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Analysis: China brings forward easing to stay in step

By Kevin Yao

BEIJING (Reuters) - As the world's major central banks hurriedly announced measures to ease stresses in global funding markets, China may have felt compelled to bring forward a move to relax policy that it could otherwise have delayed for a few weeks.

China's announcement on Wednesday it was reducing the amount of cash that banks must hold as reserves left no doubt that the world's second-biggest economy was doing exactly as it did in October 2008: joining a global effort by policymakers to stabilize a rattled financial system.

That somewhat surprise move achieved a lot. For Beijing, it was an opportunity to show how big a part of global policy-making China is and the stake it has in the stability of world markets. It helped that China needed to prop up its own economy.

It has also however meant that the timetable for China's hitherto subtle and selective policy easing has been pushed out into the open, and speeded up.

"The timing of the cut is earlier than I expected," said Andy Xie, an independent China economist. "The global coordinated action to ease dollar liquidity by six central banks is probably the trigger for China's move."

China would have cut the reserve requirement ratio for banks eventually. The economy has slowed, inflation has eased and, most worryingly, capital outflows have accelerated.

A Reuters poll earlier this week had forecast the first cut in China's bank reserves would come in December and the consensus was for the ratio to be trimmed 200 basis points from the peak 21.5 percent through 2012. Wednesday's 50 basis points cut has altered those expectations quite significantly.

Kevin Lai, a senior economist at Daiwa Capital Markets in Hong Kong, said he now expected a further 200 basis points in reserves cuts over 2012, more to prevent the economy from crash landing than to drive another boom.

Economists at HSBC expect 150 basis points of further cuts to be packed into the first half of 2012.

To some extent, the policy easing has acquired an urgency because of the worrying pace at which global funding markets are drying up and as banks caught up in the euro zone debt crisis scramble to sell assets and cut their loans.

Money markets are getting as tight as they were in the weeks after Lehman Brothers collapsed in 2008. For China, the risk of more capital outflows could cause further stress in already tight credit markets.

The U.S. Federal Reserve and other central banks, including China's, cut policy rates simultaneously in October 2008.

This time, it is a synchronized supply of cash. Central banks in Europe, Japan and elsewhere extended agreements with the Fed giving them access to even cheaper dollars.

China released cash from bank reserves and Brazil cut policy rates.

"It's clear we are all in it," said Frederic Neumann, economist with HSBC in Hong Kong. "China, as everybody else, has a stake in the stability of the global financial system and China's contribution is primarily through strong growth domestically."

CAPITAL OUTFLOWS

But the concerns over a rare but steady drain of foreign money from the economy appear to have been the primary reason for the cut in the banks' reserve requirement ratio, the first such move in nearly three years.

Preliminary data suggests capital flowed out of China in October for the first time since 2008. China had to cut bank reserves if it wanted to keep money supply stable, given bank deposits were falling and the trade surplus was shrinking.

Freeing up the money banks can lend, rather than cutting benchmark interest rates, also makes sense when inflation is still quite high at 5.5 percent, and China's policymakers are determined to deflate a property bubble.

"Obviously, they were thinking about it (cutting the RRR), and they have the hot money outflows, so it was a perfect timing for them," said ING's chief Asia economist Tim Condon.

Weak demand from China's huge developed world trading partners has sapped exports, but the economy is growing at 9-percent-plus, and domestic investment is healthy.

Neither do private economists expect the central bank to embrace other forms of aggressive easing, such as by setting a higher money supply or lending target for next year.

Annual inflation eased to 5.5 percent in October from a three-year high in July, but the real returns on bank deposits remain negative considering the one-year benchmark deposit rate was only 3.5 percent.

Any cut in interest rates could exacerbate the flight of savings into higher-yielding wealth management products or even the fledgling underground lending markets that the government is seeking to control.

"It's the start of a relaxation cycle, and the central bank is expected to take more steps -- the economic slowdown is there, and capital inflows are set to fall further, and many banks are finding liquidity shortages," said Hua Zhongwei, analyst with Huachuang Securities in Beijing.

"However, I still don't think China will cut benchmark interest rates in the coming months because that would mark a fundamental change, rather than a fine-tuning."

NEXT CUT IN JANUARY

The central bank raised the reserve requirement for banks 12 times between January 2010 and June this year, taking the ratio to a record 21.5 percent for big banks and 19.5 percent for smaller ones.

The first step in what could be a series of cuts comes just before the Central Economic Work Conference, at which China's leaders chart the course for economic policies in 2012. There again, they are expected to reiterate a policy of keeping monetary policy "prudent" but fine-tuning it when needed.

Still, because the central bank has been injecting liquidity into the banking system and selectively releasing loans to cash-starved small firms, it could be less willing to cut reserves repeatedly.

The central bank has injected a total 159 billion yuan into the banking system the past five weeks via its open market operations. It has also allowed yields on bills it auctions to fall steadily through November.

In addition, the finance ministry is likely to shift at least 1 trillion yuan of its surplus funds to commercial banks in November and December, providing a boost to their deposits.

Yet, as Wednesday's announcement showed, China may be compelled to ease policy if financial markets threaten to descend into chaos at the turn of the year. Or if its banking system freezes before the Chinese New Year break in January.

"Once central banks move, it is never a one-off. So we certainly expect more from China," said HSBC's Neumann.

(Additional reporting by Aileen Wang; Editing by Vidya Ranganathan)

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