beyondbrics

Many of the top analysts who cover the Chinese economy predicted that the central bank would loosen policy by cutting banks’ required reserves in January. It did not.

Should investors be disappointed at the lack of easing? Pleased that the government seems so confident abut the health of the economy? Or are they simply barking up the wrong tree?

Andy Rothman, a veteran economist with CLSA in Shanghai, called this week for an end to the obsession about China’s required reserve ratio - normally referred to by its clunky acronym, RRR:

Our advice? You’ve got much better ways to spend your time!

RRR, a little-used monetary policy tool in most countries, lies at the heart of the working of the People’s Bank of China. A higher ratio means that banks must lock up more of their deposits at the central bank, limiting their ability to lend. A lower ratio, of course, means just the opposite – a lesser constraint on lending.

Over time, RRR moves have become shorthand for the government’s monetary policy stance, much like interest rate decisions. An increase is seen as tightening and a decrease as loosening.

But that shorthand is the nub of the problem, Rothman argues. RRR changes do not imply loosening or tightening in China. Rather, they are simply a means for “sterilisation” – that is, for mopping up all the foreign money streaming into the economy, particularly from its mammoth trade surplus.

With foreign exchange accumulation slowing, he predicts that RRR could come down by 200 basis points or so this year. The correlation between RRR and forex reserves is neatly illustrated by this chart:

Source: CLSA

But those RRR cuts, on their own, will have little bearing on credit conditions in China. That lack of correlation is depicted here:

Source: CLSA

What explains the relative unimportance, then, of the RRR in tightening and loosening? It’s the fact that Beijing has an even more powerful tool in its arsenal.

All Chinese banks are controlled, via the personnel system (even down to the branch level), by the Communist Party. This enables the Party to set loan quotas for each bank, governing the level of lending above and beyond the RRR limitations.  The system works, because any banker who ignored his quota would soon be unemployed.

Looking at the quotas, we know that Chinese banks lent Rmb7.47tn last year and that the target has been nudged up to about Rmb8tn this year – a moderate easing and one that has already been set in motion. The RRR will just be a passenger along for the ride.

Related reading:
Chinese foreign exchange reserves shrink, FT
Renminbi under pressure as China slows, FT
China cuts reserve requirements: real easing at last? FT