Why China's RRR cut reeks of desperation

The People's Bank of China (PBoC) is "desperate" to control Shanghai's red-hot equity rally, analysts said, after the central bank slashed the reserve requirement ratio (RRR) on Sunday.

The 100 basis-point RRR cut to 18.5 percent is the biggest since 2008 and comes in response to a sharp selloff in stock futures on Friday after the China Securities Regulatory Commission (CSRC) tightened margin trading rules. The CSRC aims to cool Shanghai's stock market, which is up over 30 percent year to date at seven-year highs. Futures plunged during late trading on Friday, with the China A50 futures contract down 6 percent in New York.

"After the announcement on Friday, stock futures were looking horrible so something needed doing to put a floor under that from a short-term point of view. But everybody's going to take a look at this and say 'hold on, why are they [PBoC] overreacting so strongly?' People are going to start sensing desperation here," Paul Gambles, co-founder of MBMG Group, told CNBC on Monday.

Indeed, policy watchers were scratching their heads over the series of conflicting announcements. The PBoC is scrambling to ensure stability in China's notoriously volatile share market, said Mark Andersen, global co-head of Asset Allocation at UBS CIO Wealth Management.

"They want to see markets go up to some extent, but not out of control. With some of this margin financing, they want to see a relatively stable capital market with property prices falling so they don't mind equity prices moving up a bit to support the broader economy, but they don't want to see bubble territory," Anderson said.

The PBOC 'needs' markets

The magnitude of Sunday's RRR cut confirms that authorities have become increasingly dependent on equity markets, economists say.

Beijing is using the stock market to stimulate innovation and entrepreneurship and channel liquidity to the real economy to hedge economic downside risk, as well as to facilitate deleveraging of state-owned enterprises, HSBC said in a report. "[The RRR cut] is a political goal to create wealth effects in both A- and H-share markets."

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This past weekend was a replay of recent events, according to Macquarie Securities. Three months ago, the CSRC rolled out margin financing curbs on a Friday, only to back down Monday night after markets slumped.

These about-turns in policy aren't surprising though "as policy makers need equity markets more than ever," the bank said.

What now for stocks?

Markets widely expect further RRR cuts between May and June, with Sunday's announcement marking the central bank's shift to an aggressive easing cycle from its previous method of 'targeted stimulus.'

Macquarie expects an interest rate cut in May, followed by a 50 basis-point RRR cut later in the year. Over the next five years, it expects China to cut the RRR at least twenty times. Meanwhile, HSBC expects lower interest rates during the second-quarter and another 100 basis-point reserve ratio cut in the second half of the year.

But traders shouldn't fear that such powerful monetary easing will stoke Chinese equities further following seven weeks of gains. Shanghai and Hong Kong stocks swung between gains and losses during a choppy session on Monday, with the Shanghai Composite 1.5 percent higher at one point.

"We suspect that most investors will throw caution to the wind now given the unmistakable signal from the government to buy stocks," said a Bank of America Merrill Lynch research report. "If onshore liquidity fails to drive A-shares significantly higher in coming weeks, the market may peak reasonably soon."

"Crazy things like a 100 bps RRR cut are not going to help confidence. It's going to make people respond in the short term, but people will remain negative in the long-term," agreed MBMG's Gambles, who recommends investors to cash out now.