On July 9, the People’s Bank of China (PBoC) announced a cut in its required reserve ratio (RRR). The primary goal is to reduce costs for firms impacted by a margin squeeze resulting from rising commodity prices.
The move came as a mild surprise to most market participants, given expectations of continued policy normalization amid a robust economic recovery. However, we believe there are good reasons for this apparent change in stance.
China began 2021 on a strong footing as compared to other nations still grappling with successive waves of the pandemic. Breaking from tradition in setting a “modest” growth target of ”above 6%”, policymakers have used the opportunity to help set their house in order: limiting overall leverage with a focus on the property sector, continuing to curb shadow banking, improving environmental protection (meaning quota cuts in pollutive industries such as steelmaking) and so on. These measures, while good for the long term, have resulted in some headwinds to the recovery.
Authorities have also targeted a lower fiscal deficit, resulting in a fiscal drag versus last year of at least 1.5% and slower progress in infrastructure investment. Credit tightening progressed faster than expected and the credit impulse has already reached contractionary territory in 2Q21. Export growth is also not expected to stay at current high levels, as demand for pandemic-related goods should subside and global manufacturing centers eventually reopen. Authorities had hoped that consumption would accelerate and boost overall growth, but retail sales remain lackluster and the employment outlook from PMI surveys has been weak. Unlike the U.S., China never provided direct handouts to citizens to make up for lost income.
The recovery has also been very uneven. While upstream industries have benefited from the commodity boom, downstream industries have struggled due to rising input prices. Producer prices have risen almost 9% since last June and there is a gulf in profit growth between upstream and downstream industries.
We think the Chinese economy peaked last quarter and that activity in the second half of the year will likely be somewhat slower than in 2Q, probably troughing in 4Q21. In our view, the RRR cut is a good start to reduce costs and, combined with macroprudential measures, should limit the funds flowing to overheated/overleveraged sectors. We do not expect a sharp downturn and think that significant economic deterioration would be needed to justify a broader easing cycle. The current combination of moderate growth, benign inflation and accommodative monetary policy should provide a conducive environment for onshore fixed income assets. We remain constructive on the longer end of the Chinese government bond curve.