China stock rout fuels easing expectations

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The plunge in China's stock market - which suffered its worst weekly drop last week since 2008 - has helped fuel already-heightened expectations mainland authorities will launch fresh monetary stimulus in the near future.

The benchmark Shanghai Composite index plunged 13.3 percent last week, entering into correction territory, precipitated by concerns over rising valuations and tighter liquidity in the market.

"Insufficient open market operation liquidity injections and a coincidental surge of IPOs [initial public offerings] in the A-share market shook Chinese stocks," said Steve Wang, chief China economist at Reorient Research.

Some 23 IPOs are currently in their subscription periods, locking up over 7 trillion yuan of liquidity, well above the 4.8 trillion yuan of liquidity frozen in the previous batch of listings in early June, according to Reorient Research.

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This contributed to the rise in the seven-day repo rate - a measure of interbank funding availability - which spiked above 4 percent at one point on Friday, the highest since April.

"The sudden tightness in interbank liquidity became a catalyst for sharp profit-taking in equities," he said.

As a result, Wang believes there's a "heightened probability" of a reserve requirement ratio (RRR) cut in the near-term.

China's bull run: It's been a bubble all along?
China's bull run: It's been a bubble all along?   

"A 100 basis point RRR cut package, which could release up to RMB1.5 trillion of liquidity, is becoming a much-needed action to help restore liquidity balance ahead of the half-year crunch mark," he said.

The People's Bank of China (PBOC), the country's central bank, last cut the RRR in April when it relaxed the amount of cash that banks are required to hold as reserve by a 100 basis points to 18.5 percent the biggest since 2008.

While Li Gang Liu, head of China economic research at ANZ, also expects the PBOC to step on the monetary pedal in the coming weeks, he believes any easing moves by central bank will be driven by macro-economic conditions rather than stock market swings.

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"I don't think PBOC policy is based on stock market volatility – that's the view of Chinese brokerage firms. If they were to do that it would be a fatal mistake," Liu said. "The PBOC is responding to real economic conditions: slower macro-economic activity, falling prices, rising deflation," he added.

Liu, who expects the expects an further interest rate cuts this year, says the main problem facing the economy is that bank lending rates remain elevated.

"Last month, the interest rate facing enterprises was above 6 percent, against benchmark rate of 5.1 percent, you can see that this policy transmission has not worked," he said. "The banks don't want to lend because they have seen growth continue to slow and credit risks are rising. This is something the PBOC needs to address."