China’s cut in reserve requirements – very bullish for stocks

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The PBoC’s announcement of a 0.5% cut in the reserve requirement rate (RRR) of Chinese banks has significant consequences not only for the Chinese economy but also for China’s stock market. The cut to 20.5% for large banks follows a similar cut in December last year after hikes since January 2010 that saw the RRR increasing in 12 increments from 15.5% to 21.5%. It is estimated that one half percent change in the RRR amounts to a change of approximately 400 billion yuan or roughly US$60 billion in liquidity. It therefore means that the jump in the RRR since January 2010 has effectively drained overall liquidity by approximately US$720 billion. That is equal to approximately 6% of China’s GDP in 2010 and 2011 combined.

Although the PBoC cited weak external demand as the main reason for the drop in the RRR, liquidity became very tight in recent weeks and forced interbank rates significantly higher. The CFLP Manufacturing PMI that I seasonally adjust continues to indicate lackluster growth in China’s manufacturing sector largely as a result of weak export orders. As in 2008 the PBoC held off on further increases in the RRR in 2011 when weakness in the manufacturing PMI became apparent. The first cut in the RRR last year was announced when the manufacturing PMI contracted – again similar to what happened in 2008. The latest cut therefore indicates that the manufacturing PMI for February is likely to again show abysmal growth.

Sources: CFLP; Li & Fung; BIS; Plexus Asset Management

The weakness of China’s economy is not only confined to the manufacturing sector, though. While still signaling growth, my seasonally adjusted CFLP Non-manufacturing PMI indicates that growth has slowed to about half of the average since the recovery after the 2008/2009 crisis.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

The weakness in the non-manufacturing sector is driven by weak consumer confidence.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

My GDP-weighted seasonally adjusted CFLP PMI indicates that China’s year-on-year GDP growth has slowed to approximately 8 – 8.5% from 8.9% in the fourth quarter last year.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

The cut in the RRR is consistent with what happened in 2008 when GDP growth fell below 9%.

Sources: NBSC; BIS; Plexus Holdings.

Assuming that a 0.5% change in the RRR equaled US$60 billion throughout, I calculated the cumulative liquidity drain. It is evident that changes in liquidity lead GDP growth by approximately two quarters and the seasonally adjusted manufacturing PMI by three months.

Sources: NBSC; BIS; Plexus Holdings.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

I view the cut in the RRR as very bullish for Chinese stocks. Changes in the direction of the RRR had a major impact on the Shanghai Composite Index in the recent past. In 2008 the first cut in the RRR coincided with the bottom in the Shanghai Composite Index, while the hike in January 2010 coincided with the start of the slide in equity prices.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

The market is currently not out of sync with the underlying economy and is discounting a not seasonally adjusted CFLP Manufacturing PMI of approximately 50 for February. March and April are normally exceptionally strong months from a seasonal perspective and are likely to be supportive of stock prices. Together with the likely impact of the increase in liquidity I think the next strong bull market in Chinese stocks is underway. I stick to my view that the Chinese stock market will be the best performing equity market globally in 2012.

Sources: CFLP; Li & Fung; Plexus Holdings.

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