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China's Reserve Ratio Cut Is About Economic Efficiency

China's Reserve Ratio Cut Is About Economic Efficiency

(Bloomberg View) -- The recent decision by the People’s Bank of China to cut the effective reserve requirement ratio for banks by half a percent to 1.50 percent under certain circumstances fits with the government’s attempt to reduce leverage in the financial system. And in many ways, it will lead to more efficiency and economic growth.

There’s been speculation that the move contradicts the central bank’s deleveraging efforts and that this is yet another example of China pumping liquidity into the system to support growth. If the goal was purely to add liquidity, the PBOC has several other tools that it could have used, from daily open market operations to the Medium-Term Lending Facility to the Temporary Liquidity Facility. What’s important to understand about the cut in the reserve requirement ratio is that it would depend on a bank’s proportion of loans to small- and medium-sized enterprises -- a move that would encourage lenders to allocate more capital to these companies and less to state-owned concerns.

Deleveraging is a critical task for the Chinese government, especially in the corporate sector, where debt has increased from approximately 85 percent of gross domestic product in 2008 to more than 150 percent today. The commitment to this effort was evident in recent measures to rein in shadow financing, restrictions on mortgages, and last week’s announcement from the State Assets Supervision and Administration Commission, or SASAC, that it will impose curbs on borrowing by any industrial SOEs that have debt-to-asset ratios exceeding 70 percent. 

Measures to restructure corporate debt must be implemented simultaneously with reform of the credit allocation process of major banks. At the National Financial Work Conference in July, President Xi Jinping stated that the three key financial tasks for the government included making the financial sector better serve the real economy, containing financial risks and deepening financial reforms, and this adjustment to lending policy should help facilitate those efforts.  

The International Monetary Fund warned last year that SOEs have taken over 50 percent of bank credit, even though they account for less than 20 percent of economic output. SMEs have been negatively affected by this misallocation of capital from the banking system, which has created a need for a targeted adjustment. SMEs and micro enterprises account for less than 40 percent of loans, but contribute to 65 percent of GDP, 75 percent of employment, 50 percent of tax revenue, and 68 percent of total exports, according to a 2015 comment from a government spokesperson. 

The Organization for Economic Cooperation and Development outlined last year the case for increasing credit to SMEs. “Finance is one of the keys for unlocking the potential of small firms to innovate, upgrade and become more productive,” OECD Secretary-General Angel Gurría said during a presentation with Zhou Xiaochuan, governor of the PBOC. "SMEs and entrepreneurs can play an active role in achieving stronger and more inclusive growth, and it is now time to show our commitment to enabling the development of alternative funding options,” Gurria added.

The cut in the reserve requirement ratio wasn’t the only measure announced by the government to help SMEs. The State Council on Wednesday also announced a series of measures, including waiving value-added taxes for banks’ interest earnings from SME loans, cutting stamp duty taxes for SME loan contracts, encouraging SMEs to issue bonds, boosting SME loan guarantees, and making it easier for banks to lend to startup companies.  

 The PBOC was quick to announce that the RRR cut does not indicate a change to monetary policy. It reiterated the focus on prudent and neutral monetary policy in its quarterly policy report. Monetary policy will be focused on slowly deleveraging the corporate sector, de-risking shadow financing, and reducing property speculation. These are important for reducing financial risks, but improving the capital allocation process must continue to be a priority to sustain medium-term growth.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

David Millhouse is the head of China research and strategy at Forsyth Barr.

To contact the author of this story: David Millhouse at dmillhouse7@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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