Seen from the beginning of 2012, the Chinese economy has showed signs of slowing down. Instead of keeping the overheated economy in reasonable pace in the past years, Chinese authorities are more afraid of an earlier economic slowdown than expected. A decision to reduce the amount of cash reserves that banks are required to hold has been adopted to encourage stronger growth and enable more money to circulate in the domestic market.

A similar cut came in December 2011 after the central bank had tightened bank lending for a period of time. Recent loose monetary policy is reflective not only of predicted slower economic growth but also of the European debt crises and the anemic American economy which might hurt China’s export revenue as these are its two biggest trading partners.

Analysis

The full significance of this move is likely best seen through two separate timelines for changes expected in the Chinese economy.

In the short term, it provides evidence of China’s ongoing efforts to control the nature and extent of the slowdown in its economic growth in the face of the challenges listed above. The International Monetary Fund is expecting 8.2 percent GDP growth (revised down from a previous 9 percent estimate) for China in 2012 and leaders have recently started trying to lower expectations below the vaulted 8 percent annual growth figure long thought to be the key to maintaining social stability.

Some expected the cut in the reserve ratio to come before the Chinese New Year Holiday and suggest that their having waited this long demonstrates that Beijing is reasonably happy with the way the slowdown is proceeding.

Others see the move in the context of micro indicators such as slowdowns in cement and machine production, excavator sales, rail volumes and adjusted figures for energy consumption as part of an emerging picture suggesting that fears of a “hard landing” are well justified. It is a far less significant move than a change in the actual interest rate would have been and can be interpreted largely as an attempt to buoy sentiment.

Over the long-term, this move helps raise the question of how long the state can continue to play an active role in determining the course of economic developments in the world’s second largest economy. While China is by no means the only country that will be facing these questions, the stakes feel much higher and there is already a healthy debate among Chinese academics and business people as to what kind of changes will be necessary to ensure the long-term sustainability of the current model.

Seen in this context, the move may be part of an effort to manage a slowdown in the economy that may serve to further delay what some see as still necessary structural adjustments.

Wikistrat Bottom Lines

Opportunities

• Lowering reserve requirements should allow for an increase in the money supply and should, according to economic theory, allow for an increase in productive economic activity.
• An increase in credit may also help to decrease the effect of low demand in Europe and the United States if the “new” money is used domestically.

Risks

• Loose monetary policy relies on the assumption that credit is used for investments, not consumption. An increase in the supply of credit could fuel booms (and possibly bubbles) in non-tradable goods and services, like housing.
• Increasing the money supply could also lead to some degree of inflation. While the Chinese authorities are generally more willing to accept higher levels of inflation than their Western counterparts, unbridled inflation can lead to a host of economic problems.

Dependencies

• If this loose monetary policy doesn’t lead to an increase in economic growth, what other tools can China use to stimulate the slowing economy?
• The increase in credit is supposed to offset the decrease demand in the West. What happens if the policy fails to achieve its goal?

Bodi Du, Chris Janiec and Andrew Pratt contributed to this analysis.