China: Why banks will be pampered by more liquidity but not fully hammered with lower rates?

• In the latest State Council's executive meeting, Chinese banks have been told to make interest concessions to support economic growth. This should not surprise anyone as banks have been reaping the lion's share of profits in China. In 2019, the banking sector alone made up 36% of total profits. While pressuring banks to give unlimited support to firms is not a perfect solution with potential negative consequences for financial stability, regulators also face a dilemma in striking a balance. Keeping banks’ profitability afloat is vital to implement expansionary fiscal and monetary policies. Dividends are also distributed to the central and local governments as they are the main shareholders. In this report, we analyze Chinese banks’ liquidity needs in terms of quantity and prices, and draw implication on China’s monetary policies.
• In order to boost the economy, China has expanded its issuance quota of special local government and treasury bonds to RMB 4.75 trillion for 2020. However, banks will need enough liquidity to purchase the above bonds as they are the key bond holders in China. As of May 2020, commercial banks hold 55% of total bonds, and the granular proportion further rises to 72% for total government bonds and 87% for local government bonds. To support the demand for government’s funding and faster loan growth, it is clear that a lower reserve requirement ratio (RRR) is a must with at least another 200 bps cut in 2020.
• However, the monetary stance may be more conservative for rate cuts. While lower lending rates are beneficial for firms, any aggressive policy rate cut may harm banks’ profitability. Banks will face a narrower net interest margin (NIM) with lower lending rates. At the same time, there is a strong need for the government to keep banks’ profitability afloat to provide room for purchasing bonds and giving out loans.
• The most likely scenario is gradual cuts of the medium-term facility (MLF) rate with a lower 1-year loan prime rate (LPR) at the same or even faster pace. However, the 5-year LPR will not go down as much as other rates due to the close correlation to real estate and the mantra that “houses are not for speculation” have remained true. As such, the downward movement for policy rate should be limited to no more than 40 bps and will be used only under unexpected shocks on the economy, and a lower inflation rate has clearly provide the room if needed.

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