With little fanfare on Friday, China set a new record, forcing the country's big banks to lock up 20 percent of their deposits as reserves. That level - inconceivable in developed economies - is probably not the ceiling. But just how high can it go? Up to 30 percent? Or 50 percent?
The answer may lie in the distortions that this monetary tightening tool is beginning to impose on the economy. What has been a fairly effective way of taming inflation is, bit by bit, taking a toll on the banking sector. "Few banks have extra money on hand to put at the central bank as reserves. The situation is even worse for smaller banks," said Liu Xusheng, a senior executive at a medium-sized bank in Beijing.
"If the central bank keeps tightening reserve requirements, it will really squeeze bank earnings," said Liu, who spoke on condition that his firm's name not be given. At the root of China's rising prices is the vast amount of money that has streamed into the economy from a gaping trade surplus in recent years. Reserve requirements are a direct way of ring-fencing that excess cash, keeping banks from lending out a large chunk of it and thereby slowing money growth.
The People's Bank of China (PBOC) has increased required reserves six times since November and interest rates only twice during that time. This approach has been effective. Inflation hit a 28-month high of 5.1 percent in the year to November and has since been contained below that. "The RRR (reserve requirement ratio) has become a part of the regular tools used by the PBOC to absorb liquidity, to a certain extent in replacement of central bank bill issuance," Yu Song and Helen Qiao, economists at Goldman Sachs, said in a research note.
The advantages are clear for the central bank in opting for reserve increases instead of open-market operations. It pays just 1.62 percent per year on required reserves, compared with about 3 percent on one-year bills. Reserve requirements are also seen as preferable to interest rates. They are a more direct tool for mopping up the liquidity that has been driving inflation and, unlike interest rates, do not add to the repayment burdens of indebted local governments.
Yet the central bank's choice of policy translates into weaker earnings for commercial banks. Lenders will suffer profit and funding squeezes if reserves go much higher. With banks allowed to lend up to 75 percent of their deposit base and bonds forming another slice of assets, many analysts see a 23 percent required reserve ratio as a rough threshold beyond which their operations will be seriously crimped.
Stanley Li, an analyst at Mirae Asset Securities, estimated that every 50-basis-point increase in the reserve ratio shaves half a percentage point off banks' profits. On top of dimmer lending prospects, some banks also face a funding headache. Excess reserves kept at the central bank in anticipation of reserve ratio increases have fallen after the string of required reserve increases over the past year.
In time banks will need to sell their bond holdings to raise the money they need to meet reserve guidelines, bankers said. "That is like forcing banks to tear down the east wall to repair the west wall. It will increase risks in the banking system," said Liu, the banker in Beijing.
Quietly, Chinese bank executives have made their displeasure known. Bank of China President Li Lihui said this month that there was little room left for rreserve requirement increases Smaller banks are particularly vulnerable, said Zhu Song, a senior trader at the Bank of Communications.
"They often have relatively high loan-to-deposit ratios and will be hurt most," he said. Nevertheless, not everyone is convinced that Beijing needs to go easier on reserve requirements to protect banks. Its targeted system of slapping higher ratios on profligate banks means it can harden requirements without cutting profits for all, said Andy Brown, head of Asia bank research at UBS.
He said there was a chance that the reserve ratio could climb beyond 25 percent for banks that lend excessively. Others noted the government was already helping banks by controlling lending and deposit rates, guaranteeing a roughly 300-basis-point net interest margin that drives their profits.
"Since you are enjoying policy benefits, you have to shoulder your responsibilities when policy is tightened," said Fan Gang, a former academic adviser to the central bank. Although China's reserve requirements are among the toughest in the world right now, other nations have demanded more in the past. South Korea raised its ratio to as high as 30 percent in the 1980s and 1990s, UBS said.
Mirae's Li said China's banks are unique because they get over 90 percent of their funding from deposits. Unless they can grow their pool of deposits - a challenge made more difficult with real interest rates negative at present - China is approaching its reserve ratio ceiling, he said.
But Sun Miaoling, an analyst with CICC in Beijing, said the most important fact was that reserve requirements had proved the most direct and effective way of mopping up excess cash. "Of course, reserve requirement rises may affect bank earnings, but the central bank now has something more urgent to worry about, and that is inflation," she said. "In the past, the government helped banks clean up their bad loans, and now it is banks' turn to do something for the government."