China Cuts RRR And Risk Jumps – Should It?

The PBOC has just announced that, as of Dec. 5, it will lower the reserve-requirement-ratio by 50 basis points, marking the first reversal in the RRR policy since late 2008. Should risk celebrate or worry?

With all focus on the EU of late, the market has neglected developments elsewhere, particularly China, where the economy is clearly beginning to suffer after a vicious serious of tightening moves aimed at reining in the country’s property and credit bubbles that began in early 2010 and accelerated earlier this year. Risk has decided to celebrate this move in classic Pavlovian fashion, but is this the green light for risk, or a troubling indicator that China is on the verge of a significant adjustment in its economy as its bubbles unwind?

The key problem with China is its opacity and the inability to get a firm read on its economy from the published data, though some of that data was indeed showing signs of an economy coming well off the boil, including a recent flash PMI reading for November well under 50 and signs that inflation levels were decelerating as well. Anecdotal evidence of interlocking lending networks blowing up and overbuilding were far more worrisome.

It is important to understand this policy move as the beginning of a process as policy moves are very rarely one off affairs, but rather the start of serial bouts of further actions in the same direction. So policy makers in China obviously judge that the risks are very much weighted to the downside from here rather than the upside for the economy. The last time China eased the RRR was actually in late 2008.

Considering that the market has a terminal case of long term amnesia (preferring recent memories to longer term ones), we should ask the question of whether this move is more akin to a Fed QE2 or to the Fed’s first easing of policy in mid-September of 2007. In the former case, the market celebrated with months of liquidity celebration. But in the former case (and in other examples from US economic history and in the history of other economies) the first actual easing move was merely one of a series of indicators that an economy is in trouble and must work through a significant period of weakness before establishing a new base from which to grow. So in the Fed case from September 2007, the initial 50 bps easing touched off a raging rally in risk assets that lasted less than four weeks before the S&P500 posted its all-time top in October 2007 before falling some 57% by early 2009.

We’re not going to suggest that history always repeats, but a sober assessment of which model to follow (bubble economy needing to deleverage and retrench  vs. spraying liquidity in a bizarre, QE and post-bubble environment) is a must here.

In that light, the initial reaction/celebration is likely a red herring.