Another 1% hike in minimum reserves

Saturday evening, less than one month after its last hike (May 12), the PBoC surprised everyone (or at least me) by announcing another hike in the minimum reserve requirements. This is one day after the biggest one-day jump in the value of the RMB (0.34%, after two days of decline) in several months, which left the RMB at its all-time high this decade of 6.9230). It is also two days after SAFE announced that it will strengthen its monitoring of capital flows and of foreign currency borrowings by domestic banks.

This is the fifth time the PBoC has raised the minimum reserve requirement in 2008, but unlike the previous 50 bps hikes, this time the PBoC has told banks that the minimum reserve ratio has gone up by 100 bps. The increase will occur in two stages. On June 15 banks will have to increase the minimum amount of reserves they hold against deposits by 0.5% to 17.0%, and on June 25 they will have to raise the minimum reserve again to 17.5%. We are getting very close to the 20% level a lot of economists see as a barrier – beyond which bank profitability begins to suffer greatly.

I don’t think the market was expecting the move. My student, Shang Ning, writes: “The money market was very quiet on Friday, and didn’t seem to indicate that it expected the big jump in RRR. I think the RRR hike may have been unexpected, and the bond market should be tough next week.” There is a large IPO that will be launched soon – China State Construction Engineering Corp will be selling 12 billion shares in the Shanghai market, making it the largest IPO this year – and the sale is expected to drain a huge amount of money out of the system for several days (see “Small banks getting squeezed by IPOs” for an explanation of China’s idiosyncratic IPO dynamics). That is going to make money market conditions tight in the next week or so and may cause some damage to the stock market.

By the way the market was down 0.66% on Friday and is now trading just under 11% above the 3000 that everyone assumes is the government’s targeted “intervention” level. It will be interesting to see how the government reacts if, as I expect, next week’s markets are weaker. In fact I suspect the PBoC release came out on Saturday evening so as to give the stock market time to digest it without over-reacting.

According to the PBoC release, as translated today in Xinhua, “The rise, a further materialization of the tight monetary policy, is aimed at strengthening liquidity management in the banking system.” Regular readers know that I am apt to cringe at the claim that the PBoC is running a “tight” monetary policy – there can’t be too many definitions of “tight” that include monetizing something on the order of $350 billion in inflows in the first four months of the year, much of it speculative, imposing highly negative real interest rates, forcing down prices of a number of energy and food products (which is conceptually the same as increasing the money supply), and permitting loan growth that in any other context would be considered sizzling. I think Chinese monetary policy is extremely loose, although I recognize that until they finally address the currency regime there is almost nothing the PBoC can do except try to look busy.

Still, this hike in the minimum reserve requirement is definitely tightening of a sort, although of course provisions were made for branches of banks in the parts of the country hit by May’s earthquake, which will inevitably cause large companies to source some of their borrowing needs to their operations in Sichuan and simply transfer the money elsewhere. The question is what made the PBoC hike the reserve requirement now, and with such a large increase – 100 bps instead of the more normal 50 bps?

The answer is, in part, that they are probably trying to lessen their dependence on sterilization because it is getting increasingly hard to sell central bank bills without raising sterilization costs significantly. The interest the PBoC pays on minimum reserves is quite low – I forget the number but I think it is under 2% — and that is a lot less than the interest they are paying on bills, whose costs are rising. The MoF auctioned nearly $4 billion of 1-year bills yesterday at 3.42%, 4 bps higher than the yields the day before.

But my guess about the reasons for the timing of the hike in the minimum reserve requirement is that the monetary authorities have seen the May numbers on monetary conditions and they are not very good. There are two May numbers that matter, I think. One is the CPI. Most commentators expect CPI to have declined in May – the too-little-pork camp arguing that inflation has turned the corner, while the too-much-money camp claims that with food production back on line, in a month or two the non-food sector will replace food as the main driver of CPI inflation. If May CPI inflation has declined but non-food inflation has picked up significantly, that would indicate that the too-much-money camp is far more likely to be right, and of course the PBoC – at the center of the too-much-money camp – will be worried. I think we mortals will know the CPI number next Thursday.

The other number is the balance of payments. Inflows in 2008 were horrendous, and already make the numbers for 2007, which once seemed hard to believe, fairly boring. April especially saw a big jump in what must have been hot money inflows, and if May numbers showed more of the same, it must become increasingly obvious that China is now in a new stage of its monetary trap and must address the problem vigorously. I don’t think domestic monetary policies can have much effect as long as the problem is the currency regime, but the PBoC has been bravely trying to manage the money supply anyway, even though they have had to delay currency reform much longer than they are rumored to have liked.

My guess is that the authorities will continue to try various administrative measures – mainly greater monitoring and control of inflows – combined with attempts to tighten domestically, before finally giving up and addressing the currency directly. I know that I am still in a minority here (although no longer alone – far from it), but as every other policy fails to have any effect on underlying monetary conditions, the PBoC will eventually engineer a one-off maxi-revaluation. I don’t see how else they can regain control of their out-of-control money supply.