Why we misinterpret Chinese RRR cuts
A quick comment on China’s RRR cuts: The underlying mechanics of Chinese RRR cuts and their implications for the country’s monetary policy stance still seem to be misunderstood.
A Chinese RRR cut is NOT like a rate cut in the developed world. And it does not necessarily signify an easing of the monetary policy stance. If you want to understand whether China is increasing or decreasing accommodation you only need to look at one thing: China CNY Monthly New Loans. The Bloomberg ticker is CNLNNEW.
The transmission mechanism of monetary policy in China is too crude at this stage of development to judge the stance of monetary policy by interest rates or reserve requirements. In China, it is all about credit controls. By hook or by crook, the Chinese target a quantity of credit. Whether they get there by regulations, open market operations, rate changes, or moral suasion matters little: the acid test it the rate of increase in the quantity of credit.
Here’s a snapshot of the time series:
So, last month, in the wake of several RRR cuts since last December, the quantity of RMB loans came in at 682B, versus a survey estimate of 780B. In other words, the money supply is roughly flat since all the RRR cuts began in December. RRR cuts are not a reliable predictor of future credit growth.
Why not? The mechanics in China work like this. China targets growth in the stock of RMB credit. Last year the target was 7.5T Yuan. As of this year the authorities have stopped publishing their target, but most analysts think they are aiming for between 8 and 8.5T Yuan. (FWIW, this would imply an increase in nominal GDP growth between 7 and 13 percent if you assume no monetary deepening).
There are three basic ways in which they can “finance” this growth in the stock of credit. One, they buy T-bills in OMOs (open market operations). Two, they receive balance of payment inflows (current account surplus plus capital account inflows). Both of these sources increase base money. Three, they can lower the RRR for banks to free up resources for lending. This doesn’t increase base money but increases the multiplier. The net effect of these three levers determines the change in liquidity in the system with which banks can expand lending.
The reason the RRR cuts have taken on less meaning in the current context is that they have been mostly offsetting the diminution of China’s balance of payment inflows. Once upon a time China’s trade surpluses were so large and the capital inflows so strong that BOP inflows provided more than enough base money to fuel any amount of credit expansion the China authorities desired. In fact, there were excess inflows that China had to sterilize. Now the trade surpluses have diminished and the speculative inflows have cooled (in fact, we have even seen net outflows at various point in time). If RRR were not cut, there would be an effective tightening of liquidity conditions. (This diminution of BOP inflows is also why the Chinese have been buying fewer US Treasuries.)
The bottom line: you need to know what is happening in with the constituent elements of base money before assessing whether an RRR is accommodative or just offsetting other developments. And, in the final analysis, only the growth rate of the stock of RMB credit will tell you the unambiguous truth.
So, the next time you hear an equity analyst trumpet the arrival of an RRR cut to bolster his bullish case, make sure you check the overall context and draw your own conclusions.