Why We Want RRR Cuts

The Peoples Bank of China， the central bank， on April 20 initiated the second reserve requirement ratio （RRR） cut in 2015， which—though coming as no surprise—has extended beyond market expectations in terms of force and scope. The move will undoubtedly give the slowing economy a leg up.

In the first quarter， while the amount of new loans continued to increase， the total social financing， a broad measure of liquidity in the economy， decreased compared with the same period of last year， indicating that the financial industry failed to fully support the real economy. Deposit growth continued to decelerate， 1.6 trillion yuan （$257.92 billion） less than that in the first quarter of last year. Funds outstanding for foreign exchange reserves also dropped by 222.5 billion yuan （$35.87 billion） in the first quarter.

Meanwhile， at the end of March， broad money supply （M2） increased by 11.6 percent， 0.4 percentage points shy of the annual target. In most cases， when downward economic pressure mounts， the growth of M2 needs to be properly jacked up to realize counter-cyclical adjustment. Moreover， since China is likely to face a capital outflow in days to come， the chances of realizing the M2 growth target dont fare well.

Given all that， this round of RRR cuts and an additional targeted RRR cut combined to unleash roughly 1.3 trillion yuan （$209.56 billion）， which will reinforce banks lending capacity and ensure stable economic growth. Targeted RRR cuts focus on strengthening the weak links of the economy by lowering the RRR for banks engaged in proportionate lending to the agriculture sector and small and micro businesses.

By allowing banks to reduce deposit reserves， RRR cuts can directly increase capital supply for monetary and bond markets， and drive down the cost of issuing corporate bonds. Meanwhile， it can improve banks capital-operating capacity， increase credit supply and bring down the lending rates.

In addition， the pressure on banks to absorb savings can be effectively alleviated， which is conducive to lowering their liability costs. As the RRR falls， social financing will expand and become cheaper， and M2 will grow faster.

In my opinion， this RRR cut will significantly facilitate social financing， which bodes well for the market.

Under the circumstances of sufficient liquidity， declining financing costs， a relaxed real estate policy and reduced RRR and interest rates， the reviving property market， to some extent， may restore its vitality. As the number of property transactions rises， the growth of real estate investment will probably rally in a steady way， contributing to stable economic growth.

This year， local governments plan to issue bonds worth 1.6 trillion yuan （$257.92 trillion）. Commercial banks are still the major investors in the bond market and the biggest buyers of government bonds. As banks end up having to reserve less money and credit growth becomes more stable because of policy support and appropriate supervision， banks will be able to spend more on taking over local government bonds and then pushing forward urbanization.

Of course， if the current economic slowdown goes deeper， the chances for another RRR cut will become greater.

To realize the M2 growth target of 12-12.5 percent， in my opinion， the monetary base needs to be expanded by 1.53 trillion yuan （$246.64 billion） to 1.64 trillion yuan （$264.37 billion）. Presently， the gap is 1 trillion yuan（$161.2 billion）.

Considering local governments have to deal with their existing debts by issuing bonds， measures such as cutting RRR and expanding the monetary base should be taken to further enhance banks lending capacity. Therefore， people have good reasons to believe the RRR will be further reduced by 0.5-1 percentage point.

Whats on the minds of market participators is whether or not there will be another reduction in interest rates.

Though the real economy is in need of such a measure， if economic growth shows signs of picking up， the interest rate is not likely to fall. If economic prospects continue to be bleak， deflation will sweep China， and interest rates may be cut once more.

Still， the outlook remains auspicious. For example， since mid-March， the price of live pig has begun to bounce back， which will radiate through the pork market and then spur the year-on-year growth of the consumer price index （CPI）. Given the recent rebound， the price of imported petroleum may reverse downward trend in the second quarter. The CPI will bottom out and register a moderate increase in the rest of the year， which will make the prospective reduction less likely.