largely geared at managing the amount of money in the system. That's how economies with pegged currencies manage monetary policy, though China's controlled borders also mean the interest rates can have some impact.

So, this is why RRR cuts are viewed as significant as rate cuts in China, since managing the money supply is a key monetary tool. Plus, China's banking system is state-dominated and bank lending is the main form of financing, so the banks are crucial players in boosting lending, investing and spending.

Image copyright Reuters

Cheap money problems

Of course, there has also been a lot of worrying investment in China, and reports of insolvent companies, so it's unclear that growth, if boosted by easier money, will go into productive avenues.

Still, if cheap money can buy China some time for it to restructure its economy and bolster its financial system, then that's what most central banks aim for as cheap money is not itself the solution and can create problems.

But, divergent economic conditions, particularly if the US starts to raise rates when the RMB is closely linked to the dollar, will make that task harder.

In other words, if the US is expected to raise rates and the dollar strengthens while China eases, then more money may leave China and it makes it harder for the PBOC to control the money supply.

On the other hand, so long as China is willing to be more flexible about the RMB peg, then it certainly takes pressure off the perennial complaints about a cheap RMB, since the currency should weaken if China cuts rates and the US may soon raise them.

In any case, differential interest rates always pose a challenge for countries that peg their currencies to an economy with divergent economic conditions.

For China, and other emerging markets that are now cutting rates while the US is moving the other way, it's becoming more complicated to manage.