China: A Seemingly Aggressive Move: RRR Hiked by 100bp

‘Tight’ Monetary Policy in Action?
The PBoC announced on Saturday, December 8 that the ratio for required reserves (RRR) will be raised by 100bp to 14.5% effective December 25. This is the tenth RRR hike in 2007 and the first 100bp hike since 2004.

This 100bp RRR hike is the first monetary policy move after the authorities stated that monetary policy will turn ‘tight’ at the conclusion of the Central Work Conference on Wednesday, December 5. Against this backdrop, this move carries an important signaling effect, which could reinforce the concern among many market participants that the Chinese authorities may run the risk of ‘over-tightening’ the economy at a time when China’s external environment is deteriorating.

Limited Near-term Impact
We, however, caution against overreaction, as we believe that the near-term market impact of this seemingly aggressive policy move will be rather limited. This move appears largely aimed at offsetting the liquidity-creation impact of two year-end factors: the sharp decline in government deposits at the PBoC and a significant accumulation of FX reserves in December.

Past experiences suggest that the excess reserve ratio (ERR) tends to jump by 200-300bp in 4Q and then decline to a ‘normal’ level in January.

The sharp increase of the ERR reflects two year-end factors. First, government deposits tend to decline sharply in December. Budgetary units of various government departments tend to rush to spend toward the year-end. When the various government bodies draw down their Treasury deposits at the central bank, liquidity is released from the central bank into the banking system.

Second, official FX reserve accumulation by the PBoC tends to be significant towards the year-end, as China usually registers larger trade surpluses to the year-end. When the PBoC accumulates FX reserves, it injects liquidity into the system. To the extent that it does not fully sterilize the liquidity impact, the liquidity created tends to be reflected in higher ERR in these months.

Against this backdrop, the net liquidity impact of a 100bp RRR hike should not be as large, in my view. Given the new mandate to pursue a tight monetary policy, the PBoC appears to have taken a precautionary and preemptive move to lock up the liquidity with a view to preventing it from translating into real purchasing power that adds to the current inflationary pressures, despite knowing that some of the increase in excess reserves is seasonal and thus temporary.

Consecutive RRR hikes ≠ tight liquidity
Despite ten consecutive RRR hikes in 2007, the inter-bank interest rates – as indicated by yields on the 1-year PBoC bills – have moved up only very gradually for most of the year, suggesting that the underlying liquidity situation has not tightened meaningfully. The RRR hikes only serve to mop up ‘excess’ liquidity instead of making the underlying liquidity situation tighter.

Ten hikes and counting...
Despite 10 RRR hikes in one year and the current RRR already at a record 14.5%, we expect more RRR hikes over the course of 2008 for the following reasons. First, raising the RRR is a much more cost-effective way for the PBoC to mop up liquidity, as it only pays 1.89% on required reserve deposits compared to the current 3.9% yield paid on the one-year PBoC bill.

Second, as long as the average funding costs for the major commercial banks are still below the interest rate paid on required reserves deposits, the PBoC will likely still prefer to rely on a higher RRR to mop up liquidity without being overly concerned about the negative impact on banks’ financial performance. And, if needed, it is quite possible for the PBoC to raise the interest rates paid on required reserves deposits to create room for additional RRR hikes, in my view.

Third, more generally, we believe that, going forward, such quantity-based measures such as RRR hikes and administrative controls over bank lending will feature more prominently than price-based measures such as interest rate hikes and exchange rate appreciation, when the authorities implement a ‘tight’ monetary policy in 2008.

In essence, this policy orientation will result in the banking system sharing the bulk of macroeconomic adjustment costs with the central bank, in my view.

Risks
Notwithstanding the authorities’ recent high-profile statement to pursue a tight monetary policy in 2008 and this 100bp RRR hike in particular, we believe that the risk of ‘over-tightening’ is quite low. Chinese authorities have ‘over-tightened’ in past cycles; however, such aggressive tightening was in response to a much more serious overheating than we are currently observing (see China Economics: An ‘Untimely’ Question: What Could Go Wrong with the Economy? August 15). We continue to believe that an imported soft-landing is the most likely scenario in the event of a global synchronized downturn (see China Economics – Journey into Autumn: An Imported Soft Landing in 2008, December 3).

By Qing Wang Hong Kong
Morgan Stanley
December 11, 2007