Written by Michael Knox, chief economist, RBS Morgans

In spite of a higher-than-anticipated CPI for January, China still has ample room to ease monetary policy.

The release of a higher-than-anticipated 4.5 per cent inflation rate for the year to January led many commentators to suggest that the People’s Bank of China (PBOC) would be unable to ease monetary policy in coming months. Today, we examine the relationship between Chinese consumer prices and the Chinese required reserve ratio to discover if that commentary is correct.

The Chinese banking system is much more primitive than the West’s. That is why it still works. China varies its monetary policy in the same way that Australia did in the 1950s and the 1960s. This is by varying the Required Reserve Ratio (RRR). The required reserve ratio is the proportion of commercial bank reserves that must be lodged with the Central Bank. China tightens monetary policy by a combination of increasing the required reserve ratio. China eases monetary policy by decreasing the required reserve ratio.

The required reserve ratio has tended to drift up over time. The peak level reached in 2011 of 21.5 per cent was the highest ever seen during the existence of the People’s Bank of China. The objective of monetary policy is to control the rate of growth of the money supply. The money supply is determined by the money base and the money multiplier.

Foreign reserves are a component of the money base. In China the money base has been gradually rising because China’s foreign reserves have been gradually rising. China now has the largest foreign reserves in the world. In order to stop domestic money supply blowing out, the People’s Bank of China has had to increase the required reserve ratio over time to generate a downtrend in the money multiplier. In this way, a rising money base and a falling money multiplier have allowed stable money supply growth.

In addition to generating stable long-term money supply growth, the required reserve ratio has also been used to manage the Chinese business cycle. China reacted to the global financial crisis by dropping the required reserve ratio. This generated an acceleration of money supply growth. This in turn generated a property boom. The property boom generated an escalation in housing prices which fed through into accelerated inflation.

This inflation level peaked in July 2011 at a rate of 6.5 per cent. To reach this level, inflation had soared by five per cent from a level of only 1.5 per cent for the year to January 2010. The People’s Bank of China moved against this rising inflation by increasing the required reserve ratio from 16 per cent in January 2010 to 21.5 per cent in June 2011.

Property inflation ran out of steam in the face of this monetary assault. The result was that inflation declined to 4.1 per cent by December 2011. The PBOC reacted to this by cutting the required reserve ratio by 0.5 per cent. The market view seems to be that we need more falls in inflation for there to be further cuts in the required reserve ratio. The very slight increase in inflation in January 2012 to 4.5 per cent had led to market comment that further cuts are not possible.

In Chart 1 above we show our model of the required reserve ratio based on its historical relationship with the Chinese CPI over the period since January 2010. We find that over that period there is a close relationship between Chinese inflation and the Chinese RRR. Our model explains 90 per cent of monthly variation in the Chinese RRR over that period. Inflation leads the Chinese RRR with a lag of between one and three months.

The point is that inflation has already come down by a long way. Even at 4.5 per cent, inflation is a full two per cent lower than its peak in July 2011. Our model tells us that even a 4.5 per cent rate of inflation should result in a decline in the Chinese RRR by a lot more than 0.5 per cent. Our model tells us that the Chinese RRR in line with 4.5 per cent inflation is actually 19.5 per cent. This is 1.5 per cent lower than the current level. This suggests that even if inflation stabilises at 4.5 per cent (and we think it will go lower) that the Chinese RRR will fall by a further 1.5 per cent over coming months.

Conclusion

The suggestion that a 4.5 per cent inflation rate means that the People’s Bank of China cannot further ease monetary policy in coming months is too pessimistic. Our model suggests that even if inflation were to fall no lower than 4.5 per cent, the People’s Bank of China could still reduce the required reserve ratio by a further 1.5 per cent in the months ahead.

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Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.