Don't put hope on RRR cut

Monetary policy has been relied on to do the heavy lifting in the post global financial crisis world, and the same has been true in China. The People's Bank of China (PBOC) just announced a partial RRR cut but there is much hope that full-scale RRR cuts can ease credit conditions and arrest the slowdown in the real economy. We think such hope is misplaced – RRR is not the only or main constraint to credit expansion and credit is not the main culprit to the problems in the real economy. Don't count on RRR cuts to lift credit growth and have lasting positive impact on real economic activity.

As China's economic activity weakened recently, the call for further and bigger monetary easing grew louder. While the central bank has announced two partial cuts in the reserve requirement ratios (RRR) aimed at delivering liquidity to rural sector and small and micro enterprises, many in the market are looking for a full-scale RRR cut as a strong and convincing move to ease monetary policy and arrest the slowdown in economic activity. The government has also repeated its calls for "the financial sector to increase support to the real economy", prompting the central bank and banking regulator to come out recently and explain how they are rolling out measures to help achieve this goal.

Should China cut RRR?

Yes. China's reserve requirement is high (19.5 percent on average, and 20 percent for large State-owned banks) and the reserves are remunerated at only 1.62 percent, below the market rate. This is essentially a tax on banks that has led to distortive behaviors such as incentivizing banks to use wealth management products and interbank deposits to fund credit expansion. So cutting RRR can reduce banks' cost and distortive behaviors, which may lead to a reduction in credit cost in the real economy.

Cutting RRR can also increase liquidity in the banking system, although using reverse repos and on-lending can achieve similar result. Indeed the PBOC has used the latter measures to ease liquidity condition in recent months, and as a result interbank rates have been kept at low levels not seen since May 2013, and marginal borrowing costs for the private sector has come down as well. Of course, liquidity released by RRR cut is more "permanent", which can help anchor expectations in the market and lead to longer-term deployment of the increased liquidity by banks.

Will RRR cuts lead to a significant easing of credit condition?

Not likely. While RRR cuts will release more liquidity, that is not the only or even main constraint to credit expansion. In addition to RRR, bank lending is regulated by quantitative controls such as lending quota, prudential regulations such as loan-to-deposit ratio (LDR) and capital requirement, and sectorial credit policies that restrict lending to various areas.

Even if RRR is cut, many banks cannot lend more if the loan quota is not enlarged, LDR is not relaxed, or restrictions to certain sectors are not eased. The latter restrictions have contributed to many banks' moving aggressively into the shadow banking sector, hiding loans or loan-like credit through off-balance sheet credit or interbank credit market. It is also an important reason why easier liquidity in the interbank market in recent months has not translated into more credit in the economy.

In recent months, tighter regulation and supervision on shadow banking activities including trust, inter-bank businesses, and non-standard securitization have also led to a slowdown in the growth of non-loan credit. The increased interbank liquidity and lower interbank interest rates have already led to an increase in new corporate bond issuance in recent months, but banks are also bringing some shadow credit on to their balance sheet, which may crowd out other credit demand. If the government wants to see faster loan growth to offset the deceleration in shadow credit, it would have to relax lending quota, LDR and other quantitative and prudential regulations.

The author Wang Tao is a UBS economist.