China
100bps RRR cut to cushion growth

•        The PBoC announced 100bps Reserve Requirement Ratio (RRR) cut for most banks, to replace maturing MLF (RMB450bn), while the remaining RMB750bn will help smooth liquidity during month-end tax payment
•        The move is aimed at stabilizing broad credit growth and supporting corporate lending at a time of rising trade tension
•        The central bank reiterates neutral policy stance, we see FX policy preferring a stable RMB for now

Facts

The PBoC announced 100bps RRR cut for most banks, effective as of 15th October. After this takes effect, the PBoC will have lowered RRR for most banks by 250bps this year. Large deposit-taking institutions' RRR will be at 14.5%.

According to the PBoC, the RRR cut will release RMB1.2trn liquidity. RMB450bn will be used to replace maturing Medium-term Lending Facility (MLF) on 15th October, the rest (RMB750bn) will be net injection which will help to smooth liquidity during month-end tax payment

The move is in line with our forecast for this year. We see another 200bps cut to RRR in 2019

Economic Implications

The announcement came at the end of the Golden Week holiday, and takes effect on 15th October. The timing addresses two concerns. From a domestic perspective, the move is largely liquidity-neutral as the liquidity injection will replace maturing MLF on 15th October and offset liquidity withdrawal due to tax payment. Meanwhile, the external environment looks to have worsened while the mainland market was closed for the week-long holiday. Strong US economic data and more hawkish language from the FOMC has pushed up both the broad USD and UST yield. Meanwhile, the market in Asia also speculated that the restriction in the USMCA (trilateral deal between US, Canada and Mexico) on negotiating FTA with 'non-market countries' could be referring to China and is another indication that trade war is still escalating.

Timing aside, we believe the RRR cut is also motivated by the need to support corporate lending. Despite easier interbank liquidity and marginal relaxation of Wealth Management Product (WMP) regulations, broad credit growth is still sluggish. Total Social Financial growth slowed to 10.1% in August 2018, down from an average of 13.2% in 2017. Meanwhile, bank lending growth was steady rather than accelerating. The weakness of overall credit growth suggests that 'financial de-leveraging' and tightened regulations are still weighing on corporates' credit access. Meanwhile, fiscal support, in the form of more decisive tax cuts, are still slow to come through. Given the corporate sector will bear the brunt of a trade war, it is necessary and prudent, in our view, to increase loanable funds for corporate lending. Although we do not have further RRR cut penciled in for the rest of 2018, we believe the PBoC will remain highly sensitive to corporates' borrowing costs. Therefore further policy tweaks, including regulatory changes to incentivize corporate lending, cannot be ruled out. Despite supply side disruptions to food prices, overall inflationary pressures remain benign. The housing market is also moderating as Pledged Supplementary Lending (PSL) policy is gradually phased out. Therefore neither represents major constraint on the PBoC's current policy stance.

FX strategy: RMB depreciation pressure under control for now

In the statement that follows the announcement, the PBoC also addressed the potential influence of RRR cut on the currency. The central bank believes the impact on the currency is limited given that monetary condition is still neutral. Market yields are stable while broad money supply and total social financing growth are in line with nominal GDP growth. Instead, the PBoC believes these targeted RRR would help to guide liquidity to SMEs, private sector and innovative industries, and hence would help to rebalance economic structure and lift growth quality. These in return would help support the currency. The central bank reiterates that the RMB will be basically stable at its equilibrium levels, warranted by China's competitive exports and industrial capacities. The PBoC also suggests that it would continue to take necessary measures to ensure stability in the local currency market.

In our view this would help to reduce RMB depreciation pressure when China's financials markets re-open on Monday. USD-CNH has managed to trade largely below 6.90 when China was on holiday, thanks to tighter CNH liquidity. The 1m CNH implied yield is around 7%, a 16 month high. The offshore yuan liquidity is likely to stay relatively tight going into the Ministry of Finance RMB4.5bn bond issuance on October 10th. There was also news earlier about the PBoC signing a MoU with the HKMA to issue central bank bills in the offshore market soon (20 September, Bloomberg). The higher offshore RMB yields should deter speculation, especially given the previous instances when CNH funding tightened quickly (i.e. policy induced).

The RMB is facing some depreciation pressure given the threat of additional trade tariffs and its narrowing yield advantage over the USD. Although recent RMB weakness helps offset some of the effective tariffs (25% for initial USD50bn goods and 10% for additional USD200bn goods), we believe China's currency is only playing a supporting role in the overall policy response to slower growth. Instead, China is more focused on stimulating domestic demand with fiscal policy while accelerating economic reforms.

If more tariffs materialize, China could allow USD-RMB to adjust higher as per economic theory and market dynamics in our view. But it also stands ready to curb excessive volatility and an overshooting of the exchange rate. China has many tools to do that, including selling FX reserves (which it has not done so for some time) and encouraging long-term asset allocation by foreign investors. On the latter, the recent FX forward reserve requirement was not applied to foreign portfolio investors while China also announced income tax waivers for overseas bond investors in August. These along with low onshore FX forward points and coming index inclusions will further attract foreign bond inflows. Meanwhile, China's onshore assets should be better shielded from tighter USD liquidity, thanks to a relatively closed capital account and cheaper valuations. This presents alternative investment opportunities to long-term foreign investors.

As such, we believe impact on the CNH from this RRR cut should be manageable. Despite this onshore liquidity injection, the offshore CNH points still face upward pressure but that in return should help to cap USD-RMB spot for now, at least until we get further clarity in US-China trade negotiations. Nonetheless, we should be mindful of China's FX policy having a preference for stability lately after the one-way RMB depreciation in June-August. This is an important message.