On Friday 9th of July, the People’s Bank of China (PBoC) announced a 50bps Reserve Requirement Ratio (RRR) cut that will reduce bank funding costs and unleash a substantial quantity of liquidity support.  While the market was expecting a rate cut following State Council’s call for additional monetary policy support on the 7th of July, the timing, a mere two days later, surprised investors.  The size of the rate cut, being a universal rather than targeted, also surprised the market and confirmed the authority’s dovish pivot.  

LIQUIDITY BOOST

RRR cuts provide the cheapest and most stable long term liquidity to commercial banks in a bigger extent, relative to costly repo and medium term lending facility (MLF), which must also be repaid.  The 50bps RRR cut, effective from the 15th of July, applies to all banks (Fig 1a), will release approximately CNY1 trillion of liquidity.  The RRR for large banks will declined to a 14-year low of 12%, while that for medium banks and smaller banks will fall to 10% and 5.5% respectively.

The timely ratio cut will help commercial banks offset MLF maturities in mid-July and other tax payments due in late July, although the PBoC suggested banks to use the extra funds to support the small and medium enterprise (SME) sector – a key government priority.  SMEs, being the main source of employment, help boost growth and rebalance the economy’s reliance away from state-owned enterprises (SOEs).

DOVISH "NOMINAL OPERATIONS"

The PBoC affirmed the rate cut was part of its normal operations to support the economy, while reconfirming its commitment to stable monetary policy.  This apparent dichotomy highlights the central bank’s competing goals - supporting real economic growth while avoiding any artificial stimulation to the leveraged and interest rate sensitive sections of the economy.  

Despite PBoC protestations, the RRR cut provides a, dovish policy signal.  With post-pandemic economic growth slowing, as well as brokers cutting Gross Domestic Product (GDP) forecasts and credit conditions tightening, the rate cut suggests an official shift to more proactive fiscal and monetary policy stance in the second half of the year.  The RRR may be cut again, as early as August, to help off-set future MLF maturities. Government borrowing could increase to support additional spending on key projects.  

While these actions imply the authorities are attempting to get ahead of the curve, the PBoC’s accompanying comments should reassure investors that a flood of liquidity and broader interest rate cuts are unlikely.

INVESTOR IMPACT

Market driven interest rates declined and the curve flattened (Fig 2a) following the State Council’s original call for a RRR cut.  This trend extended and accelerated after the PBoC’s official announcement.  For Chinese bond and money market fund investors, the decline in yields since late February has generated significant capital returns, with Chinese bond markets among the best performing, year-to-date.

Although the correlation between RRR cuts and market-driven interest rates is limited (Fig 2b), the central banks dovish pivot has encouraged investors to unwind residual rate hike expectations and price in additional rate cuts.  However, the proactive nature of the RRR cut suggests yields are unlikely to fall significantly further in the near term unless key PBoC metrics (such as Q2-21 GDP, employment and domestic consumption) weaken substantially.