<p>People’s Bank of China (PBOC) announced a 100bp cut for the reserve requirement ratio (RRR) from 25 April.</p><p><b><span style="text-decoration: underline;">Reduction in financial burden</span></b></p><p>Starting from 25 April, the RRR will be reduced by 1% for commercial banks and foreign banks. At the same time, these banks have to repay the funds from the Medium-term Lending Facility (MLF). The net effect will be additional liquidity of RMB 400bn as the return of funds under MLF is smaller than the release of deposits from the RRR cut. The RRR will still be favourable for small lenders compared to large financial institutions with rates at 14% and 16% respectively.</p><p><b><span style="text-decoration: underline;">Interest rate liberalisation</span></b></p><p>PBOC is embarking on steps towards interest rate liberalisation reform by encouraging market forces to determine the cost of credit. This will allow a more efficient allocation of capital in China.</p><p>The deposit rate guidelines was recently relaxed with the removal of the implicit cap on Certificates of Deposit (CD) interest rates. This enable banks to price CDs at a higher interest rate, above the general 50% premium over the benchmark rates in China.</p><p>Lowering the RRR is in line with the interest rate liberalisation. Currently, the interest rate markets are not efficiently priced with deposit rates lagging significantly behind the interbank rates. Deposit rates ranges from 1.10 - 2.65% compared to the higher interbank rates of 3 – 4%. By lowering the RRR, it improves the transmission mechanism of interest rate by encouraging banks to reprice deposit rates higher. </p><p><b><span style="text-decoration: underline;">Supportive for SMEs</span></b></p><p>For the Chinese banks, a lower RRR is a cheaper funding source compared to MLF. The interest rate for RRR is at 1.62%, much lower than the 3.3% for 1-year MLF. Also, the liquidity released from a lower RRR is seen as a more permanent funding source compared to the periodic nature of MLF. This could help the banks to have higher NIMs from a lower cost of funds.</p><p>By reducing RRR, China is taking measures to provide liquidity support by boosting lending. The RRR cut will enable the banks to provide more support to the real economy should credit conditions worsen from ongoing trade war between the US and China.</p><p><b>Edmund Chan, CFA</b></p>