Now's not the time for China to open the credit floodgates

Hu Shuli says targeted measures, such as directing needed funds to small businesses, are more suited to China's changing economy

PUBLISHED : Wednesday, 04 June, 2014, 1:57pm
UPDATED : Thursday, 05 June, 2014, 3:18am

Market expectations are rising that China will cut the reserve requirement ratios for all banks.

On a visit to Inner Mongolia last month, Premier Li Keqiang pledged to carry out "pre-emptive fine-tuning in a timely and appropriate manner" to help relieve the financing difficulties and high borrowing costs for small businesses. Many people think this means a blanket cut of the reserve requirement.

This would be a bad move.

To be sure, sustaining China's economic growth has been a challenge this year: economic indicators such as investment levels, the industrial value-added output and corporate profits have been sliding; the property market is going through an increasingly severe adjustment; and financing costs in the real economy have remained stubbornly high. But these reflect deep-rooted problems.

Lowering the reserve requirement ratios will directly lower interest rates in the money market, but it is unlikely to lower financing costs or solve the fund-raising problems of small businesses.

Those who advocate a cut are worried about a credit crunch. But statistics show that, in May, the cost of borrowing was low, with short-term interest rates at the end of the month showing no sign of a rise. There has also been no sign of a crunch in the interbank lending market.

While it's true that business financing costs are rather high, there are many reasons for this. For one thing, rate liberalisation has raised market expectations of a higher return on money, thus raising such costs. For another, investors have become more wary of the default risks of trusts and other wealth management products, again raising borrowing costs.

At the same time, there is a severe mismatch in fund allocation, thanks to financing vehicles' and state-owned enterprises' disregard for the market. Meanwhile, some real estate companies heavily depend on refinancing, thus tying up large amounts of funds in inefficient, high-risk products while small businesses are starved of funds.

Distortions in China's financial industry are the root of the problem. Loosening the spigot aimlessly is no solution; the water must be directed to where it's needed.

Conversely, a blanket cut in the reserve requirement ratios will have many adverse effects. It will impede needed adjustments in the property market and productive capacity, as well as the reassessment of risks of local government financing vehicles.

Moreover, housing markets in third- and fourth-tier cities are showing signs of improving health, while in the major cities, transactions are slowing and prices have begun to stabilise. We fear a rebound if the government were to loosen its reins now. There are precedents, after all: banks' reserve requirement ratios were cut three times between December 2011 and May 2012, and each time it was followed by a rebound in housing sales and record prices.

As has often been said, China's economy is in transition. Policies need time to work, and some policy continuity is critical. Cutting the reserve requirement ratios will boost the economy, but at a price: it will inflate the bubble and add to the risks.

The reserve requirement ratios are on the high side, to be sure, and slight adjustments can be made where needed.

An all-round cut may be appropriate in two scenarios.

Central bank governor Zhou Xiaochuan has said that in the exceptional case of an over-accumulation of foreign exchange reserves and a too-big monetary base, China has to tighten the reserve requirement to freeze liquidity. It's not yet time to unleash the cash reserves of banks.

Cutting the reserve requirement may also be necessary in the case of an abrupt decline in economic growth. When the central bank cut the ratio in September 2008, for instance, the global financial crisis was starting to bite.

Today's China struggles with different problems, however. The issues at hand are too complex to warrant such a macro measure.

In fact, thanks to more targeted measures, the monetary outlook has already improved. These plans, for example, deserve support: a relending operation that encourages commercial banks to lend to small businesses, and a cut in the reserve requirement ratio for banks that lend to poorer regions and the agricultural sector.

The government should consider more targeted measures like these, such as encouraging banks to provide mortgages for first-time homebuyers, and encouraging lending for investments into affordable housing and rail infrastructure.

Without a correct diagnosis of its problems, China must not easily open its credit floodgates, or it will bring more harm than good. China is undergoing no fewer than three transitions simultaneously: a slowing of growth, a restructuring of its economic model, and a winding down of its stimulus measures. It must patiently deal with the problems one at a time.

This article is provided by Caixin Media, and the Chinese version of it was first published in Century Weekly magazine.