China taps the brakes

The move by China to tighten bank liquidity requirements will serve its primary objective of mopping up some of the excess cash in its financial markets, but it will also have a secondary benefit of shoring up the stability of the banks – something that has been increasingly questioned in recent months following a serious and unsustainable lend-a-thon.

Starting from Monday, most commercial banks will be required to put 16 per cent of their deposits on reserve. The move could take up to 300 billion yuan ($A47.56 billion) in liquidity out of the Chinese market. But some are already suggesting the market needs to drain much more cash – up to 800 billion yuan ($A127.28 billion) – and could mean more reserve requirement increases over the next six months. If this tightening does take place, it would be prudent for the Chinese government to implement them hand-in-hand with capital adequacy ratios, which it has already indicated are a possibility for 2010.

As Adam Carr points out this morning, "while we're all on the lookout for something that could destabilise the recovery – I don't think this is it”. Chinese moves yesterday will help add balance to an economy that is at risk of overheating and a banking sector that needs to slow down or risk running off the rails.

In 2009, Chinese banks pulled out all the stops and posted unprecedented lending growth, under pressure from the government to help fund its stimulus plan and keep the Chinese growth story ticking over. In the 11 months to November, Chinese banks advanced a record 9.21 trillion yuan (or $A1.46 trillion) in new loans. While this number is expected to shrink slightly in 2010, Chinese banks are still expected to extend loans worth around 8 trillion yuan ($A1.27 trillion) and reports from the Chinese state media indicate initial figures from the first weeks of 2010 do not show lending slowing significantly.

Several analysts and ratings agencies have started questioning the burden that this sort of credit growth has been putting on the internal risk management of the Chinese banks and what problems could arise if there is a future deterioration in loan quality. Given the bubble that has been established in the Chinese property market, if it bursts the Chinese market could face risks of the sort of debt deflation seen in the US (see China's house of cards, January 8; The five threats to China, January 11 and An explosive trade, December 31, 2009).

Fitch Ratings analysts Charlene Chu and Chunling Wen wrote in a recent report that the capital strength of Chinese banks is probably more strained than it appears, with a rising number of unreported transactions. One example given was the repackaging of loans into wealth management products and the sale of loans to other financial institutions.

"A high degree of caution is still warranted due to major ongoing weaknesses in loan classification and disclosure of off-balance sheet exposures,” Chu and Wen write in the report. They also warn that the unreported loan transactions may result in ratings for Chinese banks being lowered in 2010 and 2011.

Chinese regulators are presenting a strong face to the world, with the chairman to the China Banking Regulatory Commission Liu Mingkang saying in an open letter earlier this month that "even if aggressive lending strains the banks' capital, individual lenders and the industry as a whole are now more than adequately capitalised”.

But it seems that a different picture is emerging behind closed doors. According to reports, in November China's five largest banks submitted capital-raising plans to regulators, after the watchdog evaluated their finances, based on the banks' estimating potential 2010 deficits.

According to BNP Paribas estimates, China's 11 largest publicly traded banks would need to raise a combined 368 billion yuan ($A58.55 billion) to move their capital adequacy ratios to 12 per cent, from the current approximate average of around 11 per cent. The minimum regulatory requirement is 8 per cent for all banks. Chinese state media reported last month that the banks would need to raise around 500 billion yuan ($A79.55 billion) in 2010.

The Chinese government confirmed in December that it would move to strengthen its banking regulations in line with the kinds of new rules being demanded by the Basel Committee, and China watchers are expecting the regulator to move to increase the Chinese banks' minimum capital requirements.

But if Fitch is correct in suggesting the bank capital is likely more strained than we think, the Chinese government will also need to move to ensure transparency to avoid the sorts of 'hidden credit risk' that started the global financial crisis in the first place.