Will Beijing loosen its monetary policy again?

When Chinese premier Li Keqiang was in Inner Mongolia, a resource-rich province in the north of the country, businesses complained to him about the difficulties -- as well as the high-cost -- of borrowing from Chinese banks.

This is particularly true for small and medium-sized companies that struggle to get credit from state-owned banks. Premier Li said he would consider selectively lowering the reserve requirement ratio of banks, an important monetary policy tool in China, to inject credit into cash-starved companies.

Li’s statement has sparked a fresh round of speculation about whether Beijing is prepared to loosen monetary policy to stimulate the economy, which is under significant downward pressure. Many investment banks are predicting an imminent policy easing to help the struggling economy.

We should be wary about market speculation about monetary easing, and in particular about the kind of credit-fuelled stimulus of the past. Chinese policymakers and financiers are still nursing the hangover from the massive four trillion yuan debt-laden stimulus of the global financial crisis.

Li’s comment about cutting the reserve requirement ratio was squarely aimed at cash-starved small and medium enterprises and agribusinesses that create more jobs in the country than other sectors. 

In fact, there is nothing new about what Li actually said. Back in April, the People’s Bank of China lowered the required reserve ratio by 2 per cent, and by 0.5 per cent for rural banks and rural credit unions, whose clients are mostly small businesses.

Managing the reserve ratio, which is the amount of money that banks need to hold, is one of the most important policy tools for the Chinese central bank. The head of the financial capital department at the PBOC, Ji Zhihong, said the selective lowering of the reserve ratio was designed to address funding shortages for farmers and small businesses.

This means eligible banks that lend a certain proportion of their balance sheets to small businesses and farmers can hold lesser cash reserves than mandated by the central bank. Ji said the next step for the government was to maintain the current pace of credit expansion, but that it would focus on re-allocating loan structures.

By that he means the government will ration credit that goes into industries that already suffer from excess capacity, as well as local municipal debts. In fact, financial data shows that loans for the services industry grew 15.5 per cent at the end of April, and at the same time credit growth for industries that suffer from excess capacities was only 5.9 per cent.

At this stage, Beijing cannot afford to cut off the bloodlines to these industries such as steel, cement, and shipbuilding that employ millions of people.

“We must not cut off credit completely to industries saddled with excess capacity, local government financing vehicles and the real estate industry,” Ji told  Economic Information, a subsidiary of the official Xinhua newsagency, “At the same time, we must squeeze out the bubbles in inefficient sectors, support good companies and ration credit for inefficient companies as well as improve efficiency in credit allocation.”

One of country’s leading economists Guan Youqing, who is the deputy head of research at Minsheng Bank, explains why it does not make sense for the central bank to cut the reserve ratio systematically.  Untargeted monetary policy will not address the funding shortage problem for small and medium businesses that are crying out for more credit he says.

He explains why: China has been maintaining a relatively loose monetary policy in the past, the biggest beneficiaries of which have been the real estate sector, state-owned enterprises and other large companies. But small and medium businesses have to rely on the shadow banking system to satisfy their financing needs.

If the central bank were to loosen its purse strings again, it risks a repeat of the past. The new credit expansion is most likely to be channelled into the old guard that should not be given any more credit.

Instead of lowering the reserve ratio to allow banks to flood the market with extra liquidity, the central bank is more inclined to use open market operations such as repo to inject funds into certain sectors. For example, during the first quarter of this year, the central bank injected 100 billion yuan into agriculture and small businesses through a repurchasing agreement.

The central bank also reportedly lent 300 billion yuan to the China Development Bank last week to help it construct affordable public housing through repo. China International Capital Corp’s chief economist Peng Wensheng argues that the central bank prefers open market operations over fiddling with the reserve ratio.

Chinese leaders have been talking up the need to be unfazed by worsening economic conditions and to let the market to play a central role in allocating resources. It would be bad news for the long-term health of the economy to see the central bank loosen its monetary policy at this point.