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China Returns to Growth Mode with Major Policy Shift

By , Associate Editor, Money Morning •

The damaging global economic effects that Europe's unfolding debt crisis pose have caused a sharp reversal in China's monetary policy - one that will lead to a greater expansion of the Red Dragon's economy.

The People's Bank of China announced yesterday (Wednesday) that it would lower the percentage of deposits commercial banks must hold in reserve by 50 basis points, effective Dec. 5.

This is China's first reserve requirement cut since 2008. It drops the level to 21% for large banks and 19% for smaller institutions.

The move was unexpected from the world's second-largest economy, which has been tightening its monetary policy for more than a year.

The change underscores the country's concern that exports, its main driver of economic growth, would weaken due to lower demand from the troubled Eurozone, China's biggest consumer. However, it's also a signal that after a year of tapping the brakes on growth to curb inflation, Beijing is ready to put its foot back on the accelerator.

"This is a clear signal that Beijing has decided that the balance of risks now lies with growth, rather than inflation," Stephen Green, greater China head of research at Standard Chartered, told The Financial Times. "This is a big move, it signals China is now in loosening mode."

China's gross domestic product (GDP) in the third quarter grew by 9.1% -- the slowest pace in two years and down from 9.5% in the previous three months. That's the fourth consecutive quarter of declining GDP growth.

Loosening China's Monetary Policy

China fears its best customers, Europe and the United States, will keep reducing their imports as they're burdened with weak economies. Chinese exports in October rose by 15.9%, the smallest amount in two years.

"The weakness in exports was very much in line with the global environment, especially the slowdown in Europe, and that's going to continue through to the first quarter of next year," Li Cui, an economist with the Royal Bank of Scotland, told Reuters. "I think the underlying weakness is perhaps even weaker. [M]y estimation is that the real growth could only be around 7% to 8%, adjusting for export prices."

Exports to Europe in October slowed to a 7.5% growth rate compared to a year earlier, down from a 9.8% rate in September.

However, the country is also encouraged by the success of its recent monetary tightening measures.

Concerned about inflation, China has raised reserve requirements six times and instituted five interest-rate increases since October 2010. As a result, consumer price inflation fell to 5.5% in October after peaking at 6.5% in July.

The effects of China's tightening can also be seen in its real estate market. After being overheated for years, property prices have finally started to level off. Some Chinese cities have seen a 28% drop in apartment prices in the past few months.

That has paved the way for another run at promoting growth.

Analysts estimate the looser reserve requirements will inject about $63 billion (400 billion yuan) into the Chinese banking system to spur lending.

"The move will help ease liquidity after previous tightening measures cooled credit growth too much and may have added to the risks of a hard landing for China," Shen Jianguang, an economist at Mizuho Securities Ltd., told Bloomberg News.

The central bank's actions will also assure investors action will be taken to control the economy. China made the announcement after the Shanghai Composite Index fell 3.3%, its worst one-day loss in four months. The Shanghai stock market has tumbled about 17% so far this year.

"The fact that [the central bank] chose to act in this more public way is a signal not only that policymakers are loosening, but that they want to be seen to be doing so," Mark Williams, chief Asia economist at Capital Economics, told The FT. "Accordingly, we see this as a decisive shift in policy stance."

Ting Lu of Bank of America/Merrill Lynch told Reuters to expect the central bank to cut reserves requirements three times, by a total of 150 basis points, before the end of next year.

That bodes well for the country's growth and investment opportunities.

"Long-term, you can't afford to be without Chinese stocks," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Timing is not what you should be focused on. You need to be focused on growth, and who has the money."

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