Why China’s RRR Cut Might Not Work

While we were all out enjoying the weekend, the People’s Bank of China (PBoC) decided to sneak up on the markets and cut China’s reserve ratio requirement (RRR) by 50 basis points. A quick stroll down memory lane would reveal that this is the Chinese central bank’s third RRR cut since November last year, hinting that China is still struggling to engineer a soft landing.

With the PBoC’s recent RRR cut, the level of deposits banks are required to hold in their vaults will be slashed from 20.5% to only 20% starting May 18. This means that Chinese banks will have a little more cash available for lending to consumers and businesses.

The recent slew of weak Chinese economic data we saw last Friday must’ve been a wake-up call for the PBoC. As Pip Diddy mentioned in his Daily Forex Fundamentals post last week, China’s PPI, fixed asset investment, industrial production, and retail sales all missed expectations for the month April.

Industrial production rose by only 9.3% from a year earlier, considerably weaker than March’s 11.9% reading and the consensus of a 12.2% annual increase. Fixed asset investment showed a 20.2% climb, weaker than the estimated 20.5% rise, while new loans amounted to only 682 billion CNY instead of the predicted 780 billion CNY.

So how exactly will lowering the RRR boost China’s economy?

Lowering the RRR means that banks will be required to hold less cash in their vaults, and the most recent rate cut of 50 basis points should free up about 400 billion CNY worth of funds that can be loaned out. The purpose of this is to give new loans a kick in the butt, as only 682 billion CNY in lending was approved in April, the lowest monthly figure so far this year.

This fits in with China’s strategy of flooding the markets with liquidity, confident that both local and foreign investors will come crashing to the gates.

Digging deeper though, we can see that the lack of funds isn’t exactly at the root of the problem. Data shows that, as of March, banks are already holding in reserves 2.2% more than RRR. This is up from the 0.8% in mid-2011.

Furthermore, deposit figures have been declining and dropped by 465 billion CNY this past April. The reason for this? Chinese citizens are choosing to invest their money in higher-yielding wealth management funds. This goes to show that the money is there but Chinese businessmen are choosing to invest in financial products as opposed to owning traditional businesses or keeping everything in cash.

Hmm…. So new loans are declining while funds are readily available… If you ask me, this isn’t a problem of supply, but rather that of DEMAND! It seems as if Chinese businessmen do not see any good opportunities and are refraining from taking out loans to expand their businesses.

So while China’s solution of just dumping money into the economy whenever it needed to has worked in the past, it may no longer be the appropriate solution at this time.

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