China’s monetary policy: Doves flying over troubled water with more upcoming RRR cuts

China’s monetary policy is becoming dovish while other central banks are tightening. Together with the change in tone from “deleveraging” to “stabilizing leverage”, the dove is back but the real question is how, i.e. what prompts the change of monetary policy tools and how the monetary stance will evolve.

Earlier tight monetary policy and the crackdown on shadow banking have caused a drastic decline in the money multiplier. Against this backdrop, the most efficient policy tool is to cut RRR, which will put liquidity back to banks with an immediate effect on the money multiplier. Beyond this, targeted lending tools generally has a short-term tenor so that it will not help reducing banks’ reliance on such funding, and hence that of the corporates. The usual targeted lending tool (MLF) also benefits large banks but not so much the smaller ones, which are in most need of liquidity. The RRR cuts are obviously more general.

As such, liquidity is now unleashed to target the trouble water in the slow progress of debt-to-equity swaps and the lack of support for small-and-micro enterprises (SMEs). 71% (RMB 500 billion) of the liquidity is targeted at debt-to-equity swaps and 29% (RMB 200 billion) is allocated for supporting SMEs.

In a nutshell, the RRR cut has several immediate market implications.

• It will trigger a reduction in funding costs. Onshore bond yield has peaked already at 5.02% in February 2018 and fell to 4.87% in May 2018 with the change towards monetary policy easing. The cost of funding will head further south.
• It will exert higher pressure for the RMB to depreciate, especially following the divergence in monetary policies between the PBoC and the FED.
• The additional liquidity supporting asset prices and real estate is clearly the all-time favorite.
• Strict capital control will continue to be in place to keep cross border flows under the PBOC’s radar.

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