China’s central bank announced on the evening of November 30 that it would cut the reserve requirement ratio for commercial banks by 50 basis points, effective today. After the reduction, the RRR will be 21 per cent for large Chinese financial institutions and 17.5 per cent for smaller ones. The cut is expected to free up about 350 billion-400 billion yuan ($55 billion-$63 billion) in liquidity to help fund bank lending in the coming months. With the deteriorating eurozone crisis affecting China’s already uncertain economic outlook, an RRR cut was anticipated, though the markets did not expect it until next quarter.
The reduction comes only days ahead of the mid-December Central Economic Working Conference, where policymakers are expected to craft the direction of China's economic policy for the coming year. Taken together with the numerous small, targeted economic easing measures that have already been implemented, the RRR cut suggests that Beijing may be gradually moving away from its current regulations aimed at tightening.
While Chinese officials will attempt to avoid replicating the problems of the previous stimulus cycle, Stratfor believes the excess liquidity represented by off-balance-sheet lending – lending that has largely escaped government regulations – remains, making any potential easing of credit controls dangerous. Moreover, the threat of nonperforming loans persists, and surging so much credit into the real economy is inherently unstable. When combined with existing inflationary concerns, the task is challenging.
The People’s Bank of China last cut the RRR in December 2008 as part of a broader attempt to overcome the global financial crisis. At the time, Beijing was still facing an overheating economy and inflationary pressure (albeit eased). But with exports declining as a result of the global crisis, Chinese policymakers opted for a significantly loosened credit policy. In a three-month span the Chinese government lowered interest rates five times – to 2.25 per cent from 4.41 per cent – and the RRR four times. Lending surged dramatically from late 2008 to 2009, and a 4 trillion yuan stimulus package was launched, along with other government-led investment designed to maintain growth.
While these stimulus measures helped China keep a relatively high growth rate and prevented large-scale social instability over rising unemployment, they also had negative consequences. One significant result was restricted growth opportunities for small- to medium-sized enterprises. Rather than helping the hardest-hit SMEs, the policies sent massive credit and government funds primarily to state-owned enterprises (some estimate that 80 per cent of official credit lending went to state-owned firms, which account for a majority of the country’s gross domestic product). This is largely because of those firms’ ties to the government and easier access to financial assistance as well as Beijing’s desire to drive faster growth, which puts private enterprises competing for market share and financing at a disadvantage.
Meanwhile, only a few months after Beijing’s curbing policies in early 2008, the real estate market again became a leading destination for credit. Investors, developers and an increasing number of state-owned firms followed the longstanding path to drive growth quickly and conveniently through real estate market speculation. Consequently, property prices soared in most major cities, giving rise to a great deal of social frustration. Moreover, speculation and the increasing use of real estate as collateral led to a stronger connection with the banking system, and private capital increasingly flowing into the system via informal lending and personal investment complicated policymakers’ attempts to control the growing real estate bubble. Inflationary concerns and other negative socio-economic developments had emerged by the end of 2009, making matters worse.
Righting the ship
After two years, Beijing was forced to reverse course to address the negative effects of its stimulus policies. In 2010, China’s policymakers attempted to focus on combatting liquidity and inflationary concerns. The RRR was hiked a dozen times in 2010 and into 2011, interest rates were raised five times over the same period and tighter lending controls and real estate market measures were put into place.
But as the eurozone debt crisis worsened and the global economy entered another period of uncertainty, the threat of an economic slowdown and lower investor confidence became apparent. The manufacturing sector – employment in which accounts for around 6 to 8 per cent of the total population, according to official estimates – particularly slowed down at the beginning of October. Growth in exports was hit hard, especially considering the economic crisis in the European Union, China’s largest export market. It is not unlikely that exports will see single-digit growth as early as the next few months. Additionally, continued tightening in the real estate market and a lack of comparable growth in the availability of affordable housing due to a lack of incentives and financial constraints by the locals (despite the government’s initiative to offset the real estate slowdown) could lead to lower fixed investment.
With the inflationary pressure trending downward in the latter half of 2011 – the consumer price index has declined since August and is expected to be below 4.5 per cent year-on-year for November and after – Chinese policymakers’ major concern has gone from inflation to maintaining growth again. The old 'fine-tuning' policy – lowering central bank bills, selective RRR cuts for rural cooperative banks and lending to strained SMEs that has taken place in the past two months – is expected to give way to the broader releasing of liquidity. Top Chinese leaders, who have stressed in recent statements the need for more flexible monetary policies, have reinforced this expectation.
With these things in mind, the RRR cut announced November 30 was no surprise. However, the cut was not expected until the first quarter of 2012, and its early manifestation suggests that Beijing is concerned about its uncertain economic outlook and the worsening eurozone debt situation. Reduced interest rates and as many as four more reductions of the RRR are expected, beginning early next year.
The issue now becomes how well Beijing can manage its economic policy shift. Liquidity remains excessive at the macroeconomic level outside of government control. Although lending has dropped off from the 2009 level, liquidity from commercial banking and the surge in informal lending have made liquidity ample. Consequently, the potential easing of credit makes the excess of liquidity particularly concerning and potentially a problem for Beijing’s policy plan.
While it is a consensus among decision makers that another round of credit and fiscal expansion like that seen in 2008-09 – and the problems that came along with it – should be avoided, the challenge for China will be the decreasing number of policy options in the face of a complex economic situation. This is especially true as Beijing prepares for a leadership transition in 2012. It is essential for the success of the next group of Chinese leaders that a macroeconomic policy concerned with stability and continuity prevail. Beijing has also gradually shifted public perceptions in preparation for an economic slowdown and restructuring. Particularly after signs emerged of the threat of potential real estate problems, maintaining policy without posing an additional threat to the economy and hard lending is becoming an increasingly critical and challenging task for Beijing.
Stratfor.com Reprinted with permission of STRATFOR.