China’s Dynamic RRR: What’s That All About?

Last Friday the People’s Bank of China (PBoC) raised its reserve requirement ratio (RRR) for the sixth time since October 2010, bringing the ratio to a record high of 20%. For y’all keeping tabs on the PBoC’s previous moves, you should know that it has been raising interest rates and their RRR left and right for the past couple of months in order to cool down China’s hot inflation and drain the economy’s excess liquidity.

Interest rate hikes usually discourage more borrowing and spending, while higher RRRs force banks to keep more money in their coffers. As you’ve learned from the School of Pipsology, both methods effectively reduce the amount of money circulating in markets and usually limits liquidity and economic growth.

In fact, the PBoC likes these tools so much that it has been using them more regularly than Cyclopip takes his bath! Don’t believe me? Click on the yummy popsicle below to see the PBoC’s moves for the past couple of months:

PBoC Inflation Timeline

Aside from the PBoC’s almost predictable routine, markets also saw the recent RRR hike coming because around 1.4 trillion RMB worth of bank bills and repurchase agreements are scheduled to expire in March and April. You see, when these short bank investments expire, the economy’s money supply usually increases, potentially reversing some of the effects of the PBoC’s tightening policies.

Of course we know that this recent RRR increase won’t be the last time we’ll hear about China and its rate hikes. Just like Rebecca Black’s infamous rise to fame (Has anyone listened to her “Prom Night” yet? How about the acoustic version of “Friday”?), I’m sure China’s tightening moves will be around for a long while.

Some economic gurus even predict that another RRR hike will take place in April. On top of that, the PBoC is expected to hike its interest rates by 25 basis points in a couple of weeks or so. If China’s inflation keeps at it, I won’t be surprised if their deposit rate goes beyond 3.75% by the end of the year.

Now just because these rate hike expectations are probably already priced in, it doesn’t mean that traders won’t be paying much attention to China’s monetary policy decisions. In fact, it looks like the Asian giant is cooking up something new which could add some “oomph” to their tightening moves.

Word around the forex grapevine is that the PBoC is looking to implement a dynamic RRR system, which would involve making RRR adjustments based on economic factors such as loan growth, GDP, and inflation. Under this innovative scheme, the central bank would impose different reserve requirements for each bank depending on how their balance sheet looks instead of making all banks, big and small alike, conform to a single reserve ratio.

This “new” dynamic RRR system would provide the PBoC more flexibility, as it enables it to adjust the RRR according to changes in the economic landscape. Specifically, it allows the PBoC to have better control over loans growth, which over the past year, has exceeded forecasts despite the central bank’s efforts to cut off growth.

Some argue that another benefit of the new system is that it can be seen as a stepping stone towards transparency. With the PBoC now reviewing each and every bank separately, it could force Chinese banks to clean up their books and play nice.

Still, this is China we’re talking about. The PBoC has already been “unofficially” implementing parts of the new RRR system for some time now, allowing smaller banks to adhere to a lower RRR by virtue of having a smaller capital base. The announcement was merely a formalization of the system to the public. It doesn’t necessarily mean that the PBoC will be any more or less transparent that it has been in the past.

The real question itching me though is, what does this mean for Chinese monetary policy?

On one hand, it would appear that the PBoC is taking a hands-on and pro-active approach in its monetary policy. After all, inflation is on the rise and one way to curb it is by raising interest rates and the RRR.

On the other hand, it seems that the PBoC isn’t as strict as it would appear. By assigning different RRRs to each bank, the central bank is in effect giving a lot of leeway to Chinese banks, particularly the smaller ones. Of course, it is difficult to implement the same rules to all the banks, because each bank has its own unique scenario and circumstances to deal with.

Could it be that the PBoC just employed another diversion tactic and is actually softening its monetary policy stance? Share your thoughts through the comment box below and vote in our poll!