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China Cuts the RR

Cutting the banking required reserves ratio could signal a big change...
ISN'T it funny, asks Greg Canavan at The Daily Reckoning Australia, how the quality of leadership and of politics in general in this country has deteriorated along with the economy?
With economic conditions set to get even worse in the years to come, does this mean we have to put up with more political pathetic-ness?
Chances are the answer is yes. Great leaders generally emerge out of times of economic hardship. Just like an addict needs to hit rock bottom before they take the necessary steps to recover, so too an economy needs to go through tough times before the majority of people wake up and demand genuine change.
You could draw the same parallel with what's happening on a global scale. Our reverence of central banks and money printing will only be exposed as false once their policies basically destroy the system.
It's abundantly clear that cheap money is a cancer on the economy, that it destroys the value of money (in relation to asset prices, if not consumer prices) and that it simply doesn't work. But we're so far down the road in this monetary experiment that to stop now would be akin to going cold turkey halfway through the party. Cold turkey only works once you've hit rock bottom. That's when the will to change is greatest, and not a minute before.
So we're on the road to global monetary debasement...first against asset prices and then against everyday goods and services. The latter could take another few years though.
The latest central bank to try and 'do something' is the People's Bank of China (PBoC). Although it is hard to keep up; the Danes cut interest rates last night for the fourth time this year in a futile attempt to maintain their peg with the Euro.
That's partly the reason behind China's latest move too. I wrote here a few weeks ago that I thought the Yuan/US Dollar peg would be the next to go...another casualty of the global currency wars.
Last week, the PBoC lowered the amount of reserves that banks are required to hold against its deposits, which frees up around 500 billion Yuan for potential new loans.
The mainstream media hailed this as monetary easing but in the scheme of things, an additional 500 billion Yuan in loans is tiny. Look at the Chinese stock market's fell on the news.
To see why this news might not be so bullish after all, you have to understand the effect of the Yuan/US Dollar peg.
The initial pegged exchange rate undervalued the Yuan, which lead to China generating massive trade surpluses and foreign exchange reserves.
What many people don't realise is that those reserves form the backbone of China's financial system. They don't sit on some vault somewhere, available for a rainy day when China really needs them. Not exactly, anyway.
Here's how it works, roughly...
When US Dollars flow into the country, the PBoC must print Yuan to maintain the exchange rate peg. The Dollars go into the foreign exchange vault, and the newly printed Yuan go into the Chinese banking system as commercial bank reserves.
Just think of it as double entry accounting. On the one side, you have an asset (the FX reserves) and on the other you have a liability, which are the domestic banking reserves.
As these assets and liabilities grew (thanks to the pegged exchange rate), China had to do something to stop all the newly created bank reserves flowing into the economy and leading to an inflation blow out. So they started increasing the reserve requirement. That is, they made banks hold more and more cash as reserves.
The reserve requirement (RR) for large banks increased over the past decade from around 7.5% to over 20%. The recent move brings it down to 19%. So, thinking about it simplistically, the RR went up as China's foreign exchange levels (and domestic bank reserves) went up. But now, that trend could be changing.
Bloomberg reports that in the fourth quarter of 2014, capital outflows in China were the largest since 1998. That's not as extreme as it sounds, because it wasn't a huge amount (US$90 billion), but it is unusual.
It suggests that speculative capital sitting in China hoping for a Yuan revaluation might be starting to leave. This is a drain on domestic liquidity. When your economy is suffering from a credit binge hangover, liquidity constraints aren't welcome.
As far as I can tell, the RR cut reflects an attempt to maintain liquidity and offset the effect of capital flight, rather than act as a monetary stimulus.
The bad news is that you can probably expect to see capital continue to leave China as the Yuan's peg to a Dollar bull market takes its toll on China's economy. The good news is that China has considerable defences against this and can lower the RR for some time to come.
The message? Don't get too excited. China is in a long fight to keep its economic head above water after an epic credit boom.
For that matter, so is Australia.

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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