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Analysis: China needs new policy course as capital tide turns

By Kevin Yao

BEIJING (Reuters) - China's economy has surfed for years on a crest of hefty capital inflows, but the tide that brought gains in money supply is turning as global growth slows.

Capital has flowed out the past two months. If that persists, the challenge for the People's Bank of China will be to adjust policies to keep the country's growth rates from falling much.

That will be no mean feat for policymakers schooled in absorbing inflows averaging 256 billion yuan ($40.5 billion) a month since July 2005, but short on experience of how to handle outflows.

"I think this indicates a significant change in the environment for monetary policy -- from large 'twin surpluses' to a more balanced external position," Hua Zhongwei, an economist at Huachuang Securities in Beijing, told Reuters.

"So the situation under which the central bank 'passively' releases liquidity into the economy will change. It may have to pump out money in a pro-active way," he said.

The most likely way that pump will operate is through a simple reversal of the increases in the amount of cash commercial banks are required to keep as reserves -- the same tool that was used to drain the excess liquidity created by capital inflows.

The 600 basis points of required reserve ratio (RRR) hikes between January 2010 and June 2011 to a record level of 21.5 percent drained some 4 trillion yuan from China's economy.

That was as the central bank fought to bring money supply growth down from a breakneck -- and dangerously inflationary --pace close to 30 percent in late 2009, to a level closer to the 12-14 percent that international economists believe China targets.

A WAY TO COMPENSATE

Unlocking that reservoir of reserves is the obvious way to compensate for the $8.3 billion in outflows revealed in central bank foreign exchange data for October and November. The 50 bps RRR cut on November 30 released an estimated 350 billion yuan into the banking system.

Capital outflows from China may continue in the short term as Europe's sovereign debt crisis undermines risk appetite and investors seek safe havens.

Foreign direct investment in China fell 9.8 percent in November from a year earlier to $8.8 billion, the first drop in 28 months as inflows from the United States and Europe faltered.

The beauty of injecting liquidity via RRR cuts is that it compensates for capital flight without notionally shifting the declared stance of monetary policy, assuming it is the level of money supply growth that officials target.

That's especially important in an economy with average inflation this year running 1.5 percentage points above the 4 percent official target and retail sales growth galloping at a 17 percent clip so far in 2011.

The central bank insists it will keep policy prudent in 2012, even though many economists believe it shifted to a looser policy stance when it cut banks' reserve requirement ratio (RRR) in November for the first time in three years.

CREATING CASH POOLS

Central bank governor Zhou Xiaochuan has raised the idea of creating cash "pools" to absorb hot money inflows. Analysts say that implies Zhou always intended to recycle the cash mopped up via reserve rises to cushion slowing growth.

"It's time to unleash money from the pools," Hua said.

Private sector economists polled by Reuters earlier this month expected the PBOC cut deliver 200 bps of RRR cuts by the end of 2012 and refrain from an outright cut to interest rates unless there is a sudden shock to the economy.

The next cut in the RRR is widely expected to come soon because demand for bank liquidity rises ahead of the Chinese Lunar New Year, which begins on January 23.

A related issue for liquidity is that the amount of maturing central bank bills is expected to shrink to a monthly average of 65 billion yuan in the January-March period from a monthly average of 222.5 billion yuan in 2011.

Freeing up the money banks can lend is desirable on many levels for China's leadership, which remains sensitive to public opinion despite the lack of direct parliamentary elections.

Real returns on bank deposits are negative, hurting savers faced with annual inflation stubbornly higher than the one-year deposit rate of 3.5 percent.

THE JAWS OF LOAN SHARKS

Small business owners say they have been forced into the jaws of loan sharks by the tight credit policies of the past two years, sparking a national scandal.

Analysts expect the central bank to target 8-9 trillion yuan in new loans for 2012 -- up from 7.5 trillion yuan they estimate was targeted this year -- to keep credit conditions accommodative and indicating a willingness to loosen the grip on the loan-to-deposit ratio, now at 75 percent.

And tweaking the currency, which market participants believe China has been doing recently, is a diplomatic minefield given that many politicians around the world believe China keeps its currency weak to support exports.

Analysts expect yuan appreciation to the dollar to slow to around 3 percent in 2012 from this year's 4 percent rate, with much of the rise anticipated in the second half of next year if China opts for yuan stability to cope with the deepening debt crisis in its biggest export market -- Europe.

Peng Wensheng, chief economist at CICC in Beijing, expects the central bank to cut RRR to 18 percent by the end of 2012 to achieve a 14 percent annual growth of broad M2 money supply -- a level he says is compatible with 8-9 percent economic growth.

Peng reckons net foreign exchange purchases could halve to 1.5 trillion yuan in 2012 from an estimated 3 trillion yuan this year, suggesting the central bank has to pump out the balance to compensate for the fall in the monetary base.

"The authorities can inject cash into the banking system via reserve requirement cuts or open market operations," Peng said in a note to clients.

"(But) even if the authorities have a positive attitude towards expanding credit, there are doubts over how they will be able to achieve the goals," he said.

(Reporting by Kevin Yao; Editing by Nick Edwards and Richard Borsuk)

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