The chief economist of China International Capital Corporation says that the Chinese central bank’s recent decision to reduce the reserve requirement ratio in order to incentivise financial inclusion will unleash huge amounts of liquidity, given that it the vast majority of the country’s lenders will qualify.
On 30 September the People’s Bank of China announced that commercial banks whose financial inclusion lending percentage is at least 1.5% would enjoy a reserve requirement reduction of 0.5 percentage points starting from 2018.
Commercial banks whose financial inclusion lending percentage is at least 10% will enjoy a reserve requirement ratio reduction of 1.5 percentage point.
According to Liang Hong (梁红), chief economist with Chinese investment bank CICC, PBOC has set the financial inclusion lending threshold at extremely low level, which means that the vast preponderance of China’s lenders will qualify for the reserve ratio cut.
“The category of financial inclusion [banks] covers depository institutions accounting for over 95% of total banking sector assets,” writes Liang in an editorial published by Sina.
“The current first-tier directed reserve ratio reduction requires that financial inclusion loans account for only 1.5% [of total lending], while the second-tier preferential reserve ratio only mandates 10%, both of which are marked reductions compared to 30 – 50% financial inclusion ratios that had previously been set for reserve ratio reductions.”
Liang cites estimates from PBOC itself indicating that all of China’s large and medium-sized commercial banks will qualify for the 0.5 percentage point reserve ratio reduction, as well approximately 90% of municipal commercial banks and 95% of non-county rural commercial banks.
She further points out that the majority of county-level municipal and rural banks satisfy the requirements for the 1.5 percentage point reserve ratio reduction, accounting for around 15% of total banking sector assets.
“Overall we estimate that following the implementation of the two-tier reserve ratio reduction, a total of 800 billion to 1 trillion yuan in liquidity will be released.”
According to Hong, however, the new policy is not designed to alleviate short-term liquidity pressure.
Hong points out that foreign exchange has not poured into China in large amounts since 2014,and that given constraints on the growth of the base money, reducing the reserve ratio serve to raise the money multiplier and increase the money supply amidst record low M2 growth.
“Although the significance of M2 money supply index has seen a structural decline, the fall in M2 year-on-year growth to a historic low of 8.9% highlights constraints of a comparatively high reserve ratio on monetary issuance,” said Hong.
“Also, because interest rates are quite low, deposit reserves can be interpreted as a hidden tax burden on banks. According to CICC estimates, every 1 percentage point reduction in the deposit reserve ratio translates into a reduction in the hidden tax on the banking sector of 1 percentage point.
For these reasons Hong considered the reserve ratio reduction to be of benefit to stabilising market expectations of liquidity as well as the overall direction of monetary policy, as wells revitalising banking sector profits.
“Overall, the pre-October break announcement of a ‘financial inclusion’ reserve ratio reduction could shake up the composition of market liquidity expectations,” said Hong.
While CICC does not expect further reserve ratio cuts in the short-term, there remains considerable room for more reductions across the mid-term given the high baseline at present.
“We expect Q4 economic growth to remain resilient, and CPI to potentially rise prior to the year’s end,” wrote Hong. “At the same time recent foreign exchange outflows have eased markedly, and we cannot rule out the return of foreign exchange net inflows before the year’s end.
“Consequently, against this cyclical background, the room for loosening of monetary policy loosening is limited, and there are definite impediments to ongoing reserve ratio reductions in the near-term.
“In the mid-term, however, China’s current statutory reserve ratio requirement of 17% is high by global standards, and needs further reduction.”
Hong highlights a number of reasons for eventually reducing the China’s reserve ratio requirement to what CICC considers to be the more reasonable level of around 10%.
Chief amongst them is the fact that the high reserve ratio is one of the key reasons that Chinese banks are inclined to transfer their assets off balance-sheet into shadow banking operations, which serves to undermine the stability of the financial sector.
China’s base money reserves also remain quite large at around 40% of GDP, as compared to 20% for the United States, which means that the central bank still has ample room to shrink its balance sheet.
“Stated otherwise, if the reserve ratio isn’t adjusted, the central bank must directly influence market liquidity via large-scale open market operations and re-lending operations, which readily expands market volatility.”