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China's reserve requirement cut to give banks some breathing room

China's liquidity shot to its lenders via a surprise broad-based cut to their reserve requirements could give banks some breathing space as the lower cost of lending may help alleviate potential asset quality concerns, analysts say.

Two days after the State Council, China's cabinet, called for a reduction in the amount of money that banks need to hold in reserve, the People's Bank of China announced on July 9 that it will lower the reserve requirement ratio for financial institutions by 0.5 percentage point to a weighted average of 8.9% starting July 15. The cut will release about 1 trillion yuan of liquidity, according to the central bank's release.

"The move will lower banks' funding costs and interest rate on loans. It will also stabilize asset quality as the released liquidity can help borrowers repay debts that will mature soon," said Wang Zhen, a Shanghai-based analyst at UOB Kay Hian Research. Banks can also invest some of the released liquidity in bonds or other products for a higher return than putting in reserve instruments. This will likely improve the return on the released capital by about 2 percentage points, he said.

Chinese banks' profitability has been eroded by high funding costs, pressure on margins amid low-interest rates and tighter regulations on loans to key business segments such as real estate development. The world's second-biggest economy was the first to recover from the COVID-19 pandemic, but rising global commodity prices and an uneven recovery in some of its key markets has raised the specter of growth plateauing and asset quality deteriorating.

China's gross domestic product increased 18.3% year over year in the first quarter of 2021, but that was mainly due to a low base of comparison as the COVID-19 pandemic roiled the economy in the same period of 2020. Measured over the previous quarter, the economy grew a mere 0.6% in the January-to-March period in 2021.

Sense of unease

Iris Pang, Hong Kong-based chief economist for Greater China at ING Bank, said she got a "sense of unease" that China's banks may be under stress and may face higher nonperforming loans.

"These bad loans could stem from the recent deleveraging reform. Banks have not been able to lend to real estate developers as easily as before and have shrunk their mortgage business," Pang wrote in a July 9 note for clients. "Fintechs, which banks also lend to, have also been subject to deleveraging reform, and this may have had some impact," she said.

The reserve requirement ratio cut will give banks more breathing room on capital and liquidity, though it may only be a temporary reprieve as the amount is "quite small" when compared with the 185.5 trillion yuan of total loans outstanding as of the end of June. "China may need another [reserve requirement ratio] cut in the fourth quarter," Pang added.

However, after the cut, "banks would enjoy a lower interest cost," Pang said. "If banks need liquidity, then maybe 70% [of the released liquidity] will go into lending," she said in an email to S&P Global Market Intelligence on July 12.

The reduced reserve requirements will lower financial institutions' funding costs by about 13 billion yuan a year and, in turn, bring down the costs of overall social financing, the People's Bank of China said. Social financing growth in the country fell a further 0.1 percentage point to 10.9% in June after decreasing 2.4 percentage points between March and May, according to a July 15 report by UBS.

As of July 9, US$1 was equivalent to 6.48 Chinese yuan.