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Morningstar | People's Bank of China Introduces Required Reserve Ratio Cut Effective Oct. 15

On Oct. 7, People's Bank of China announced a 1-percentage-point reduction in the Chinese central bank’s required reserve ratio effective Oct. 15. This is the third RRR cut in 2018 following the 100- and 50-basis-point cuts announced in April and June. We retain our fair value estimates for the Chinese banks as we believe the benefits of liquidity injection are largely offset by weaker loan pricing and higher credit costs as the economy is facing mounting challenges both domestically and externally. Our top picks are ICBC and Agricultural Bank of China, which are trading at 29% and 24% discounts to our fair value estimates, respectively. Assuming other assumptions are unchanged, we believe current prices imply bad-debt ratios reaching about 11.0% and 10.0% for these two banks. We believe risks for these banks are manageable, as their prudent operations and cheap funding costs enable high profitability and thus strong ability to absorb credit losses gradually.

The rate cut will release CNY 1.2 trillion in funds for banks, with CNY 450 billion used to pay back the medium-term lending facility that will mature Oct. 15. This rate cut aims to provide long-term cheap funding for banks and encourage them to channel credit to the real economy at lower costs. The regulator also looks to provide liquidity support to the troubled bond market, which is seeing climbing defaults caused by a contraction in shadow banking credits. Given the inefficiencies in the country’s monetary transmission mechanism, we are sticking to our view that the RRR cuts are a difficult way to boost lending, given rising risk aversion for banks and tighter financial regulations to curb off-balance-sheet lending. Thus, we expect limited benefits for the economy. While large banks might see cheaper funding costs and strong on-balance-sheet credit growth, the extent will depend on PBOC's ongoing open-market operations and MLF operations to either inject or withdraw liquidity from the market.

We estimate the RRR cut will boost full-year net profits of listed banks by about 0.9% and about 0.2% in 2018, since it’s effective in mid-October, by lowering bank’s funding costs, where CNY 1.2 trillion MLF borrowings priced at 3.3% were replaced by RRR funds being released. We estimate a 1-basis-point reduction in average funding costs for banks, assuming 100% of unleased funds are used to replaced MLF borrowings. However, the impact on liquidity conditions largely depends on PBOC’s ongoing open-market operations and MLF operations. October will see mounting pressure of liquidity outflows, including about an estimated CNY 1 trillion tax payment for the corporate sector and CNY 600 billion bank borrowings from PBOC maturing. The CNY 600 billion is part of the CNY 3.2 trillion and CNY 5.4 trillion outstanding balances under the pledged supplementary lending and MLF, respectively. In sum, we believe the RRR cut once again signals the policy priorities shifting toward supporting economic growth from financial deleveraging, while the actual impact on the economy and banks is limited, given the defects in monetary transmission mechanism and lack of proper financing substitutes to fill the gap left by shadow banking contraction.