The PBOC cuts the RRR….Ok, so what does that mean?

The people’s bank of China (PBOC) is the central bank of China. Over the weekend they have cut their Reserve Requirement Ratio or in short the RRR by 50 basis points or 0.5%. That’s all well and good but what does it mean and how does it affect us?

 

The RRR is simply a required amount of money that Chinese banks both large and small must keep in their accounts to cover their deposits. Banks generally operate on the principle that many or millions of people deposit their hard earned cash in their bank accounts, in return for this safety and potential ability to earn interest on these savings then banks are able to lend out these deposits and earn a return on it themselves, the difference between the two rates i.e rates paid and rates received is how banks make money.

 

However this is one of the many reasons we got into the global banking crisis in the first place as too often banks were lending out far too much of these deposits and not keeping enough on hold or commonly referred to as overleveraging themselves. This is what leads to a “run on a bank” where depositors worry that their money is not safe and rush to withdraw their cash only to find it’s not there anymore.

 

China uses this tool as a form of monetary policy in order to influence the amount of money supply in the system. When they cut the RRR then they are signalling that they want the banks to lend out more deposits and vice versa when they increase the RRR. This is similar to monetary policy in the West when the ECB, BOE or FED increase or decrease interest rates.

 

The Chinese government tweaks this ratio in response to how they feel the economy is progressing. If the economy is booming and inflation is high then it risks “overheating” and maybe a potential bubble is forming, so INCREASING the RRR serves to reduce lending and take money out of the system in an effort to cool down the economy and avoid the bubble.  If the economy is stagnating and experiencing a soft patch then DECREASING the RRR signals to banks to lend out more money to the economy in an effort to revive its momentum.  To put this in context the recent move of cutting the RRR by 50bps has freed up an estimated 400 billion Yuan or $64billiondollars according to Reuters to be lent out to the system.

 

The PBOC have now cut this RRR three times in 6 months signalling that the Chinese economy which in relative terms is still very strong is starting to cool down a touch. The PBOC tweaks these ratios in response to economic data received monitoring the economy. Of late the data has been deteriorating slightly. While China is evolving every day it is still very much an industrial economy. Recent Industrial production data have signalled a slowdown (Chinese IP has slowed from 13.8% in October ’11 to 11.9% in April ’12)

 

How this affects those of us in the west is not as clear cut but in short think of it as a domino effect. China is increasingly becoming the dominant global economy. The amount of import/export activity form this country alone is mind boggling, recent data suggested a dip in activity of imports. This signals that Chinese producers are buying fewer raw materials from other nations namely Europe, USA and Australia to produce their goods. So a dip in the Chinese economy however slight will have the domino effect on the rest of the world as they are such interlinked trading partners. Less exports to China means less output for Europe which in turn leads to more likelihood of a further European recession.

 

Global markets usually react to a Chinese RRR cut positively as it signals more investment in the Chinese economy and therefore a global benefit. You could argue why is it not negative as it shows that China is slowing down and therefore global GDP should be decreasing?  However markets are usually forward looking and therefore trying to price in the positive effects of a RRR cut and also it signals that the PBOC are willing to do what it takes to keep their economy strong.

 

Will it work? If I had the answer to that I would be a very rich man. Quite often an RRR cut in the short term has a positive effect on the markets but I believe that the recent slowing of the Chinese economy has more to do with the harmful effects of the European financial and political problems than the actual underlying demand in the Chinese economy.  Also I believe that the move was highly anticipated from investors. The Chinese domestic economy is blazing and retail sales are still strong but their trading partners are feeling the pinch a bit and normal service will be returned if and when Europe and to a certain extent USA get back on track to growth.

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