China Cuts RRR A Further 0.50%
As the trade war between the US and China heats up it seems that neither side is showing any sign of backing away from the conflict. Instead, China has made moves to shore up its economy in order to continue its battle with the US as the PBoC has once again cut the requirement reserve ration by 0.50%. This move has freed up roughly 700 billion CNY to help support the economy. The money, however, has been earmarked for two purposes.
Government owned, and large banks will be able to use roughly 500 billion CNY to fund “debt to equity” swaps while other banks, including foreign lenders, can access the remaining 200 billion CNY to lend to SMEs. This layered cut by the PBoC is aimed at mitigating the two biggest risks facing the economy. Firstly by relieving the default pressure on companies introduced by financial deleveraging reform, and secondly providing a buffer for SMEs that could be negatively impacted by the trade war.
Debt to Equity Swaps
The current format of the swaps is that the primary bank of an over-leveraged company can create a subsidiary to hold the company’s equity by reducing the debt for the company. This subsidiary is typically either a trust or an asset management company. The primary bank then includes other investors who become equity holders such as social security funds and state owned asset management companies. While the swap ratio should be determined by the market, given that the number of these swaps is so small, the “market” prices of the swap is usually established via negotiations between the company and the equity investors.
Helping Ease Credit Concerns
The cut in place for debt-to-equity swaps should work to lower the leverage ratios of participating corporates and therefore reduce the number of defaults. Defaults have been increasing in China since the implementation of financial deleveraging reform which was introduced in April when the state announced several new policies.
This latest RRR cut should help assuage the markets concerns about the reduced credit quality of corporates that have been affected by the deleveraging reform. However, we are not likely to see an immediate decline in credit costs and the market will likely adopt a “wait and see” approach given that the debt-to-equity swaps needs time to positively impact the credit market.
Helping SMEs Survive the Trade War
The other key element of the RRR cut is the help it provides for SMEs. The purpose here is the same as the RRR cut in April. As the trade war intensifies, there is likely to be increasing support from the state both in terms of monetary support, as with the RRR cut and also fiscal support, such as tax cuts. This latest cut, alongside the cut in April should see cash available for SME loans increase by around 600 billion CNY.
However, whether this will prove to be enough to provide a buffer for companies affected by the escalating trade and investment war between the US and China remains to be seen. With this in mind it is likely that the PBoC will cut the RRR further this year. In terms of gauging the timing of the next cut, the PBoC will probably look to avoid quarter end timing as it will be keen to emphasise that RRR cuts are a long-term monetary policy tool and not just for easing liquidity constraints at quarter end. Furthermore, the bank will likely wait to see the effects of these dual cuts work over the summer making October the most likely candidate for a further cut.