Normalized, not tightened

The People’s Bank of China raised the reserve requirement ratio for commercial banks 50 basis points Friday to 9%, effective from November 15, the third such hike this year.

The news has been viewed as another step in the central bank’s war to peg back economic growth, which scorched across the financial world’s consciousness at 11.3% in the second quarter, the fastest in over a decade, before pulling back slightly in the third quarter. The theory goes that by reducing the amount banks can lend, the move will peg back fixed asset investment which, alongside the surging trade surplus, is held to be primarily responsible for the booming economy.

But as JP Morgan pointed out in a research note over the weekend, the move will have little, if any, effect on bank lending. The gist of the argument follows:

"As we have noted earlier, the central bank’s RRR rate hikes so far this year has not really led to significant tightening in overall monetary conditions yet. Indeed, excess reserves of all financial institutions still stood at 2.52% at the end of September, though it did come off from 4.17% by December 2005. In effect, banks seem to have been cutting back the excess reserves to fulfill the 1% increase in reserve requirements (50bp hike effective in July and August respectively). Thus, by hiking the official RRR further, the central bank aims to further "lock in" the excess liquidity at the commercial banks, rather than leaving the room for such excess reserves to be leaked back to the market/economy at any time. In short, only when the official RRR rises towards 10%, as we expect, will further adjustments in the RRR become "effective binding constraints" on overall liquidity conditions in the banking system."

So, because banks already have greater reserve positions than required, the hike will have no impact. And even if it did, would it really slow the economy? Probably not by much. Although it is true that new loans are well above government targets, it is also true that bank lending has very little to do with the spiralling investment situation, with the bulk of fixed asset investment growth driven by retained earnings rather than bank credit. Therefore, even if bank lending were a more significant factor in booming fixed asset investment and growth, the move would have no impact.

So why do it? According to JP Morgan, the latest decision is part of a move to normalize overall monetary conditions rather than "excessively tighten the monetary environment".

As the PBOC pointed out in its press report, overall liquidity in the banking system is still moving in the wrong direction due to sustained balance of payments surplus. This puts pressure on the banks to increase their lending to stay in the black, adding slightly to investment and growth pressures but considerably raising the spectre of more bad loans to come (does anybody remember bad loans?).

This, and not fixed asset investment, is surely the real concern for Beijing, particularly as the banking sector prepares to open fully to foreign entrants.