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RRR cut more reasonable than expected2023/3/27 9:56:52(Beijing Time) Lange Steel

With a liquidity injection of 559 billion yuan ($81.59 billion) via one-year medium-term lending facility loans so far this year and the comments made by Yi Gang — governor of the People's Bank of China, the central bank — before the two sessions saying that "the current level of some key variables concerning monetary policy is appropriate", the market actually had weaker expectations for cuts in the reserve requirement ratio over the short term. But under such a scenario, the PBOC announced on March 17 an RRR cut of 0.25 percentage point for financial institutions starting today.

The latest move was somewhat unexpected for many, though it is a move that makes sense in several aspects.

Key stabilizing move

Both the Central Economic Work Conference at the end of last year and the Government Work Report of this year's two sessions have highlighted the work of stabilizing growth, employment and prices, continuity, stability and pertinence of policies, and coordination among different policy packages, so as to promote high-quality development. Premier Li Qiang also said during his first news conference after the two sessions that the government will introduce a number of policy combinations as follows: macro policies, expanding demand, advancing reform and innovation, and preventing and defusing risks.

China's economy has had a good start this year, and the rapid and smooth transition of the COVID-19 prevention policy at the beginning of the year has laid a solid foundation for economic recovery. It could more or less be foretold by looking at the financial and manufacturing purchasing managers' indexes, which were unveiled ahead of the January-February performance release. In the first two months, new loans by financial institutions increased by 1.5 trillion yuan year-on-year. In February, the growth of outstanding total social financing picked up to 9.9 percent from January's six-year low of 9.4 percent. The manufacturing PMI index rose to 52.6 percent from 50.1 percent in the previous month — the highest level reached since May 2012.

China's value-added industrial output — a gauge of activity in the manufacturing, mining and utilities sectors — grew 2.4 percent in the January-February period from a year earlier after a 1.3 percent rise in December, figures released by the National Bureau of Statistics showed on March 15. Retail sales surged 3.5 percent year-on-year in the same period, after a 1.8 percent decline in December. Fixed-asset investment — a gauge of expenditures for items including infrastructure, property, machinery and equipment — increased 5.5 percent year-on-year in the January-February period, compared with a 5.1 percent rise for the whole of 2022.

Though the country has achieved an impressive feat in the first two months, it is important to recognize that the foundation for economic recovery is not yet solid. Internally, the resiliency of the real estate sector remains to be seen, and there is still pressure on employment stabilization. Externally, there are potential risks triggered by central banks' tightening moves in major economies. Although key economic data of these economies in the first two months showed more resilience than expected, the effect of monetary tightening has not yet been fully released and the overall slowdown may not have hit its nadir yet.

In addition, there are signs of export weakness. In the January-February period, China's exports in US dollar terms fell by 6.8 percent year-on-year, compared with a year-on-year increase of 7 percent in December — mainly dragged down by much lower exports to developed markets. Among them, exports to the European Union fell by 12.2 percent year-on-year while those to the United States sunk 21.8 percent compared to the same period last year. Following the recent collapse of Silicon Valley Bank, Goldman Sachs cut its forecast for US economic growth this year by 0.3 percentage points to 1.2 percent.

Against the current backdrop, growth of China's manufacturing investment decreased 1 percentage point compared to that of last year and stood at 8.1 percent in the first two months. Private investment increased by 0.8 percent, down by 0.1 percentage point from the previous year. The average urban survey unemployment rate was 5.55 percent, among which the average unemployment rate of young people aged between 16 and 24 was 17.7 percent, up 0.05 and 1 percentage point, respectively, compared with December figures.

Therefore, this year's economic growth target of 5 percent is a bottom-line target set with comprehensive consideration, among which the most significant factor is the expectation of a stronger pull from high-quality drivers. In order to hedge internal and external uncertainties and ensure better economic results throughout the year, more flexible monetary policy will help consolidate the foundation of the current economic recovery and further boost market confidence.

