Written by Michael Knox, chief economist, RBS Morgans

Our model of the Chinese Required Reserve Ratio suggests we can expect five cuts in the ratio in coming months.

Back on 13 February 2012, we talked about the relationship between the rate of change of consumer inflation in China and the rate at which the People’s Bank of China (the Central Bank) sets the Required Reserve Ratio (LINK) . The Required Reserve Ratio is the proportion of commercial bank reserves that must be lodged with the Central Bank. China uses this rather than interest rates as its central tool in setting monetary policy.

We showed that the Required Reserve Ratio was really driven by the level of domestic inflation in China. We showed a model which told us that a cut in Chinese inflation would result in a cut in the Required Reserve Ratio usually in the next three months. Our updated model of the Required Reserve Ratio is shown in Chart one below. The actual level of the Required Reserve Ratio is shown as the blue line. Our model of the estimated future changes of the Required Reserve Ratio is shown as the red line.

Back on 13 February, we noted that the Chinese inflation rate for the year to January of 4.5 per cent was already below the peak of 6.5 per cent in July 2011. This meant that there was already room for further cuts in the Required Reserve Ratio. The People’s Bank of China then followed with the cut of 0.5 per cent. Since that time, the National Bureau of Statistics of China has reported on 9 March that the February inflation level has declined further to 3.2 per cent.

The reason for the further decline was interesting. Although food prices went up by 6.2 per cent, nonfood prices rose by only 1.7 per cent. Of the increase in food prices of 6.2 per cent, grain prices rose by 5.4 per cent. Meat and poultry prices rose by 12.9 per cent. Fish prices went up by 7.5 per cent.

The productivity of China’s services sector, however, kept inflation in the non-food sector in check. Prices for transportation and communications rose by an almost invisible 0.1 per cent. Of these, intercity transport fares rose by only 1.6 per cent. Intra-city transport fares rose by only 0.6 per cent. Communication prices or telecom prices fell by 13.5 per cent.

Other areas of the services sector were just as good. The prices for recreation, education and the culture services went down by 0.4 per cent. Education services went up by only 1.3 per cent.

The big problem that caused the blowout in inflation in the most recent cycle was housing prices or as the Chinese say, “prices for residence”. The result of the period of tight monetary policy in 2011 was to reduce inflation in this sector of only 2.1 per cent. Prices for house renting went up by 2.5 per cent.

Our model explains 89.2 per cent of monthly variation in the Required Reserve Ratio with a lead of three months. Our model tells us that the decline in Chinese inflation to 3.2 per cent in February should lead to a decline in the Chinese Required Reserve Ratio by two and a half percentage points. This should bring it down from a current level of 20.5 per cent to around 18 per cent by the middle of the year. A likely scenario would be a cut of 50 basis points or half of one per cent in each month for the next five months. Such a cut would be strongly expansionary for domestic demand in the Chinese economy in 2013.

Conclusion

Our model suggests that the decline in Chinese inflation to 3.2 per cent in February should allow cuts of a full 2.5 per cent in the Required Reserve Ratio over coming months. We think a likely scenario is a cut of half of one per cent in this ratio every month for the next five months. These cuts would be strongly expansionary for domestic month in the Chinese economy in 2013.

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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.