Tuesday, July 5, 2011

Why PBoC Prefers Reserve Requirement Ratio (RRR) Hikes

The below article shall explain why the Chinese central bank, People's Bank of China (PBoC), still prefers to make use of reserve requirement ratio (RRR) hikes than interest rate hikes. This article also involves an immediate upgrade of our CPI target.

Nowadays, there is no escaping inflation in China, signs of it are everywhere throughout the country after our first Inflation Warning. To describe the current situation more precisely, we would call it inflation spiral, or the second wave of inflation, which occurs when inflation and wage level climb up spirally. It is well-known that the European Central Bank (ECB) is afraid of this kind of inflation spiral very much, and would quickly consider to raise interest rates if that happens. Here in China, PBoC reacts quite differently as the wage level continues to climb up.

In our earlier article, we already pointed out the real reasons Why PBoC NOT Raising Interest Rates Promptly when inflation is high. Everyone knows that China has a huge gap between the rich and the poor, and therefore a high inflation would only fuel civil unrest and possibly pose threat to social stability in China. So what can PBoC do? PBoC now prefers to rely on more reserve requirement ratio (RRR) hikes and central bank note issuance during its regular open market operations to re-absorb the excessive liquidity in the monetary system. This arrangement is originally intended to avoid rising inflation expectation, but it seems PBoC has also considered it for a few more special functions as below:

(1) Under a higher reserve requirement ratio (RRR) and a lesser liquidity in the monetary system, Chinese banks are only willing to lend money to lower-risk borrowers, such as State-owned Enterprises (SOEs) or Chinese local governments. Since SOEs and Chinese local governments technically face very low threat of bankruptcy in China, they usually become the safe heaven for Chinese banks to maintain their lending business during every liquidity crisis. Because of that, SOEs or Chinese local governments through LGFVs (Local Government Financing Vehicles), despite of their current high debt level, can be a lot easier to get loans from Chinese banks. By comparing with interest rate hikes, reserve requirement ratio (RRR) hikes can also ensure sufficient supply of cheaper money to keep SOEs (State-owned Enterprises) or Chinese local governments alive.

This arrangement, however, does have its own drawback. When liquidity really becomes a problem (too much liquidity is absorbed), the SHIBOR (Shanghai Inter-Bank Offered Rate), especially the shorter-term interbank market rate, will rise rapidly. For example, on 22 June 2011, China's benchmark barometer of short-term liquidity supply, the weighted average 7-day repurchase (repo) rate hit 9.5%, the highest level since the previous 2007 market crash. At that moment, Chinese banks basically had enough money to lend only to State-owned Enterprises (SOEs) or Chinese local governments, and they did not have incentives to finance their new customers such as small non state-owned enterprises. Those SMEs (Small-and-Medium-sized Enterprises) are generally considered high risk by Chinese banks owing to insufficient financial information for their credit worthiness assessment. What is more, unlike SOEs (State-owned Enterprises) or Chinese local governments, SMEs are not protected from bankruptcy.

As the current reserve requirement ratio is already high (now RRR reaches 21.5%), some SMEs have to compete for loans from other sources by giving out much higher annual interest rates, sometimes 40% to over 100%. That said, SMEs need to pay for much higher than borrowing costs than they normally require if PBoC chose interest rate hikes instead of RRR hikes to tame inflation.

Yes reserve requirement ratio (RRR) hikes could cause real troubles to the SME sector, but if you were Chinese policymakers and you could only save one of them which one you would prefer to save: SOEs or SMEs? Obviously now PBoC chooses SOEs and relies on more reserve requirement ratio (RRR) hikes to re-absorb the excessive liquidity in the open market.

(2) By using reserve requirement ratio (RRR) hikes, PBoC may feel more comfortable to delay their interest rate hikes that have a more direct impact on the economic growth. In China, economic growth is still the number one and the most important factor for PBoC to consider during selection of its monetary policy tools.

(3) Despite the drawback mentioned above, reserve requirement ratio (RRR) hikes do have a positive effect on some SMEs in sectors having surplus capacity. In China, many industry sectors are still suffered from excessive production capacity. With limited source of monetary liquidity, SMEs in these sectors can then abolish surplus capacity and also restructure their outdated production capacity in a much more faster pace.

(4) Reserve requirement ratio (RRR) hikes can also reduce the risk of over-lending in China banking system. It pushes Chinese bankers to execute more risk controls and focus more on lower-risk big customers. This will, eventually, improve their overall bad loans ratio.

For the above reasons we, Mr China, decide to lift our 2011 China CPI target to +4.5% YoY as PBoC prefers to hike reserve requirement ratio (RRR) more than interest rates and the real deposit rate already exceeded -2% (now it becomes 3.25% - 5.5% = -2.25% in May). This new target of +4.5% should automatically supersede our original 2011 CPI target of +3.5%.

Having said that, however, we do not agree totally with what PBoC is doing. Excessive reserve requirement ratio (RRR) hikes do create some real problems for Chinese economy. In our coming article(s), we will explore these problems in more details with you.


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