China's Mixed Message on Bank Lending

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by: Leland Miller

In mid-January, the People’s Bank of China (PBOC) announced that Chinese banks had lent a total of 7.95 trillion yuan ($1.2 trillion) in 2010, considerably above the government’s declared target of 7.5 trillion. This is in addition to another 2-4 trillion yuan of off-balance-sheet lending for the year, meaning overall Chinese lending in 2010 was in the vicinity of 10-12 trillion yuan. This is a huge number, especially on the heels of a 9.6 trillion yuan lending spree in 2009.

But, with inflation on the rise and the global recession finally ebbing, 2011 will be different, right? Not so fast.

Following last month’s annual Central Economic Work Conference, an annual pow-wow where Chinese financial authorities announce broad macro policy goals for the coming year, Beijing declared that tempering loan growth would be a key priority for the coming year.

Yet, Chinese banks continued their lending frenzy through the first weeks of January, doling out 600 billion yuan ($91 billion) in new loans in the first week of 2011 alone. Lending in January may reach 1 trillion yuan, Caijing magazine has forecasted.

This has left bank regulators and policymakers alike scrambling for a better solution.

Unlike monetary policy in the West, which relies principally on managed interest rates, China has traditionally relied on a more simplistic, two-pronged approach: wielding the spigot and the mop. In theory, the PBOC sets loan quotas to dictate the amount of loans (liquidity) it wishes to dump into the system, then soaks up any excess liquidity by ordering banks to park a certain percentage of their reserves with the PBOC. (That rate—known as the reserve requirement ratio (RRR)—is currently 19.5% for China’s largest banks.)

A combination of factors, however, has worked to undermine the efficacy of the loan quota system. First, Chinese banks typically hit their loan targets far before year end, leaving regulators the impossible (and perhaps dangerous) job of enforcing an almost total clampdown of credit at the end of the year. In 2010, for instance, Chinese banks hit their quota mark in November, but still managed to loan a massive 480 billion yuan in December.

Moreover, according to a December report by Fitch ratings, Chinese banks have learned to simply offload trillions in loans from their balance sheets by artificially reducing their holdings of discounted bills and repackaging loans into investment products for sale to investors. As a result, the actual loan quota number has become essentially meaningless.

None of this should be surprising. In an economy as large and complex as China’s, the “spigot/mop” approach to monetary policy is woefully inadequate. But, rather than meaningfully hiking interest rates—which would help control runaway lending, but also eliminate the credit (subsidies) that keeps low margin Chinese businesses afloat—Beijing has opted to simply tinker with the banking system more aggressively.

Now here is where it gets interesting. On January 6, sources close to the PBOC announced that China will no longer rely on a formal lending target for banks in 2011. Instead, it will evaluate a set of factors—tailored to individual banks—including loan growth, minimum capital adequacy ratios and government targets for inflation and economic expansion to determine the reserve requirement for each bank.

As the Financial Times noted,

By closely monitoring each bank individually and responding to lending surges with regular targeted reserve requirement adjustments and tighter capital requirements, the regulators hope to smooth out the credit cycle and keep overall credit growth in check.

Described as a "dynamic differentiated reserve requirement ratio (DRRR)," any credit expansion by a lender that is not matched by its capital strength will trigger an increase in that lender’s RRR levels. As People’s Daily explained, “banks that fail to meet such criteria will be ordered to adjust their credit immediately.”

Yet, less than two weeks after the PBOC introduced this fancy new DARR concept, new first quarter loan quotas were surprisingly leaked to the press. According to Caixin, Chinese regulators on January 19th ordered the nation’s four biggest banks to cap their combined new loans in the first quarter at 726 billion yuan ($110 billion), a shockingly low number considering that loan flow in the first week of January alone had hit 210 billion yuan and last year’s 1Q allowance was almost double that number.

Other reports that week also signaled that at least informal annual loan quotas had been put into place.

China's central bank has cut its 2011 lending target for banks by 10 percent from last year, the official Securities Journal reported on Tuesday, citing unidentified banking sources.

Although the Chinese central bank has yet to announce an annual lending target for the year, it has reduced the target by as much as 10 percent from the value of loans handed out last year, the newspaper said.

That means banks can lend between 7.2 trillion and 7.5 trillion yuan (about $1.1 trillion) this year, the newspaper said.

On January 24th, the quota leaks became more explicit. According to Sina News, banks were warned not to break their designated January 2011 loan limits or their credit approval system would be halted—indicating some sort of firm loan quotas had to be in place. Yet on the same day, the China Banking Regulatory Commission (CBRC) announced that it would "resume the monitoring of daily bank lending figures.” According to Caixin,

[C]ommercial banks will need to report their lending activity on a daily basis and the regulator will give instructions to each bank according to its credit ceiling.

That sure sounds a lot like DARR.

So what is actually going on here? Do Beijing’s mixed and often contradictory messages on 2011 bank lending reflect a flexible new approach, outright panic over the January loan numbers, or an emerging battle between bureaucratic regulatory powerhouses? Is there a formal loan quota for 2011, an informal quota, or have regulators decided to attack overlending by the Big Four with a different set of tools than for small and medium-sized institutions?

Next week I’ll examine the dynamics behind China's bank lending battlefield.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.