As widely expected, China's central bank announced it would cut the Required Reserve Ratio (RRR) for some banks by 0.5% effective July 5, just over two months after the PBOC did a similar cut on April 17, the first such easing since the start of 2016.
The move is expected to unlock 700 billion yuan ($108 billion) in liquidity amid growing trade war tensions, a sharp slowdown in the Chinese economy, a tumbling stock market, rising forced margin call, and a spike in corporate defaults.
According to the central bank, the aim of the cut is" to support small and micro enterprises, and to further promote the debt-to-equity swap program." The cut will apply to major state-run commercial banks, joint-stock commercial lenders, postal banks, city commercial lenders, rural banks and foreign banks, in other words: virtually everyone.
“The size of the liquidity being unleashed has beat expectations and it’s larger than the previous two cuts this year”, said Citic fixed income research head Ming Ming. “It’s almost a universal cut as it covers almost all lenders.”
The RRR cut was also widely expected following the publication of a central bank working paper on Tuesday calling for such a cut.
A cut in China's RRR by the PBOC is imminent following central bank’s working paper released Tuesday arguing for such a cut.— zerohedge (@zerohedge) June 20, 2018
According to Bloomberg, the cut is designed to achieve two things:
- The 500 billion yuan unlocked for the nation’s five biggest state-run banks and 12 joint-stock commercial lenders will be channeled to debt-to-equity swaps, which can reduce companies’ debt burdens and help cleaning up banks’ balance sheets. It comes following no less than 20 corporate bond defaults in 2018, and ahead of a wave of corporate repayments that has prompted analysts to express fears about a default avalanche. Chinese companies have to repay a total of 2.7 trillion yuan of bonds in the onshore and offshore market in the second half of this year, and together with another 3.3 trillion yuan of trust products set to mature in the second half. The pressure on China's corporate has manifested itself in the spike in the yield premium of three-year AA- rated bonds over similar-maturity AAA notes, which has blown out 72 bps since March to 225 basis points, the highest level since August 2016, an indication of the recent pressures on weaker firms.
- Separately, the 200 billion yuan freed for smaller lenders such as the postal bank and city commercial lenders will be used to support funding for smaller businesses. It comes amid concerns that the growing trade war between the US and China could further impair the already sharply slowing down Chinese economy which earlier this month reported "shockingly weak" economic data...
... amid a plunge in China credit creation and a record drop in Chinese off-balance sheet financing, and is meant to provide an economic spark to offset the risk of further economic contraction.
In a separate statement, the PBOC said that the move will "help push forward the steady progress of structural deleveraging, and strengthen support to the weak links of small-and-micro businesses. It is a targeted and precise fine-tuning. The PBOC will keep implementing prudent and neutral monetary policy, and create a favorable monetary and financial environment for high-quality development and supply-side reform."
However, countering speculation that the RRR cut may indicate a shift in China's deleveraging posture, Wen Bin, a researcher at China Minsheng Banking Corp. told Bloomberg that "the RRR cut this time doesn’t change the PBOC’s prudent policy stance. The decision fits the current economic and liquidity situation. It is also an innovative move and addresses structural problems, as the central bank ordered the lenders to use the money unleashed to push forward debt-to-equity swaps and support small-and-micro-sized businesses. This can help relieve financial burdens for some companies while reducing leverage."
In other words, China is spinning the RRR as a move meant to fund mass deleveraging through debt for equity swaps, not as the start of an easing cycle which would send the Yuan sliding and could potentially be perceived as a stealth devaluation by the US, resulting in even more aggressive trade retaliation.
The move will ease liquidity shortages currently seen in the implementation of debt-to-equity programs, and it shows that policy makers still don’t want to send a signal of across-the-board easing, Ming said. "The central bank may have predicted rising debt risks in the near future, so it decided to set up such an arrangement," he said.
That said, the PBOC explicitly said that the funds unlocked from the reserve ratio cut shouldn’t be used to support so-called zombie companies, of which China has many as even the IMF noted in December. It remains to be seen if this is just a smokescreen, considering that the companies most in need of deleveraging are precisely China's "walking dead" companies.
Finally, there is the market, which many have suggested is the real reason for the much anticipated cut. As a reminder, the Shanghai Composite recently slumped below 3,000 for the first time since the summer of 2016.
The risk here, however, is not just to China's wealth effect, but to a wave of margin calls resulting in forced selling of stocks pledged as collateral for loans. About $1 trillion worth of stocks listed in Shanghai or Shenzhen, China’s two main market, are being pledged as collateral for loans, according to data from the China Securities Depository and Clearing Corp., or ChinaClear. The staggering number is equivalent to about 12% of the market.
Plenty of Chinese stocks are also used as collateral in margin financing, whereby investors borrow to plow more money into stocks. In all, some 23% of all market positions were leveraged in some way by the end of last year in China, according to Bank of America Merrill Lynch.
As the WSJ explained recently, the pledging of shares as loan collateral is particularly prevalent among smaller private companies. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds.
Here the risk for other shareholders is that when major investors take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors likely made the crash worse.
And, as a result of the recent market rout, last week UBS said that it sees a growing risk in China's stock pledges; the bank calculated that the market cap of pledged stocks that have fallen below levels triggering liquidation amounts to 440 billion yuan with some 500 billion yuan below warning line, which translates to ~1% and 1.1% of China’s entire market value of $6.8 trillion. A separate analysis by TF Securities, as of Jun 19th, stock prices of 619 companies were close to levels where margin calls will be triggered.
It is unclear whether the relatively modest $100BN in released liquidity will be able to hit all of China's desired targets of assisting corporate deleveraging, slowing the mass default wave, preventing the economic slowdown and arresting the stock market rout and surging margin calls. It is, however, unlikely especially if Trump persists in imposing further tariffs on Chinese goods, suggesting that as much as the PBOC denies it, today's RRR cut is just the start of China's easing process.