Inflation secondary

Although the domestic economy is off to a good start, we should keep a clear mind about the reality reflected by low inflation reports that aggregate demand may still be insufficient. The country's consumer price index remained tame coming into 2023, with the February reading standing at 1 percent. The producer price index, which gauges factory-gate prices, showed an annual fall for a fifth month in a row in February, declining by 1.4 percent from a year earlier, after a 0.8 percent annual contraction in January, the NBS said.

This year, due to weakening external demand, there may still be oversupply, regardless of recovering domestic demand. In February, the production index of China's manufacturing PMI rebounded sharply to 56.7 from 49.8 in January, and was much higher than growth in the new orders index during the same period, showing signs of faster-recovering supply than demand. China's domestic demand recovery has not yet reached above its potential level, while inflationary pressure is significantly lower than that of developed countries.

Many may wonder about price stabilizing strategies highlighted in many key meetings, which refer to stabilizing domestic commodity prices. The macro background for such a call is that global commodity prices soared from 2021 to 2022 under the influence of factors such as excessive stimulus measures in developed countries and geopolitical tensions. At present, inflation in developed countries is still resilient and the future trend is highly uncertain, with concerns also existing over risks of recession and the spillover effect of monetary policy shifts. China depends heavily on imports of raw materials such as oil, coal, copper and iron ore. Under such a situation, imported inflation is indeed worthy of vigilant monitoring. However, as a country fully self-sufficient in its food supply, China is facing more controllable conditions in terms of food price fluctuations.

Stabilizing prices requires a proper response to the market's own expectations. Developed countries' hindsight moves are not advisable and, the risks brought by low inflation, such as confusion in expectations and unnecessary tightening of financial conditions, should also be taken into consideration. In addition, China's inflation-driven model may have shifted, and it is difficult to predict what level of inflation will be seen in the future. In the past, China saw its real estate sector drive overheating demand, causing high inflation. However, at present, housing price expectations have not improved while household balance sheets are still in a repairable state, and willingness to leverage remains to be seen. All these factors are different from the past when there was heavy inflation.

Move to stabilize matters

Though the RMB exchange rate is an automatic stabilizer of the balance between the yuan and other currencies, and a two-way fluctuation enhances the independence of monetary policy, no central bank can be completely independent of the US Federal Reserve. Monetary policy adjustments are still subject to exchange rate fluctuations.

Although China saw its trade surplus expand in 2022, the price attributes of assets dominated the trend of the RMB exchange rate throughout the year. Due to rising pressure from low inflation and the nation's stabilizing moves, China loosened its monetary policy against the trend, significantly narrowing the interest rate differential between the yuan and the greenback and weighing on the RMB exchange rate. With risks of the Fed's tightening gradually appearing, market expectations for a firm anti-inflation drive have begun to waver, along with weakening expectations concerning other developed markets. On March 8, Canada's central bank was the first to announce a pause in interest rate hikes. In this way, it is more difficult for the exchange rate to become a constraint on China's monetary policy.

The overseas banking turmoil is not a direct driver of this round of RRR cuts. Since the 1998 financial reforms, the operating capacity of China's banking industry has improved significantly and risk supervision has been continuously strengthened. This is seen by the recent failure of Silicon Valley Bank, which turned out to be a black swan for the overseas banking sector. But during the same period, there was no similar situation in the domestic securities market, which was in sharp contrast to overseas peers.

At present, China's banking system is working to support economic momentum and expand credit services. Pressure from easing financing costs and making concessions has significantly reduced the net interest margin of lenders, and for some small and medium-sized banks it is even greater. Therefore, the March 17 RRR reduction, which is expected to release about 600 billion yuan in long-term funds, will help ease the pressure and improve sentiment in the sector.

To sum up, the RRR cut is definitely not a response to so-called banking woes spreading overseas, but instead an appropriate stabilizing move in a timely manner to further consolidate good momentum for economic recovery. It was a topic that has been discussed for quite a while in China. The RRR cut, which may be somewhat unexpected, is reasonable. Of course, China should also learn lessons from the recent turmoil in the European and US banking sectors, and make smart preparations for changes occurring in accordance with economic principles. China should further adhere to the implementation of prudent monetary policy and avoid moves that may cause big fluctuations in capital and asset prices.

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