China Economics Seminar

An interesting debate is taking place among the top financial regulators and bankers in China.

In the China Securities Journal on Feb 27th, former PBoC vice-governor Wu Xiaoling said that PBoC should focus more on M2 growth instead of new banks loan as the monetary policy target. She argued “it is very difficult to achieve the M2 growth target with such strict control on bank lending and China should ease the control on loan-to-deposit ratio”. She suggested that inter-bank deposits should be counted when calculating LTD ratio (loan-to-deposit ratio) so that the LTD ratio of national small &medium banks would have dropped from 69.1% to 63.8% by the end of 2011. Also, Li Mingxian, chairman of Guangdong development bank suggested that financial regulators should set different ceilings of LTD ratios for large, medium and small banks. Currently, the ceiling of LTD ratio is set at 75% for all commercial banks as written in the law of People’s Republic of China on commercial banking.

Wu raised a very interesting question about the PBoC’s monetary targets which have been quite confusing. According to the Law of the People's Republic of China on the People's Bank of China, the monetary policy target is to maintain the stability of the value of the currency and thereby promote economic growth. To achieve the goal, the PBoC has several intermediate monetary targets. Before 2011, M2 growth and new lending quota were two explicit intermediate targets. They are officially announced by the Premier in the National People’s Congress in early March, but credible rumors start spreading in the market since late December.

However, in December 2010 the PBoC said that there would not be a new loan target anymore because of the growth of off-balance-sheet products and direct financing. Instead they started calculating the so-called “total social financing”, which includes bank loans, stock offering, debt issuance as well as many sorts of off-balance-sheet instruments. TSF is a better proxy to reflect how the financial system funds real economy in China, but it is difficult to say that it has become a new intermediate monetary target. The Annual Government Working Report has excluded the new lending quota, but it has not included a total social financing target either. In the 2011 Government Working Report, it only said “keep a reasonable social financing scale” and “set M2 growth target at 16%”.

Since the Government Working Report has stopped announcing the lending quota, M2 growth is supposed to be the only intermediate monetary policy target now. Then why did Wu suddenly say that M2 should be the major monetary policy target? A reasonable explanation is that the lending quota still exists as an important indicator, though the PBoC is trying to shift to a broader statistic. Moreover, the loan quota has constrained the monetary creation process and therefore the M2 growth will come lower than expectation. Why has this happened? Firstly, as the market interest rate becomes much higher than the benchmark interest rate set by the PBoC, deposits have fled from the banks’ balance sheets to off-balance-sheet products and the so called “shadow banking” sector so that deposit growth has slowed down. Secondly, strict control on the 75% LTD ratio has limited banks’ credit expansion ability; therefore fewer deposits are created. Under the current situation, loan growth has to grow faster to achieve the M2 growth target. To let loan growth become faster, LTD ratio has to be eased in certain ways. As Wu Xiaoling suggested, if inter-bank deposits are counted in calculating the LTD ratio, it will have dropped significantly and bank loans will grow faster. In addition, Sun Guofeng, deputy head of monetary policy department of the PBoC, also says in his recent book China’s Financial Reforms – Through Eyes of a Front-bencher that the 75% LTD ratio is not a reasonable rule; bank lending is not a monetary policy target but just a tool to realize the monetary supply target. It seems that a consensus is forming on the PBoC’s side that LTD ratio has to be eased and the commercial banks certainly support this idea.

However, it is the China Banking Regulation Commission (CBRC) who is in charge of monitoring the LTD ratio and the banking watchdog has not agreed with the central bank yet. On Feb 28^th, just one day after Wu Xiaoling’s comments, Caixin magazine cited an unidentified senior financial regulator that the LTD ratio should not be abandoned and it cannot be abandoned. The regulator added that “the LTD ratio has been an important and effective tool to manage liquidity risk, so that it is not proper to delete it”.

The regulator is right and the LTD ratio was even more important than the reserve requirement in cooling the credit growth in the last battle against inflation. Many people are worried that bank if China eases the LTD ratio, bank loans will surge again and it will make the investment bubble even worse and inflation growth may rebound. However, if CPI growth continues to drop as expected and monthly new loan misses expectation again in February, the voice of easing LTD ratio will become stronger and stronger in the next months. We believe that the financial regulators will definitely take measures to relax the LTD ratio very soon.

Chen Long

Central Banking Seminar