Monetary easing won't be enough to help Chinese SMEs feeling the funding squeeze

Financial repression - government policies that create an environment of low or negative real interest rates, with the goal of generating cheap financing for public spending - has long been a key feature of Chinese economic policy. But, with funding costs for businesses trending up, this is finally starting to change.

Early this year, the State Council made lowering funding costs for businesses, especially small and medium-sized enterprises, a top priority. For its part, the People's Bank of China has engaged in cautious monetary loosening, which includes freeing up more funds for lending by banks that allocate a certain proportion of their total loan portfolio to SMEs. The central bank, through its "pledged supplementary lending" programme, has also started lending directly to banks that have promised to use the funds for social housing construction.

But, so far, efforts to lower funding costs have had a limited impact. Indeed, the weighted average interest rate on bank credit to non-financial enterprises remains close to 7 per cent, while economic growth has edged down from 7.4 per cent year on year in the past three months to 7.3 per cent in the current quarter.

The situation may not yet be dire, but it is far from ideal - especially at a time when the authorities are pursuing structural reform. The PBOC now faces a dilemma. If it loosens monetary policy further - by, say, cutting banks' reserve requirement ratios - the momentum for restructuring could be lost; and there is no guarantee the additional liquidity would flow into the real sector. But if the PBOC refuses to budge, the combination of high interest rates and slow growth may send the economy into a tailspin. In fact, the PBOC has little choice but to engage in monetary-policy loosening. But it can avoid the pitfalls of such an approach by placing it within a broader, more comprehensive strategy that accounts for the underlying causes of the rise in funding costs for businesses.

The first factor driving up funding costs is the outsize profitability of China's commercial banks - more than 23 per cent, on average, for the top five last year - which account for some 35 per cent of total profits earned by the 500 largest Chinese companies. Indeed, the average for banks is nearly four times that for Chinese companies as a whole, for which the average profit is just over 6 per cent.

Moreover, slowing growth, tighter prudential regulation, and increased liability have made banks much more risk-averse, driving them to demand a significantly higher risk premium from borrowers, who must now not only provide collateral, but also find third parties to guarantee the loans. In many cases, banks are requiring a second group of guarantors to guarantee the first group. This growing aversion to risk makes it particularly difficult for SMEs to borrow from commercial banks, forcing them to turn to the under-regulated shadow banking sector.