Higher China RRR to drive up borrowing costs

BEIJING: China should rely on raising banks' required reserve ratios to mop up excess cash in the economy, and sustained cash withdrawals could drive up bank lending rates, a former deputy central bank governor said on Monday.

Wu Xiaoling, who is now a senior lawmaker, also said China should embrace greater yuan flexibility to help curb imported inflation but over time it has to introduce two-way currency swings to cool speculation on yuan appreciation.

"Raising the bank reserve ratio could effectively control liquidity and drive up market interest rates. Lending rates could in turn rise when banks don't have sufficient cash," she told reporters on the sidelines of the annual parliament meeting.

"I think we should rely more on banks' reserve requirements to mop up liquidity, but I'm not saying we don't need to raise interest rates."

Commercial banks have started to charge higher interest rates on loans as they don't have enough cash on hand -- indicated by recent strains in short-term funding on the money market as the policy tightening has started to bite, Wu said.

China currently sets a floor on lending rates and a ceiling on deposit rates, with a roughly 3 percentage point gap between them, a spread that is the source of a large chunk of bank revenues.

The People's Bank of China has raised required reserves eight times since early 2010, driving the level to 19.5 percent for big banks. It has raised benchmark interest rates three times since October in a bid to put a lid on rising inflation.

Wu argued that the real lending rate, rather than the real deposit, should be the most important factor when the central bank considers whether to raise benchmark rates.

The central bank may face a tough job to achieve its newly announced 16 percent annual broad money supply growth as they have to extend new loans to existing investment projects.

"Banks are facing a dilemma -- if they continue to lend, inflation pressures will rise, if they stop lending, some investment projects will have to be halted," she said.

China's monetary conditions remain relatively loose given that the central bank's 16 percent M2 money supply growth target was higher than the combined annual GDP growth projection of 8 percent and annual inflation target of 4 percent, Wu said.