Opinion / China Watch

China seeks to curtail lending to prevent inflation
By JAMES T. AREDDY (WSJ)
Updated: 2006-06-19 08:20

http://online.wsj.com/public/article/SB115046775124382390-imldtklZudouSeYYwlES47fsj3c_20060623.html?mod=regionallinks

SHANGHAI -- China's latest credit tightening could push the country's financial markets lower in a critical week that will see domestic pricing of a stock offer by Bank of China Ltd., the biggest ever initial public offering in mainland China. Less clear is whether it will have the intended effect: curbing Chinese bank lending to damp torrid economic growth and head off any resulting inflationary pressures.

The move, the second since April aimed at slowing the world's largest and fastest-growing developing economy, sent ripples of concern Friday through international markets, causing the dollar to strengthen briefly. A slowing of the economy could soften commodity prices and crimp some multinationals' sales in China. In China, it could dent a stock market that is off its high for 2006, though the benchmark Shanghai Composite Index is still up 36% so far this year.

China's central bank, the People's Bank of China, said late Friday it will lift its reserve-requirement ratio for commercial banks, effective early next month, by a half percentage point to 8%. The reserve requirement targets the amount of deposits that banks must set aside instead of lend; a bank holding deposits of the equivalent of $100 would have to set aside $8 in reserves, thus limiting the amount it can lend.

"It's just freezing the liquidity," said Jonathan Anderson, UBS AG's chief regional economist in Hong Kong. "The real impact is to get banks to start slowing" their lending.

Still, analysts expect prices of Chinese stocks and bonds to fall initially as banks adjust their balance sheets to comply with the change. "The A shares will drop a little [today] but will soon resume their increases," said Hu Weidong, an analyst at Xiangcai Securities Co. in Shanghai, who worries more about rising interest rates in the bond market.

A heavy drain of financial-system liquidity could cool demand for shares in Bank of China being priced and offered for Chinese investors this week, though analysts still anticipate strong interest for the Beijing bank's stock.

Bank of China is expected to set the pricing Thursday for its offer of as much as $2.5 billion in Class A shares for the Shanghai market. The offer will supplement this month's $11.2 billion IPO in Hong Kong.

Tighter credit coupled with recent gains in the yuan and new rules on property speculation reflect how China's leaders are increasingly concerned that a surge of loans is prompting excessive investment, which in turn could spill over to higher prices. A raft of financial data during the past week pointed to quickening growth and possible inflation, despite an increase in lending rates in April.

For instance, the central bank said its key money-supply measure expanded 19% in May from a year earlier, while lending in yuan increased 16% in May. The rates were some of the highest in two years. China's economy grew at a rate of 10.3% in the first quarter.

With increased lending, investment levels are surging. Fixed-asset investment jumped 30% during the first five months of this year, the government reported last week. As investment in new factories and property rises, so do risks the projects will incur losses and bank loans will go bad.

Banks provide almost all of the financing in China's economy, and China's top leaders openly called on them to slow lending after the past week's economic data. "The fast growth in the fixed-asset investment should be firmly curbed," Premier Wen Jiabao said last week.

Authorities are particularly concerned with overinvestment in risky industries such as property. Manufacturing is another worry, as increasing numbers of factories are driving up China's costs of importing energy and raw materials.

China's surprise April increase in lending rates was the first boost since late 2004, and the move -- the benchmark one-year-loan rate rose 0.27 percentage point to 5.58% -- signaled to economists that the government will address fast growth with market-oriented measures. However, the May data reported in the past week strongly suggested the higher interest costs had little impact in curtailing borrower demand for loans.

In contrast, the reserve requirement takes cash out of the system at its source -- the banks -- and it has traditionally had a stronger effect on bank behavior than other credit-tightening moves. It was raised most recently in April 2004 and September 2003. The central bank says the latest increase will remove the equivalent of $18.75 billion from the banking system but won't take effect until July 5, a time gap that likely reflects the jostling that banks need to do to adhere to the policy.

The instrument is "blunt," but "its effectiveness tends to be eroded very quickly," Goldman Sachs economist Hong Liang said in a report. Yu Kai, an analyst at Newland Securities Co. in Wuhan, said the stock market "has been talking on it since this May, and the market performance has already reflected these expectations."

Today, Chinese banks could sell domestic bonds to raise cash, which also would signal higher interest rates in the country's debt markets. China's market interest rates already have been creeping up this year, partly in anticipation of more tightening, with one-year central-bank bills fetching as much as 2.48% last week, compared with 1.9% at the beginning of 2006.

Banks in China lend so freely because of their large deposit base, and figures suggest most are well able to adhere to the new reserve requirement. On average at the end of March, China's banks had placed 10.5% of total customer deposits of nearly $4 trillion at the central bank, above the new regulatory minimum reserve requirement of 8%. But weaker banks believed to be doing the most speculative lending might be more severely affected, partly because higher reserve ratios apply to them. In addition, banks have far lower excess reserves on average than they did before the 2003 ratio increase was announced -- a move that briefly sent overnight interest rates above 15% in China as banks scrambled to raise cash by selling bonds.

U.S. stocks initially fell Friday as investors worried that China's move to slow lending could affect corporate earnings. The Dow Jones Industrial Average edged down 0.64 point to 11014.55.

Mr. Anderson of UBS said investors shouldn't be concerned that Chinese authorities are trying to slow the economy so much as they are braking its recent "accelerationist" tendencies. He said an increase in reserves was expected.

China also has been taking less-market-oriented steps to cool the economy, in particular by adjusting rules in ways designed to make property speculation less appealing.

Meanwhile, China has been permitting the yuan to rise more quickly in recent days, another possible effort to tighten credit in the financial system.

In Shanghai currency trading late Friday, the U.S. dollar was at 7.9992 yuan, after trading in a range of 7.9970 yuan and 8.0007 yuan. While not significant in the context of global currency-exchange movements, the level of eight yuan to the dollar is a psychologically important point that the currency market tested in three of five sessions last week.

As the yuan rises, it makes China's exports more expensive in U.S. dollar terms. The U.S. administration has argued that a stronger yuan helps reduce China's trade surplus.

Citigroup Inc. economist Yiping Huang said a rising yuan will be used along with higher interest rates and other measures to cool China's economy. "Accelerated appreciation of the [yuan] now looks inevitable," he said in a note Friday.