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No End in Sight for Loose Monetary Policy

06-04 16:14 Caijing

After overseeing a flood of bank credit in the first quarter, will Chinese money regulators tighten policy? Don't bet on it.

By Caijing economist Lu Lei

(Caijing.com.cn) Chinese bank lending increased to more than 5 trillion yuan between January and April, nearly three times the credit level reported during the same period last year. Even if new loans average only 500 billion yuan during each of the remaining eight months of 2009, the year's total would be more than 9 trillion yuan – more than all loans issued over the previous two years combined.

The industrial sector's recent performance provides solid grounds for concern over this rapid credit growth. A National Statistics Bureau survey of 22 regions found industrial profits totaled only 323 billion yuan during the first quarter, down 32 percent from a year earlier. That means annual profits for all industries will amount to only about 1.6 trillion yuan this year.

Outstanding loans currently stand at 35 trillion yuan. Assuming companies have kept a moderate debt ratio averaging less than 50 percent, their capital investments now exceed 35 trillion yuan. And profits of 1.6 trillion yuan versus 35 trillion in capital investment means an annual return rate of only 4.57 percent, below the weighted loan interest rate of 4.76 percent we saw in March. In this sense, companies seem to be in a rather weak position to finance debt with earnings.

But although these preliminary analyses bode ill for bank risk, there are three reasons to believe that the central bank will not divert from what's now a loose monetary course.

First of all, consider the context of oversight. China's central bank has no responsibility for banking regulation, which means it may be too focused on macro control to properly consider bank risk prevention. Dealing with banks exposed to greater risk by increasing loans in the face of an adverse economic climate is left to the regulatory body; the central bank is not held accountable.

We've seen regulators raise the required provision coverage ratio to 150 percent in preparation for a worsening economy. Thus, the central bank -- despite its dedication to financial stability -- is more like a mechanic than a guardian, in the sense that it only deals with existing losses, acting as a "lender of last resort" when depository banks turn insolvent.

The regulator could shoulder full responsibility for tightening the credit spigot, even though all it has in hand are rigid standards for provisions such as capital adequacy and coverage ratios. That's a lot less handy than the central bank's requirements for reserve ratios. We really should ask why regulatory functions have to be kept separate from the central bank.

The second reason why we don't expect any slackening of the monetary reins has to do with the auxiliary role that monetary policy plays in fiscal policy. Long-term loans in the first quarter reached 1.9 trillion yuan -- 1.1 trillion yuan more than a year before. Most of that money went toward projects that supplemented proactive fiscal spending. The central bank stated in a monetary policy implementation report that new loans for public infrastructure projects, including irrigation and environmental protection, increased 378 billion yuan in the first quarter on a yearly basis, while transportation and logistics industry loans jumped 230 billion yuan, and borrowing by leasing and commercial services rose 190 billion yuan.

Looking at tax revenues, local governments nationwide were unable to collect as much in the first quarter as in the same period 2008. In fact, tax receipts fell 1.4 percent, in sharp contrast to the 34.7 percent increase posted a year earlier. Cursed with double pressure from a directive to invest and shrinking revenue, local governments have had every incentive to use banks as financing proxies.

Now we're faced with the possibility of undesirable negative GDP growth. Banks, concerned about defaults, may grant only 300 billion yuan in new loans every month for the rest of the year. So we're stuck with a painful choice between two losing scenarios: a more moderate monetary policy that would cripple fiscal policy, leading to an outright "hard-landing;" or continuing a loose monetary policy backed by fiscal spending, which risks future loan losses and a weaker market. To get around the problem, the central bank may be forced to fill holes at banks by pumping in money, in effect imposing an inflation tax on all consumers.

Finally, supporters of loose monetary policy can point to ongoing price declines. Massive credit, even to the degree we've seen this year in China, does not necessarily lead to inflation. Current circumstances point to price weakness: The United States is shedding hundreds of thousands of jobs every month, the euro zone sees little hope for a quick recovery, and Japan recently reported its worst quarterly contraction since World War II. So China does not have to worry about inflation.

In addition, drastic volatility in oil and commodity markets reflects concern over the dollar but not a rebound pushed by fundamental demand. So the only results of credit-backed output expansion can be oversupply and depressed prices.

Besides, China's foreign exchange reserve balance has changed dramatically since September. The amount of yuan that the central bank uses to buy foreign exchange on the market has been declining. This money pool used to comprise a major part of the "base money" available within credit circles, so the central bank needs to increase the "money multiplier" to maintain growth in the broad money supply.

To do so, the central bank has to cut interest rates, reduce the required reserve ratio, or both. Our view is that the former alternative is more likely because this could partially ease financial pressures for businesses. An advisable course would be to decrease deposit rates to levels below loan rates so depositors are not too disappointed by declines in anticipated interest gains.

We do not advocate lowering the required reserve ratio, as that would undermine regulatory efforts to raise capital adequacy and provision reserve ratios and strengthen the banking system's health. A more fundamental solution may be to embed regulatory functions in the monetary authority, so that financial security and macroeconomic direction can be better balanced and coordinated.

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