Liquidity off the leash in China

Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.

Liquidity off the leash in China

This week, the economic focus has switched from the bitter round of trade wars to a proactive policy shift taking place in China designed to encourage a higher level of lending by their banks.

The backdrop for the shift is currency weakness and a slowdown in activity. The Chinese Renminbi (RMB) has depreciated 7.5% against the Dollar (USD) over the last four months and, while this would normally spur trade, exports are instead falling at their fastest rate for two years. Simultaneously, growth in the manufacturing sector is stagnating. The outcome which lies ahead is a gradual slowdown in China’s GDP with growth expected to fall to 6.6% from the current level of 6.7%.

By way of a response, the People’s Bank of China (PBoC), China’s central bank, announced they are cutting the reserve ratio requirements for their domestic banks by 1%.

A bank’s reserve ratio is set with reference to deposits taken from customers. Simplified, imagine a bank taking a deposit of £100 from you. If the reserve ratio is set at 15% the bank is only able to lend £85, being compelled to keep £15 in reserve. In our example, if the reserve ratio is reduced to 10% the bank can lend out an additional £5.

The change announced to reduce the reserve ratio by 1% allows the release of an estimated 750bn Chinese Yen Renminbi (CYN) (£82bn) of additional lending capacity.

Chinese Reserve Ratio Requirement set by the PBoC

Source Bloomberg, October 2018

Allowing banks to lend more to businesses and consumers in the form of loans is something that should help promote economic activity. This in turn helps maintain a growth pathway which underpins the notion that China’s leaders are capable managers of the economy. This is particularly important now because China is transitioning from a manufacturing-export model to a services-consumption based economic model.

If we turn back to the bank reserve ratio set there are some interesting points of detail to note.

• Due to the systemic threats posed by larger banks, central authorities set their rates higher than they do for smaller banks.

• In comparison to most developed economies, the reserve ratio in China is significantly higher, despite recent cuts.

• Ratios for medium and large sized banks are now back to pre-crisis levels whilst the reserve ratio for smaller banks is the lowest ever.

• This is the second reduction to bank reserve ratios in as many months

With a reduction in the reserve ratio underway, this will help counteract mounting economic pressures on China, not only from the US, but also their allies who view China’s prior trade tactics in a dim light. We do not know for sure how this will play out. There have been rumours that Chinese ownership of US treasuries could be used as a weapon allowing China to hit back at Trump. By selling US bonds aggressively they could force up Treasury yields and heap pressure back onto the US market and ultimately the real economy.

The US and China are truly engaged in challenge for global leadership. This isn’t likely to be over anytime soon as the stakes for winning and losing are significant.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.

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