The cash amount that should be reserved for Chinese financial institutions, or the reserve requirement ratio (RRR), was lowered by 50 basis points starting July 15, excluding those that have already held the ratio at a low level of 5 percent. The measure, part of the financial sector's efforts to support the real economy, would release about 1 trillion yuan ($154.24 billion) in long-term liquidity, the People's Bank of China (PBC), the central bank, said.

After the reduction, the weighted average RRR for financial institutions stands at 8.9 percent.

China's economic growth has maintained stable momentum despite the COVID-19 epidemic, improving 12.7 percent year on year in the first half of 2021. Against this backdrop, the RRR cut has sparked heated debate. Does the move mean China is shifting away from a prudent monetary policy?

Why now?

The decision was made in compliance with the outcome of an executive meeting of the State Council on July 7. According to that meeting, China must firmly shore up its real economy, especially in support of the micro, small and medium-sized enterprises (MSMEs). To that end, the government will adopt monetary tools, such as cuts in the RRR for commercial lenders, with such measures expected to mitigate the impact of commodity price hikes since the beginning of this year on affected companies. Subsequently, the country will refrain from mass stimulus, maintain stability of the monetary policy and enhance its effectiveness.

Over the past year, commodity price hikes have impacted midstream manufacturing and downstream consumer goods industries worldwide. Many Chinese enterprises, due to the rising cost of raw materials, faced difficulties in maintaining profitability.

The PBC said the move is intended to optimize the capital structure of financial institutions and improve their services to reinforce the real economy. By cutting the RRR, more capital will be channeled into the market. It will then further buffer the impact of commodity price hikes on downstream industries and MSMEs, allowing for them to take advantage of the cheaper financing to hedge against the growing raw material costs.

The latest RRR cut is well-timed. It clearly demonstrates that policymakers have been fully aware of the downside risks to economic growth and are implementing customized precautions.

What is the impact?

This time, MSMEs are the major beneficiaries of the RRR cut.

In response to the market's concerns, the PBC has made it clear that it would adjust financing structure and increase financial institutions' credit support to micro and small enterprises. It also pledged efforts to prevent the additional liquidity from flowing into stocks and real estate projects.

As a matter of fact, China's economy is feeling the pressure, with the real economy, MSMEs, especially those midstream and downstream enterprises, bearing the brunt.

The slowdown in development, let alone bankruptcy, of those MSMEs, which account for more than 90 percent of businesses in China, can pose a risk to the economy, impact urban employment and eventually lead to a systemic crisis. Therefore, with the new RRR cut, those who are suffering the impact of COVID-19 and commodity price hikes are expected to receive support to tide them over through the temporary difficulties.

China's consumer price index, a closely observed gauge of inflation, rose 1.1 percent year on year in June, data from the National Bureau of Statistics showed. This figure stood below the 1.3 percent year-on-year growth recorded in May. The producer price index, which measures costs for goods at the factory gate, increased 0.3 percent on a monthly basis in June, dropping by 1.3 percentage points from May, according to the data. The two readings indicate that the price trend is generally controllable and there is no need to worry about potential inflation brought on by the RRR cut.

Prudence prevails

According to the Report on the Work of the Government delivered by Premier Li Keqiang at the Fourth Session of the 13th National People's Congress, the top legislature of the country, China will enhance the quality, efficiency and sustainability of a proactive fiscal policy as well as keep its prudent monetary policy flexible, targeted and at a reasonable and appropriate level. Li stressed that the country will maintain a proper and adequate level of liquidity supply and see "increases in money supply and aggregate financing are generally in step with economic growth in nominal terms."

Nevertheless, the RRR cut, under positive economic growth, has begun to raise the question of whether China's monetary policy is shifting.

The global spread of COVID-19 has seen major economies such as the U.S. adopting extra-loose monetary policies and pumping massive liquidity into the market. This has led to a serious surplus of global liquidity, distorting traditional resource allocation and investment valuation, as well as directly pushing up commodity prices rated in U.S. dollars. This is the most important driving force behind the global inflation risk.

China has kept its fiscal policy proactive and monetary policy prudent, even though it also needs to boost its economic recovery. After the new cut, the RRR for large financial institutions will stay at 12 percent, a figure that proves China's monetary policy is not loosening the reins.

Taking the fiscal policy into account, in the first five months of this year, China's fiscal deficit came to 2.38 trillion yuan ($369 billion), less than that of the same period last year, and all types of fiscal deficits nationwide saw declines. Compared with 2020, the fiscal policy has been less expansionary, and fiscal investment has basically returned to its pre-epidemic status. At this time, the impact of the RRR cut on the market will be limited with the shrinkage of the fiscal deficits.

Coming in from the combined impact of fiscal and monetary policies, the liquidity in the financial system remains stable—and China's monetary policy unchanged.

Going forward, the nation's monetary policy will prioritize stability and focus on the domestic economic situation and price trends to support the real economy. The central bank will ensure that the growth of money supply and social financing matches nominal economic growth. It will step up support to the green transformation and technological innovation of small and medium-sized enterprises, and will keep comprehensive social financing costs stable with slight declines. Overall, China will create a suitable monetary and financial environment for the country's high-quality development as well as further supply-side structural reform.

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