Can China Stop its Banks from Lending?

Will a shift away from bank lending quotas actually help rein in lending by Chinese banks?  Beijing thinks so.

On January 11, 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.  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 and reining in inflation would be key priorities 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.  In fact, lending in January may reach 1 trillion yuan, Caijing magazine reported last week, citing analysts.

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 18.5% 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 hike interest rates—which would help moderate 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.

So here's the government's new play: While an official announcement is still pending, sources close to the PBOC claimed on January 6 that China will no longer rely on a formal lending target for banks in 2011. Instead, regulators will evaluate a series of factors including loan growth, minimum capital adequacy ratios and government targets for inflation and economic expansion, and then determine the reserve requirement for each bank separately.  As the Financial Times notes,

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 adjustment of differentiated reserve requirement ratio," 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 explains, “banks that fail to meet such criteria will be ordered to adjust their credit immediately.”

Will this system actually increase transparency and evenhandedness in the Chinese banking system, as regulators hope?  Perhaps.  But the reality is, it may not matter.

So long as Chinese banks offer deposit rates that lag behind the rate of inflation, Chinese money will continue to be pumped back into the economy, driving inflation higher still.  Cracking down on profligate lending is a crucial first step, but without wholesale changes to its monetary toolbox, Beijing is only postponing an inevitable reckoning.

 

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