China faces self-imposed lending crunch

June 14, 2010

Chinese banks have got in the habit of lending more than is necessary to keep up the nation’s growth rate. This year, they may not be able to lend enough.

The constraint comes from the banking regulator, which sets an annual target for new lending. This year’s is 7.5 trillion yuan ($1.1 billion), or 18.7 percent growth of the loan base. At first glance, the rate of increase looks reasonable: the expected nominal GDP growth rate plus about 4 percentage points to account for the greater financial intensity that comes with economic development.

From the lenders’ point of view, the target is manageable, if only with some adjustments. Bank of China and Bank of Communications are raising capital to allow them to hit their loan limits without straining their balance sheets, while China Construction Bank has cut its loan growth target.

For the economy, though, the target looks too low. Banks probably need to provide 8.5 trillion yuan, about 15 percent more than the target, to keep steady growth.

The calculation is simple. Long-term projects probably need the same amount they got last year to remain viable — 5 trillion yuan. The loan base have been growing at an average rate of 15 percent for a decade, excluding the 30 percent of 2009. To get back onto the long term path, banks will need to create a further 3.5 trillion yuan of credit.

If the banks obey their regulator, some borrowers will get squeezed. The list of losers is not likely to include many projects backed by the central government. Home buyers may also be fine, because Chinese banks consider mortgages to be among their safest assets. That leaves private companies and cash-poor local governments as victims. Yet both groups are important for creating jobs and driving GDP growth, even unprofitable infrastructure projects. Beijing won’t want to see them starved of capital.

So perhaps the regulator will not be too firm about the lending limit. That would either require banks to raise even more capital or to reduce their capital strength. A one percentage point reduction of the current 11 percent capital adequacy ratio would in theory be enough to allow banks to lend an extra 4 trillion yuan, according to a Breakingviews analysis.

But a laxer approach to lending has risks of its own. Banks could lend badly, ending up with higher losses. And the increased liquidity in the economy could fuel asset price and inflation.

Top officials and banking regulators appear to be divided on what to do. Some favour short-term growth pain for the sake of long-term financial stability. But most of China’s leaders seem to think continued growth is the overwhelming priority. If the expansionist camp wins out, the costs may be left to the next generation of leaders.

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