RRRs - now 14.5 percent for large institutions and 12.5 percent for smaller banks - will be lowered by a total of 100 basis points in two stages, the PBOC said.
The reserve requirement ratio refers to the percentage of cash that financial institutions are required to place in the central bank as reserves, against the amount of deposits they hold. In addition, the PBOC launched an innovative monetary policy tool called the targeted medium-term lending facility (TMLF) to provide stable funds to commercial banks.
The move will unleash about 800 billion yuan (116.6 billion USA dollars) of capital into the market and effectively increase loan funding sources of small, micro and private businesses.
Policy support might include tax reduction, across-the-board reserve requirement ratio (RRR) cuts, and targeted RRR cuts.
"Looking ahead, China's key policy challenge is to manage trade-related headwinds while maintaining efforts to limit financial risks", the bank said its latest assessment on the world's second-largest economy.
The offshore yuan pared gains slightly to trade 0.1 per cent higher at 6.8763 per dollar as of 6:30 p.m. local time.
"The People's Bank of China (PBoC) will inject a significant amount of cheap funds to plug the liquidity hole", said Ming Ming, Citic's head of fixed-income research.
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"We will maintain reasonable and sufficient liquidity, maintain reasonable growth in the scale of money and credit and social financing, stabilise macro-leverage and seek internal and external balances", it said.
"This may in part be a reaction to the bad PMI data and the equity market sell-off we have seen", said Michelle Lam, a greater China economist at Societe Generale SA in Hong Kong.
The ratio for large lenders will be cut from 14.5 percent now to 13.5 percent.
China's manufacturing purchasing managers index fell into the contraction territory last month, the weakest since early 2016.
China reported on Monday that factory activity shrank in December for the first time in over two years.
Lian Ping, chief economist at the Bank of Communications, said the pressure of the economic slowdown would show up in the first half of 2019 when the existing United States tariffs on US$250 billion of Chinese goods would bite deeper into the economy.
The announcement came just hours after Premier Li Keqiang said China would take further action to bolster the economy, including RRR cuts and more cuts in taxes and fees. "This is a classic case of banking disintermediation amid the down cycle".