Is problem lending by banks in China fixed--or is it simply moving to other channels?

03/09/2011 11:53 am EST


Jim Jubak

Founder and Editor,

China has rewarded some of its biggest banks with a carrot after beating them with a stick. And the financial markets have cheered. The cheering is so loud, in fact, that it is helping the world’s emerging markets put in a potential bottom.

I worry, however, that the real message is that problem loans are shifting from banks to other channels.

China has raised reserve requirements for all its banks to a punitive 19.5% in an effort to slow bank lending, reduce the growth rate of the money supply, and rein in inflation.

But some banks have had to keep even more in reserves because the government has decided they are too loose with their loans. The higher reserve requirements—I’ve heard these banks have had to keep an extra percentage point of reserves with the People’s Bank—were an attempt to get the banks in line with government policy.

And apparently it worked. New loans in February were less than 600 billion yuan. That was below the 650 billion yuan financial markets had expected. And it follows a January that also saw new loans below expectations. As a reward, government sources told Reuters on March 7, the government has removed the extra reserve requirements. (Analysts warn, however, that this doesn’t mean that China is about to lower its overall reserve requirements. In fact they’re predicting another increase this month.)

China’s financial markets rallied on the news—and that rally comes at a very opportune moment for the world’s emerging markets.

Last week the IShares MSCI Emerging Market index (you can track it by following the index ETF with the ticker EEM) climbed back over its 50-day moving average. The index found support near the November low and the move above that level seemed to indicate that the correction in emerging markets was coming to an end.

This week, thanks to move upward in China stocks (Hong Kong’s Hang Seng was up 1.7% on March 8), the move above the 50-day-moving average looks to be holding.

I do think that emerging markets are putting in a bottom. But I don’t think it’s going to happen without another set back or three. Just as the turmoil in Libya (and before that in Egypt) depressed emerging market stocks, rumors on March 8 that Muammar Gaddafi had approached his opponents with an offer to negotiate his departure from the country fed into a rally in emerging market stocks. (The offer seems to have been made but rejected as far as I can tell from news sources.)

But these emerging markets—and economies—still need to negotiate minor problems like controlling inflation, rising interest rates, slowing growth and the like. I wouldn’t underestimate how tough those problems will be to address even after a resolution to the Libyan civil war.

For example, let’s take a second look at the government’s victory over loose bank lending in China. When the government announced last weekend that it was going to do away with an explicit target for new bank loans and instead go with a money supply (M2) target, officials also talked of plans to expand the definition of M2 to include other, growing forms of lending. For example, this expanded measure of society-wide money supply growth would include increasingly important inter-company loans. Those have proven to be as hard to control as bank lending. In the future they’re likely to be even more important—and even harder to control.

Maybe the cheering shouldn’t be quite so loud.
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