On Sunday, the Chinese Central Bank reduced the amount of reserves that commercial banks need to hold by one percent. The one percent cut is larger than expected, and marks the second time the government has cut the reserve requirement in the past three months. The reserve cut could add another $200 billion to China's total money supply.
The reserve cut gives credibility to Prime Minister Li Keqiang's statement that China has the tools necessary to combat any economic slowdown. China's GDP growth has slowed recently, as the country transitions from a fixed investment led economy to a consumption based economy. Because of slower credit growth, China's housing sector is weak. Housing prices are lower year over year while land sales are down 32%. Because of the Yuan's appreciation, manufacturing and exports are weak as well. China's PMI is hovering around the flat 50 level. Fortunately, China has many traditional policy tools to combat the slowdown. Because China's inflation rate is just 1.4%, and interest rates are at 5.35%, the PBOC can lower interest rates a lot further.
The government also has many unconventional methods in its toolbox to stimulate the economy. Although the government has already lowered coal generated electricity prices once, it can lower electricity prices further if the economy needs it. Given that it has $4 trillion in foreign exchange reserves, the government can use some of its reserves to recapitalize banks. If banks have fewer bad loans and more reserves, they will lend more, increasing the money supply. The Chinese government can also lower taxes on the lower class and relax regulations for migrants to increase consumption.
Reserve cut positive for the stock market
Easing is good for the market for a couple reasons. In times of easing, part of the new money supply turns into hot money that people use to buy stocks. That extra demand triggers a wave of speculation that powers the index higher. Because interest rates fall, some yield seekers have no choice but to buy higher risk stock market securities in lieu of bank CD's to preserve their incomes. The yield seeker's purchases add to stock demand. Finally, because debt is cheap, companies often issue more debt to buy back stocks, which adds to aggregate demand.
History shows that the Shanghai index can rally a lot further if the Chinese government continues to ease. Because of Abenomics, the Nikkei rallied from 8,000 in 2012 to almost 20,000. When the BOJ eased in 1985, the Nikkei rallied from 13,000 to over 40,000. Similarly, because of QE, the S&P 500 rallied from 666 to over 2,080 today.
I believe the Shanghai index will correct more than it did in January when the government previously increased margin requirements. I believe that the index will quickly recover, however, and that the 4,000 will be the level where the Shanghai index consolidates around for a few months as the government eases further to improve the economy and tightens margin requirements to make sure the market doesn't rise too far too fast.
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