As the global economic storm clouds darken, Beijing continues to ease its monetary policy settings, while strenuously denying that it is doing any such thing. In the latest move, the People's Bank of China has cut the required reserve ratio for 20 small co-operative banks from 16.5 per cent to 16 per cent. This means that the banks will not be compelled to set aside so much of their deposits as reserves, which should allow them to increase their lending. Officials have denied this represents any easing of the central bank's monetary stance. Apparently the PBOC is explaining away the move by saying that it is merely relaxing penalties it imposed a year ago on the banks for not making enough loans to small rural businesses. If true, this explanation displays some truly tortured official reasoning. The banks in question weren't lending enough, so the authorities punished them by restricting their ability to lend? As an idea, that's almost as bizarre as the euro zone's defunct stability and growth pact, which threatened to punish governments running large budget deficits by hitting them with heavy fines. In short, the explanation stretches credulity, which is why observers are treating the cut as the precursor to a more general across-the-board reduction in required reserve ratios. If the authorities do go ahead over the next few months and cut reserve ratios, it will be welcome news for mainland banks. As the authorities have sought to tighten monetary policy by mopping up more of the liquidity flooding into the mainland's financial system through the trade surplus, they have raised banks' reserve requirements to unprecedented levels. Following the last increase in June, large banks are obliged to lodge 21.5 per cent of their customers' deposits with the central bank, up from 15.5 per cent two years ago and just 6 per cent in the early years of the last decade. The ratio for most smaller banks is 19.5 per cent (see the first chart). Setting aside such a large proportion of deposits is grievously expensive for mainland banks. As the central bank has raised bank interest rates as part of its tightening campaign, it has failed to increase the rates it pays on bank reserves. That means the banks earn an interest rate of just 1.6 per cent on their required reserves, while paying their customers a benchmark rate on their deposits of 3.5 per cent. In other words, the banks are making a negative interest rate spread of 1.9 per cent on one-fifth of their deposits. In effect what the central bank is doing is passing a portion of the cost of its policy of currency intervention on to commercial banks. That's great for the central bank, but it further weakens a banking system already facing a declining deposit base and the prospect of a nasty deterioration in asset quality following the lending binge of 2009 and 2010. As a result, any cut in required reserve ratios will help shore up the mainland's banks by reducing the portion of their deposits on which they are obliged to sustain losses. Whether that will reassure investors is doubtful, however. Earlier this week, hedge fund manager and China bear Jim Chanos described the mainland banking system as 'built on quicksand'. Last month, analysts at Credit Suisse estimated that between 8 and 12 per cent of mainland banks' outstanding loans are likely to turn bad, largely because of their heavy exposure to local government-backed investment projects. Assuming a generous 40 per cent recovery ratio, such levels of non-performing loans would threaten to wipe out between 40 and 60 per cent of the banking system's equity. As a result, investors are likely to remain wary of the banking sector even if the authorities do go ahead and cut required reserve ratios. Still, every little bit of support will help.