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Reserve rates cut but government still behind the curve

The accusation of being 'behind the curve' has dogged the current Chinese administration since it took office in 2002. The announcement of a reserve requirement cut at the weekend isn't likely to weaken that charge. A reserve cut had been expected since mid-April. Still, the government failed to act, despite mounting evidence from the provinces that industry was really struggling in the face of anemic global demand and Beijing's own anti-inflation policies.

That rates moved a day after a set of dismal economic data reports highlights again the State Council's inability to reach consensus on policy decisions, and its tendecy to allow problems to build in the system until a set of bad news prompts a kneejerk -- and often overly-aggressive --response.

It has been five years since the collapse of the U.S. housing market, and China has had a relatively good crisis. The government's aggressive CNY4 trillion response helped compensate for lost external demand, and the economy averaged 9.6% growth between 2008 and last year. That stimulus, announced in November 2008, was an uncharacteristically bold response to a once-in-a-lifetime systemic crisis that threatened the global financial system. Since then, it has been business as usual; responding to inflation only when prices have surged to the point of widespread public anger and now tentatively easing policy as private sector firms struggle for survival amid soaring curbside interest rates and anemic domestic demand.

China's current slowdown was engineered by government policy designed to tackle rising inflation and deflate nationwide property bubbles. The rationale has always been that the government's overwhelming control of the levers of the economy meant it could restimulate activity just as easily as it slowed it, and that underpinned this year's confident 8%-plus GDP forecasts. Moves to cut the reserve requirement in December and February boosted confidence that the central government had finally let go of its worries about inflation, and was moving to kickstart growth as price pressures faded and as euro-induced panic weighed on global risk sentiment. The weakness seen in January-February -- and, to a certain extent, March data -- was written off as distortions created by the Chinese New Year holiday.

But the weeks following the end of the holiday season have brought little respite. If anything, evidence mounted pointing to an industrial base struggling in the face of policies designed to keep prices and speculation in check. That it has gone on too long is reflected in business surveys, particularly those produced by HSBC/Markit, which tend to focus on smaller, privately-held firms that exist at the mercy of the unregulated underground financing system.

The index remained below the 50-mark separating expansion from contraction for a sixth straight month in April. More worryingly, the survey indicated that companies are shedding jobs at the fastest rate in 37-months.

The government hasn't been sitting on its hands in recent weeks. The People's Bank of China has injected around CNY400 billion into the interbank market via open market operations since the start of the year, while Beijing has announced key reforms, including the start of a private finance program in Wenzhou, the eastern-seaboard city which has arguably suffered most from the domestic credit crunch.

But it has been negligent in heeding calls from industry for a more aggressive pace of policy easing, including access to credit. While the State Council has debated the economy's need for looser policy and struggled to reach consensus on action -- opting for relative inaction instead -- industry has suffered. This culminated with the release of economic data reports at the end of last week. Trade, industrial output, investment and retail sales growth all fell short of market expectations, triggering a wave of analyst downgrades for growth this quarter and this year.

But the myth of Beijing's apparent insouciance was betrayed on Saturday evening, when the PBOC announced the reserve requirement cut. A cut had been expected ever since the release of first quarter GDP in mid-April. That it followed the miserable April data reports signaled a degree of panic within the establishment, and suggested a realization that officials waited too late to heed industry's call.

The reserve cut has been followed by the predictable flood of analyst reports, instructing clients to expect more loosening moves in the weeks and months ahead. They more than echoed the reports following the December and February cuts, despite the weeks of inactivity that followed. Inflation now appears to be firmly under control, while global economic conditions only appear to be worsening, even without the threat of a partial unraveling of the European Union.

Domestically, weak bank lending activity points to inadequate credit, but also falling demand for loans -- a situation that will require far more than the CNY400 billion that will be released into the system by this week's reserve cut. The reserve cut suggests the government is now suitably spooked about the economy and onside, ready to act to support the domestic economy and achieve 8% growth this year.

But the central government will need to follow up Saturday's move with more policy loosening, including taking advantage of its relatively comfortable fiscal position, if investors -- and corporate officers -- are going to avoid the sense that it's deja vu all over again.




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