China injects liquidity to lift economy, counter capital outflow

China's central bank announced the first systemic cut to the reserve requirement ratio (RRR) since May 2012 as it faces growing pressure on capital outflows and an economic slowdown.

Starting on Thursday, Chinese banks will see their RRR lowered by 50 basis points, with qualified city and rural commercial banks engaged in proportionate lending to small firms, farming and major water projects, having their RRR cut by an additional 50 basis points.

The RRR is the minimum level of reserves banks must hold. Before the cut, big banks must hold 20 percent of their deposits in reserve, while the ratio for small and medium-sized banks was 16.5 percent.

Market analysts agree with the central bank's latest move, saying it is aimed at offsetting rising pressure of capital flowing out of the country, coping with liquidity shortage due to seasonal factors and downward risks facing the world's second largest economy.

Wang Tao, chief China economist with UBS, said the first goal of the RRR cut was to help maintain stable liquidity and prevent a notable slowdown in base money growth amid increased capital outflows.

She estimated net capital outflows exceeded 160 billion U.S. dollars in the fourth quarter, accounting for more than half of 2014's total.

"In addition, liquidity demand is set to spike as Chinese New Year approaches, alongside anticipated new IPO subscriptions which will likely further strain interbank liquidity conditions," she said.

Lian Ping, chief economist with Bank of Communications, concurred by adding that the yuan's recent depreciation against the dollar may be expediting capital outflows.

The move has closely followed Feb. 1 official data showing a contraction of manufacturing activities in January, which indicated a weakening economy. Meanwhile, the 7.4-percent GDP growth in 2014 also marked the slowest rate in 24 years.

Calling the latest central bank move as a fine-tuning measure, Ma Jun, chief economist of the central bank's research bureau said the central bank should orient policies toward stabilizing growth amid big downward pressure on the economy that is seeing weak manufacturing, sluggish property investment, and low inflation.

In announcing the RRR cut late Wednesday, the central bank said it would "continue a prudent monetary policy, striking a balance between tight and loose, guiding monetary credit and private financing to grow steadily and moderately, promoting a healthy and steady economy.

Wang Tao said that the latest RRR cut should not be regarded as major monetary stimulus. "The RRR cut is merely offsetting the shrinking contributions from foreign exchange accumulation, and is not a large net liquidity injection that will amplify China's base money supply to result in massive credit expansion."

Economists estimate the RRR cut will inject 650 billion to 700 billion yuan into the system, while further monetary easing is expected in the coming months.

Lian Ping predicted at least one more RRR cut by 50 basis points within the year, most likely within the first half due to monetary policies starting to take effect and an expected pickup in the real estate market, RRR cut pressure in H2 will decrease," Lian said.

J.P. Morgan China Chief Economist predicted the central bank will cut interest rates by 25 basis points in the first quarter.

However, Lian Ping dismissed such a possibility by arguing that the effects of the last rate cut remains to be assessed. "The benchmark lending rate currently is at a historical low. Given that an interest rate cut will further narrow interest rate margins between home and abroad, it may accelerate capital outflows," he warned.

The central bank cut benchmark interest rates for the first time in more than two years in November 2014.