China''s
central bank needs to sharpen its knives. Monetary tightening
measures have so far failed to rein back runaway economic
growth or stop share prices from reaching vertigo-inducing
heights. Further measures expected in the second half
of 2007 are likely to have only a limited cooling effect.
Standard & Poor''s Ratings Services believes that a
judicious mix of interest, exchange, and reserve rate
adjustments, as well as direct administrative measures,
will be the key to dampening unsustainable growth and
safeguarding long-term stability. A heavy-handed approach,
however, could have a significantly negative impact on
the economy.
We
maintain our positive outlook on the banking sector over
the medium term. Reform initiatives remain on track and
credit profiles continue to improve. Nevertheless, small
banks--in particular small city commercial banks--are
likely to face more pressure than their stronger counterparts
over the near term as a liquidity tightening cycle weeds
out weak corporate players.
Cuts
Haven''t Hit Home
China''s central bank, the People''s Bank of China, has
turned on the sprinklers several times this year. On May
18, 2007, it raised the one-year benchmark deposit rate
by 27 basis points (bps), the one-year benchmark lending
rate by 18 bps, and the reserve requirement ratio for
banks by 50 bps to 11.5 per cent. The central bank also
widened the Chinese renminbi''s daily trading band against
the U.S. dollar to 0.5 per cent from 0.3 per cent. Since
April 2006, the deposit rate has risen by 81 bps and the
lending rate by 99 bps.
The
latest interest rate changes signal the authorities'' wish
to harness emerging inflation and rein in surging share
prices. But more than baby-steps are needed. Slightly
higher lending rates won''t discourage most firms from
expanding capacity, given nominal annual GDP growth of
more than 10 per cent in recent years.
The
ear-popping returns for equity investors over the past
18 months mean that few will be tempted to sell up and
place their assets in bank deposit accounts, particularly
at a time when inflation expectations are gathering momentum.
China''s Consumer Price Index stood at 3 per cent in April
2007, compared with a marginally higher one-year benchmark
deposit rate of 3.06 per cent after the recent interest
rate hike.
Rising
Reserve Ratio Mops Up Liquidity
We expect the Chinese renminbi to appreciate only mildly
over the next six months, despite the widened daily trading
band. This is unlikely to dent growth. The central bank''s
reluctance to expose the export-dependent economy to excessive
currency risk and its desire to stave off carry losses
on its foreign assets limit the scope for appreciation.
The
spread between the yield on long-term US Treasuries and
the interest rate on required bank reserves is only about
300 bps. The central bank could suffer losses if the Chinese
renminbi appreciates significantly more than 3 per cent
a year. The reserve ratio should therefore remain the
major tool to sterilize liquidity flooding into the market.
The series of bank reserve ratio hikes have been effective
in absorbingliquidity generated from new inflows of foreign
exchange and containing sterilization costs. Liquidity
is still too high, however, and further hikes in the reserve
ratio could hit small banks.
Banks
with narrow customer funding bases, particularly small
city commercial banks, could face increasing pressure
to make asset composition adjustments as the required
reserve ratio continues to
climb. The average deposit reserve ratio of city commercial
banks was only about 11.4 per cent at the end of 2006.
We expect a significant slowdown in loan growth in this
segment, which will have a knock-on effect on interest
income generation.
Intervention
Needs To Be Handled Carefully
A heavy-handed application of direct measures to restrain
investment growth and asset prices could have a significantly
negative impact on the economy. Direct administrative
and tax measures are abrupt; their impact unpredictable.
Policy missteps could trigger a sharper slowdown than
intended. A significant weakening of borrowers'' credit
profiles would hit the banking sector particularly hard.
Our
positive outlook is supported by strong reform momentum
and an ongoing improvement in the sector''s credit profile,
primarily driven by improving financial positions, corporate
risk cultures, and risk management capabilities.
Non-interest
income exhibits strong growth momentum. We estimate the
sector''s non-interest income will grow at a sustained
rate of more than 20 per cent for the next five years.
The impact of interest rate hikes on banks'' real funding
costs will likely be limited. Higher deposit rates should
be partly offset by shorter deposit maturities, as savers
won''t want to tie up their cash for too long in a rising
interest rate environment. In addition, the deposit rate
on demand deposits, which account for about 40 per cent
of the sector''s total deposits, remains unchanged.
While
banks'' asset quality and profitability could take a near-term
knock, the economy would be hit far harder over the long
term if rapid growth is left unchecked. The central bank
therefore needs to show its claws.
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