Adjusting China’s Required Reserve Ratio: More Harm than Good?

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On Wednesday, February 4, China’s Central Bank cut its required reserve ratio (RRR), the minimum percentage of deposits its commercial banks must hold in liquid reserves, by 50 basis points, or 0.5%. This cut occurred during a period of particular economic uncertainty for China: in 2014, the country experienced its lowest rate of GDP growth in the past 24 years.

China’s stagnating growth, down to 7.3% in the last quarter of 2014, is largely a product of excessive capital outflows stemming from consumption of foreign currencies. For example, an increased consumption of the American dollar, brought about by both diminishing trust in Chinese assets and higher expected interest rates in the US, has led capital to flow out of China. These outflows have far reaching consequences; less working capital means reduced investment in Chinese businesses, and consequently less business growth.  Moreover, this surge in external spending is not trivial, as China’s fourth quarter deficit of $91 billion on its capital accounts exceeded all of its prior quarterly measurements on record.

What does China’s rise in capital outflows mean for a country struggling to transition from a low-value producer to high-value consumer? For one, it signifies a dearth of domestic assets necessary to provide credit for the development of local businesses. Secondly, without sufficient available credit, it is unlikely that China will have the capacity to prioritize the technological innovation it sorely needs to reboot its growth.

By lowering the required reserve ratio of its commercial banks, China’s leadership hopes it has found an immediate solution. A lower RRR would boost available credit and inject capital into China’s markets, thereby stimulating the economy. According to Haibin Zhu, chief economist at JPMorgan in Hong Kong, “The most important reason for the cut is liquidity demand in the banking system” (NY Times). With greater quantities of available cash, banks will lend more money. This will result in decreased interest rates, which will devalue the Chinese yuan and make Chinese goods more competitive in global markets.

At least in theory, this stimulus is the desired result of decreasing interest rates. In practice, however, opening up greater lines of credit in this manner may prove more harmful than helpful.

As Chinese commercial banks offer more loans, the majority of these will be directed toward large industrial or real estate companies that are in immediate need. Ironically, China will be bolstering the very sector of its economy that it must transition away from in order to achieve successful long-term growth.

While additional credit may temporarily keep these companies afloat, the potential for growth in China’s industrial and real estate sector is tenuous. China’s supply of labor is nearing a point of exhaustion, and once a threshold is reached, rises in wages will raise the cost of producing labor-intensive goods, thereby adversely impacting global demand.

In this manner, providing life-supporting credit for companies that were once profitable may be a misguided investment. Doing so will ultimately conceal China’s complex internal issues, rather than address them. If the country truly hopes to reinvigorate its economy, it must make more calculated investments in the sectors most beneficial for its future.

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