BEIJING--China's central bank is increasingly finding itself in a bind, balancing its need to continue easing credit to support economic growth against its stated goal of keeping the Chinese currency stable.
Late Monday, the People's Bank of China lowered the amount of deposits banks must hold in reserve by 0.5 percentage point, freeing up an estimated 700 billion yuan ($107 billion) in funds for banks to make loans. The move marks a reversal in the central bank's stance from two months ago, when it resisted using such aggressive easing tools for fear that they could weaken the yuan.
The timing of the easing measure, just after China assured Group of 20 finance chiefs it wouldn't deliberately weaken the yuan, quickly raised eyebrows.
The action "portends further volatility in the yuan as market participants try to fathom the central bank's intentions regarding the yuan and whether yuan depreciation itself will be used as a tool to support growth," said Eswar Prasad, a Cornell University professor and former China head of the International Monetary Fund.
For the central bank, a burgeoning liquidity shortage, which poses a threat to overall financial stability, has for now replaced the stability of the yuan as the top concern, according to an official close to the bank. The first sign of a cash squeeze came late last week, when China's overnight money-market rates, a key gauge of liquidity, surged and caused Chinese stocks to plunge.
On Monday, prior to the central bank's move, Shanghai's benchmark stock index fell 2.9% to nearly its lowest point in 14 months. The yuan declined during the day and fell further after the reserve-requirement announcement, hitting its weakest level in about three weeks. It was at 6.5539 per dollar late in China from 6.5452 early in the day. Still, the yuan had been kept largely stable against the dollar since mid-January.
"With the exchange rate relatively stable for now, the central bank is shifting its attention to dealing with the downward pressure on the economy," said Zhong Zhengsheng, director of economic research at Hua Chuang Securities, a state-owned brokerage.
But the pressure on Beijing to avoid a sharp weakening of the yuan isn't going away, especially after its public pledge not to drastically devalue the currency. Lowering the reserve-requirement ratio for banks tends to weigh on the yuan's value by increasing lending, which leads to a larger supply of yuan in the economy.
At the same time, more businesses and individuals seek to take money out of the country as China's economy slows, also putting downward pressure on the yuan. That means the central bank may have to keep intervening in the currency markets to keep the yuan within a reasonable range, analysts and economists say.
Such interventions would not only undo the intended effects of monetary easing but also cause market liquidity to tighten. That is because the central bank would sell dollars to buy yuan, effectively draining yuan funds out of the financial system.
"The central bank is in a difficult situation," said Zhu Chaoping, China economist at UOB Kay Hian Holdings Ltd. "As it keeps intervening to stabilize the yuan, more funds get taken out of the system, which would then force it to ease further, causing more depreciation pressure on the yuan."
One big reason for the most recent cash squeeze is a sharp rise in money leaving China. As an indication of the outflows, China's foreign-exchange reserves plunged by $99.5 billion in January, to $3.23 trillion. Chinese consumers withdrawing cash from banks during the Lunar New Year holiday, which ended two weeks ago, also contributed to the squeeze.
The decision to cut banks' reserve requirements, effective Tuesday, is the latest surprise turn in China's financial policies and comes as demands mount on Chinese authorities to better explain policy moves.
Minutes of a meeting held by the central bank and attended by China's senior banking executives in January show that officials avoided a reserve-requirement cut then to avoid downward pressure on the yuan, also known as the renminbi. Such a step would send "too strong an easing signal," Zhang Xiaohui, an assistant governor at the central bank, said at the time, adding "we need to put a high emphasis on maintaining the renminbi's stability when managing liquidity."
Instead, to meet the rising cash needs from banks, the central bank turned to short- and medium-term loan facilities to pump more than one trillion yuan of temporary funding into the banking system.
But that type of funding comes with a high cost for Chinese banks, with interest rates at least 0.6 percentage point to one percentage point higher than the rates on official deposit reserves, estimates Zhou Hao, a senior economist at Commerzbank AG.
In addition, a reduction in reserve requirements frees up funds for banks to lend on a permanent basis, while injecting liquidity through short- and medium-term tools means the money can be taken back by the central bank when those loans expire.
The central bank didn't offer a written explanation to accompany its reserve-requirement announcement Monday, unlike its practice as part of major policy actions in the past year.
Meanwhile, investors and analysts question the benefits of further monetary easing. Total financing in the economy grew strongly in January, official data show, but many companies, especially small and private businesses, still complain about difficulties in accessing credit.
At the same time, property prices in China's first-tier cities including Shenzhen, Shanghai and Beijing have risen sharply in recent months, fueling concerns that easier credit is fanning asset bubbles just as China seeks to eliminate excesses in many sectors.
"Despite the increased loosening bias, recent policies haven't had a big impact on the real economy," said Chen Xingdong, chief China economist at BNP Paribas.
Write to Lingling Wei at lingling.wei@wsj.com
