“A complex system that works is invariably found to have evolved from a simple system that worked. A complex system designed from scratch never works and cannot be patched up to make it work. You have to start over, beginning with a working simple system.” – John Gall, American author and retired paediatrician
The People’s Bank of China (PBoC) announced its first permanent and general reserve requirement ratio (RRR) cut since February 2016. The RRR cut is one percentage point for most commercial banks and is effective on April 25. The direct implication of this move is that the proportion of deposits that large Chinese banks will have to hold as reserves with the PBoC will decline from 17 to 16 per cent.
The headline number suggests an increase in system-wide liquidity of RMB 1.3 trillion, the easing effect, however, is actually much lower at RMB 400 billion as RMB 900 billion of the released reserves will be used to replace the existing medium-term liquidity facility (MLF).
The PBoC has used three main tools to impact monetary policy on the Mainland:
- Open-market operations;
- Reserve rate requirements; and
- The medium-term liquidity facility.
In January 2016, the PBoC in a bid to be more responsive to market demands increased the frequency of its open-market operations from twice a week to daily. The seven-day reverse repo is the primary instrument used by the PBoC to conduct its open market operations and to guide short-term market interest rates.
The reserve requirement ratio is the PBoC’s main instrument for managing longer-term liquidity – it provides a means to respond to capital inflows and outflows. For example, When China experienced huge capital inflows starting in the early 2000s, and foreign-exchange reserves increased to US dollars four trillion, the PBOC started increasing the RRR when it was at 6 per cent taking it all the way up to 21.5 per cent in 2011. More recently, the PBoC has made RRR cuts to offset liquidity withdrawn by the decline of foreign reserves.
The MLF, introduced by the PBoC in September 2014, offers three- to six-month loans to commercial lenders. The PBOC uses the MLF on a monthly basis to inject three- to six-month liquidity into the banking system, and the rate on the MLF guide medium-term market interest rates. Part of the liquidity from the RRR cut will be to repay the MLF loans from the PBoC – in effect creating some uncertainty with respect to the MLF being utilised by the PBoC in the future.
Following the recent RRR cut announcement, the PBoC commented that the cut does not represent easing but is rather a reflection of their “prudent and neutral” monetary policy stance. Nonetheless, we see the move as a signal from the PBoC that it is moving away from its more recent tightening bias towards easing, especially given that the easing is the first major decision made by central bank under its new leadership team. Moreover, if the PBoC did not want to signal the shift in bias, it could have continued using the MLF as a means of injecting liquidity into the system, instead it choose to make a 1 percentage point cut in the RRR. The only other times the PBoC cut the RRR so drastically in the last ten years was (1) following the Lehman Brothers bankruptcy in 2008 and in April 2015 when capital outflows were at or near their peak and were placing a real strain on system-wide liquidity.
In all likelihood, the announcement to cut the RRR by the PBoC is motivated by the slowing level of credit growth in the economy. March M2 money supply growth slowed to 8.2 per cent year-over-year – close to the lowest ever recorded level of 8.1 per cent. Additionally, outstanding total social financing (TSF) – regarded by many China watchers as the most important indicator for aggregate credit – slowed to 10.5 per cent year-over-year, down from 11.2 per cent in February. Since both M2 and TSF are key leading indicators for GDP growth, the central bank, it seems, is trying to counter the headwinds of toughening financial regulation through the RRR cut.
China Monthly Money Supply M2 Growth Year-over-Year
Source: Bloomberg
In Our Thoughts and Investments Ideas for 2018, we wrote:
“We expect 2018 to be not too dissimilar with the Chinese government continuing to strike a balance between using the stick and offering the carrot.”
We see the RRR cut has the carrot to the stick that is much tougher financial regulation and higher interest rates. We believe that this combination of RRR cuts, increasingly tougher financial regulation and higher interest rates is likely to continue for the rest of 2018, and the PBoC is unlikely to revise it official stance on monetary policy as being anything other than “neutral and prudent”.
Investment Perspective
The PBoC’s move to cut the RRR by 1 percentage point is positive for Chinese equities as any marginal improvement in liquidity would be considered to be. The signalling of a switch from a tightening to an easing bias, however, can be a sustained tailwind for the equity market, especially if, as we suspect, this recent RRR cut is not the last of the cuts for 2018.
Easing monetary policy is not the only tailwind for Chinese equities. We recently met with MSCI – the indices provider for global capital markets – to discuss the potential weight of China A Shares in MSCI’s emerging market index. China A Shares will be included in the MSCI Emerging Markets Index from June this year with an index weight of around 75 basis points – the weight is essentially negligible relative to the size of the Chinese market. The interesting point, however, is that were China to be included in the index at its full weight – this requires foreign investment restrictions in China to be greatly relaxed – the weight of China A Shares in the index would rise to 50 per cent.
Based on MSCI’s estimates, approximately US dollar 1.5 trillion in passive assets track the MSCI Emerging Market Index, at full weight that entails USD 750 billion of passive funds flowing into China A Shares – a significant amount by any measure. While we do not expect the 50 per cent index weight to be reached any time soon, China has started to significantly ease foreign ownership restrictions through various means:
- The Shanghai-Hong Kong Stock Connect scheme launched in November 2014 is the first and the only market that Western investors can be connected to Chinese stock market but with limitations. Starting 1 May, the daily quotas of the stock connect schemes linking mainland and Hong Kong markets will be increased to facilitate higher level on trading by non-Mainland investors.
- The potential launch of a second connect scheme in 2018. The second scheme will be with London and will enable allow the flow of capital between London and Shanghai.
- Removing the cap on foreign ownership of banks and asset management companies, and lift the cap on foreign ownership of securities companies, fund managers, futures companies and life insurers from 49 to 51 per cent, with a view to removing it entirely in the next three years.
- Removal of foreign-ownership limits for ship and aircraft manufacturing and other key industries this year.
As these measures are enacted, MSCI will gradually continue to increase the weight of China A Shares in its emerging markets index leading to a constant stream of inflows into the China A Shares market.
With the PBoC now signalling a shift towards an easing bias and the potential of growing MSCI flows, we see no valid reason to not have an allocation to China A Shares.
We are long Xtrackers Harvest CSI 300 China A Shares ETF $ASHR.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.