Did China just join the global currency wars?

The People's Bank of China has joined its global peers in adopting a looser monetary policy to boost the country's slowing economy. The central bank cut the reserve requirement ratio -- or the amount of deposits that banks must hold in reserve with the central bank -- by 0.5 per cent to 19.5 per cent for large commercial banks. It provides additional easing to smaller banks that have met the lending target to small and medium sized enterprises, slashing the reserve-requirement ratio by another 0.5 per cent.

This is the first time the central bank has slashed the reserve ratio since May 2012. Chinese banks hold 113.86 trillion yuan in deposits. The across-the-board cut in the reserve ratio will free up 570 billion yuan's worth of cash for the banks to lend out. The additional cut for smaller banks will add another 130 billion yuan to the total.

The People's Bank has been reluctant to cut interest rates or lower the reserve ratio in recent times due to concerns about building up more debt to the already highly leveraged corporate, as well as local government, balance sheets. Why did the central bank finally cut the reserve ratio?

It wants to boost confidence. Chinese GDP growth in 2014 was one of the slowest periods on record. The country's manufacturing sector also contracted for the first time since September 2012 with the official PMI falling to 49.8 -- below the expansion threshold. Economists are predicting an even tougher year ahead for 2015.

Throughout 2014, the central bank used an alphabet soup of monetary tools to inject liquidity into the financial system without lowering the reserve ratio and only cut interest rates once. It did so reluctantly in order to help the cost of funding for the struggling SME sector.

The central bank wants to send out a signal that it will adopt a more accommodative policy to counter a weakening economy. “The PBOC last year was widely reported to have lowered the RRR for selected banks but it didn't publicise these moves, apparently to avoid giving the impression that its policy stance had changed. Today's more open approach is consistent with the more accommodative stance being taken since the benchmark interest cut in November,” says Mark Williams, chief asia economist for Capital Economics.

Apart from boosting confidence, the central bank's cut in the RRR is also to address the problem of a massive outflow of capital last quarter and to offset drainage on domestic liquidity. Historically, Beijing has used the reserve ratio to soak up hot money flowing into China -- especially in the aftermath of quantitative easing in the US. 

However, because of a recovering US economy and the end of QE, the money is flowing in the opposition direction. China's foreign exchange regulator said the country had a $US91 billion deficit in its capital and financial accounts last quarter. This outflow of capital has reduced the country's domestic liquidity.

Over the longer term, China's vast accumulation of foreign exchange reserves is probably coming to an end. As a result, Chinese banks no longer need to hold nearly 20 per cent of their total deposits to sterilise the large inflow of the greenback. So the central bank is effectively easing a 'tax' burden on its domestic banks.

Does the latest cut in the reserve ratio signal the Chinese central bank's decision to join the rank of its global peers in adopting loose monetary policy to stimulate the economy? The estimated 700 billion yuan or $US112bn additional cash will have a limited stimulatory impact on the economy. Don't forget China is a $10 trillion economy now.

The move is symbolically important; the central bank wants to give a more lasting boost to the real economy, increase the banks' risk appetite -- especially for the struggling SME sector that has been starved of credit due to the high cost of funding. The additional cut to the reserve ratio for banks that lend a certain amount of money to SMEs and the agricultural sector is evident of that. 

The Chinese central bank still maintains a high benchmark interest rate (5.6 per cent) and high reserve ratio at 19.5 per cent. So there is a lot of room for the bank to move if the economy gets worse. At the moment, the central bank is happy with its piecemeal approach and doesn't want to abandon its tight grip on credit creation.