The Most Surprising Thing About China's RRR Cut

Following China's 50bps RRR cut this morning, coupled with a 25 bps easing in deposit and lending rates, there have been numerous strategist reactions, most of which suggesting what the PBOC did was in response to China's crashing stock market and slowing economy. But mostly the market, and not so much China's perhaps as that of Europe: moments ago Eurostoxx closed up a whopping 5.0% with the Dax soaring 5.32%. As a reminder, the German stock market has been the most punished among western bourses due to concerns trade with China will deteriorate leading to a drop in German exporter revenue and profitability.

And yet, hours before the RRR announcement, a Bloomberg note came citing "people familiar with situation " which said that China halts intervention in stock market so far this week as policy makers debate merits of an unprecedented government campaign to prop up share prices and what to do next. The note added that some leaders support argument that stock market is too small relative to broader economy to cause crisis, adding that "leaders also believe intervention is too costly."

So how does one reconcile China's reported detachment from manipulating the stock market having failed to prop it up with the interest rate cut announcement this morning.

The missing piece to the puzzle came from a report by SocGen's Wai Yao, who first summarized the total liquidity addition impact from today's rate hike as follows "the total amount of liquidity injected will be close to CNY700bn, or $106bn based on today's onshore exchange rate." And then she explained just why the PBOC was desperate to unlock this amount of liquidity: it had nothing to do with either the stock market, nor the economy, and everything to do with the PBOC's decision from two weeks ago to devalue the Yuan. To wit:

In perspective, the PBoC may have sold more official FX reserves than this amount since the currency regime change on 11 August.

Said otherwise, SocGen is suggesting that China has sold $106 billion in Treasurys in the past 2 weeks!

And there is the punchline. It explains why the PBOC did not cut rates over the weekend as everyone expected, which resulted in a combined 16% market rout on Monday and Tuesday - after all, the PBOC understands very well what the trade off to waiting was, and it still delayed until today by which point the carnage in local stocks was too much. Great enough in fact for China to not have eased if stabilizing the market was not a key consideration.

In other words, today's RRR cut has little to do with net easing considerations, with the market, or the economy, and everything to do with a China which is suddenly dumping a record amount of reserves as it scrambles to stabilize the Yuan, only this time in the open market!

The battle to stabilise the currency has had a significant tightening effect on domestic liquidity conditions. It is the PBoC's decision whether or not to keep at it. If the PBoC wants to stabilise currency expectations for good, there are only two ways to achieve this: complete FX flexibility or zero FX flexibility. At present, the latter is also increasingly unviable, since the capital account is much more open. Therefore, the PBoC has merely to keep selling FX reserves until it lets go.

And since it can't let go now that it has started off on this path, or rather it can but only if it pulls a Swiss National Bank and admit FX intervention defeat, the one place where the PBOC can find the required funding to continue the FX war is via such moves as RRR cuts.

SocGen makes some other key observations:

Based on our calculations, the effective RRR rate of the Chinese banking system is actually below 15%, rather than the reported headline of 18% (include the cut today). If the PBoC were to reduce the RRR quickly to a minimum level, say 5% effectively, the amount of the liquidity injection would be over CNY13tn or $2tn, which should be large enough scope for FX intervention.

It should, unless the escalation from all the other countries that have also seen their currencies tumble in value is not proportional enough to require constant intervention by China.

A question arises: just what is China selling. SocGen has an answer for that as well:

From an operational perspective, China's FX reserves are estimated to be two-thirds made up of relatively liquid assets. According to TIC data, China held $1,271bn US treasuries end-June 2015, but treasury bills and notes accounted for only $3.1bn. The currency composition is said to be similar to the IMF's COFER data: 2/3 USD, 1/5 EUR and 5% each of GBP and JPY. Given that EUR and JPY depreciation contributed the most to the RMB's NEER appreciation in the past year, it is plausible that the PBoC may not limit its intervention to selling only USD-denominated assets.

SocGen's conclusion: "In a nutshell, the PBoC's war chest is sizeable no doubt, but not unlimited. It is not a good idea to keep at this battle of currency stabilisation for too long."

Still, for the time being many more such RRR-cuts (and other interim reliquifications) are imminent if only for the duration of China's FX war, with the critical distinction that the proceeds will not reach the banks, nor the economy, but remain locked in within the PBOC's FX devaluation machinery!

Since the RRR cut is for reversing liquidity tightening and the rate cut is diluted by liberalisation, we need to monitor the development of onshore interbank rates in the coming weeks to assess whether the PBoC's move today would amount to any net easing. It seems to us that 7-day repo rate at 2.5% is a critical line. If this rate drops below that level and remains low, then we can say with more confidence that there is monetary policy easing. If not, then more, a lot more, needs to be done.

And there you have it: while global markets received China's announcement with their typical "a central bank just came to our reascue" exuberance, the reality is that as least today's RRR cut will have zero impact on spurring aggregate demand, and is merely a delayed response to FX interventions that have already taken place.

Said otherwise, for China to net ease, it will have to do more, much more.

Ironically, doing so, will merely accelerate the capital outflows as a result of the ongoing plunge in the CNY, which leads to the circular logic of China's intervention: the more it intervenes in an attempt to stabilize every aspect of its economy and finance, the more it will have to intervene, until either it wins, or something snaps.

Our money is on the latter.