The People’s Bank of China has begun easing monetary policy to respond to slowing economic growth, falling producer prices, and peak bond repayments. The success of this round of monetary easing depends on the allocation of funds to relevant companies and the effectiveness of heavy-handed restrictions on capital flows.
In response to slowing economic growth, falling producer prices, and peak bond repayments the People’s Bank of China has begun easing monetary policy. On January 15, the PBOC lowered banks’ required reserve ratio (RRR) by half a percentage point to 14 percent. It will be reduced by another half point on January 25. The central bank governor, Yi Gang, has said that there is room for further reductions and the cuts will be paired with policies that incentivize lending to small and micro enterprises. Yi also said he expects the cuts to release 1.5 trillion CNY into the banking system.
This round of monetary easing can only generate long-term positive benefits if two conditions are met: state banks must allocate a large enough proportion of the released funds to the relevant private companies. Second, strong outflow restrictions which can insulate the Chinese economy sufficiently from US rate hikes are necessary. Otherwise, the easing could lead to an even bigger accumulation of bad debt by state-owned companies and could result in damaging capital outflows.
State banks must be incentivized to lend to the private sector
With peak amounts of debt maturing in 2019, providing liquidity is necessary to protect big corporates with weak cash flows from default. But for the easing to also generate growth in the real economy it must reach credit-starved sectors. If not, the easing will only postpone an urgently needed resolution of problems in the financial sector without strengthening the economy’s ability to service debt.
The Chinese financial system allocates a disproportionate amount of new lending to unproductive investments. This becomes visible by looking at the relationship between new credit and GDP, the second of which is consistently smaller, meaning that debt is increasing at a faster pace than the ability to service it.
Domestic debt levels have risen steeply across all sectors of China’s economy – in 2018, total credit to non-financials exceeded 250% of GDP, compared to 150% before the global financial crisis struck a decade ago.
Since the beginning of 2017, the government has waged a partially successful deleveraging campaign. Positive achievements include moving off-balance-sheet shadow finance products back on to banks’ balance sheets. This is now clearly visible in credit data; the growth of bank lending is increasingly outpacing that of off-balance sheet financial products. Yet, the overall campaign has yet to see credit growth fall below nominal GDP growth. (See also our blog post: Policy in China still puts growth before deleveraging)
For small and micro enterprises, which already were neglected by the financial system, the deleveraging campaign brought about more difficulties in accessing financial opportunities. Under pressure to contain risks, banks directed the lion’s share of their lending to larger entities which are perceived to be more reliable when it comes to repayment. In the first quarter of 2018, outstanding bank loans to small and micro enterprises grew at 14.4 percent. By the third quarter, growth had fallen to 9.8 percent. Meanwhile, overall bank lending remained almost unchanged, growing at 12.9 percent.
This sector is an important factor in the Chinese economy. Tightening credit conditions in the sector limit the abilities of potentially lucrative smaller businesses to take off or expand, which will hamper the growth potential of the economy. By injecting credit into the sector, the Chinese government tries to reduce the pressure. The PBOC now incentivizes state bank lending to the private sector by giving banks that lend sufficiently to smaller enterprises more room to set their own interest rates. This will be very difficult to accomplish as large institutions difficult to reform.