February 18,2011

The Dark Side of China's Lending Curb

By Lu Ting,Hong Kong

The PBoC just announced to raise reserve requirement ratio (RRR) by 50bp, effective on 24 February. After this hike, RRR will be 19.5% for large banks and 17.5-19.0% for smaller banks. This 50bp RRR hike will drain about RMB350bn from the banking system. We expect two more 50bp RRR hikes this year.

 

Why the RRR hike? A technical explanation

Surely the PBoC wants to tame inflation by controlling lending growth. But the special timing of this RRR hike has a technical backdrop of much improved interbank liquidity situation post the CNY holiday: (1) The 7-day repo rates slumped from above 8.0% before the CNY holiday to 2.8% today; (2) RMB352bn and RMB668bn in central bank bills are to mature in February and March respectively; (3) Cash in circulation surged RMB1.35tn in January before the CNY holiday and most of those cash will return to banks right after the CNY, providing ample liquidity to banks.

 

The dark side of RRR hikes

Despite the effectiveness in draining liquidity from banks, overly relying on RRR hikes could pose increasing risks to China's financial stability. Though it might be easy to hike RRR when the PBoC wishes to absorb liquidity and send signals of its determination in curbing inflation (or controlling lending), the PBoC cannot flexibly cut RRR when short-term liquidity is too tight in fear of sending wrong signals. We believe the above 8.0% 7-day Shibor rates before the CNY holiday was a result of mismanagement of the PBoC. China's government agencies ratchet up tightening measures to an unnecessary degree (in order to show their allegiance…the extreme restriction on home purchase in Beijing is a good example).

 

Policy implications: loan target in Feb and interest rates

First, though the PBoC starts to target economy-wide financing (or called social financing), managing banks' lending growth is the predominant channel for the PBoC to control money supply. We expect the PBoC will likely cap new loans in February at around RMB700-800bn. Second, we expect the PBoC to hold off hiking interest rates in from now to end-March. We expect the next window for rate hikes is in April.

 

Market and economic impacts: should be quite small

Markets have whispered about this RRR hike since yesterday, so the RRR hike is not a surprise. For the short term, given the comeback of liquidity to banks, the RRR hike has no big impact on interbank rates and the loanable funds (anyway, new lending will be strictly controlled). The 7-day repo rates could rebound for a couple of days and then return to below 3% again.

 

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