The People's Bank of China [File photo]

The People's Bank of China (PBOC) recently decided to lower the required reserve ratio by 0.5 percentage points (effective from December 5, 2011) for Chinese depository financial institutions. As a result, the required reserve ratio falls to 21 percent from an unprecedented 21.5 percent, which resulted from 12 reserve ratio hikes in the last two years. The recent move on the reserve requirement signifies a turning point in the PBOC's monetary policy stance from its tightening campaign to a loosening one; and maintaining growth seems to have begun to supersede the need to tackle inflation.

The reasons for the policy turn are essentially three-fold: pressures from the economic downturn, global economic uncertainty, and an emerging liquidity crunch. First, the recent decline of real economic performance, especially in trade and real-estate sectors, prompted the PBOC to loosen its monetary policy. Based on the existing Chinese economic structure, China's major growth engines continue to be exports and fixed asset investment. In this regard, the purchasing managers' index (PMI), a gauge of manufacturing activity, tumbled to 49 in November this year, a fresh sign of a contraction of manufacturing activity that hasn't occurred since February of 2009. Second, increased global risks from the eurozone sovereign debt crisis to the fragile U.S. economic recovery have worsened international economic environment for the export-oriented and FDI-dependent Chinese economy. A looming financial crisis in the eurozone could potentially trigger off liquidity tightening worldwide. Third, the Chinese economy has already felt the pinch from recent notable decreases in net capital inflow into China's financial system and real sectors, as well as from liquidity crunch resulting from monetary austerity measures which target inflation control and real-estate asset bubbles.

The current situation reminds us of the scene three years ago, though there was not much international capital fleeing out of China at that time. Policymakers in almost every major country in the world adopted massive fiscal and monetary stimulus measures to save them from the 2008 financial tsunami. In retrospect, stimulus packages appear to have mitigated the financial meltdown and economic shocks and have tided over many economies in the world. This is indeed what Keynesian macroeconomic policy supposedly does through engineering "leaning-against-the-wind" changes in aggregate demand. Nevertheless, Keynesian policy is certainly not a panacea; it is simply short-run based and demand-side biased. More importantly, it aims at changing only aggregate demand in the established existing economic structures, totally ignoring the risk that the "wrong" structures could distort policy effects and eventually backfire.

The biggest structural challenge facing policymakers in China is financial repression: negative real interest rates, high bank-reserve requirement, and de facto two-tier financial structure for state-owned enterprises and other enterprises (mostly medium- and small-sized enterprises). Underpriced capital due to the interest-rate control and inflation pressure has helped interest rate-sensitive enterprises to continue in their fixed-asset investment expansion, even in an austerity period when they usually have to do so at the expense of small- and medium-sized enterprises (the crowding-out effect). With financial repression, what monetary policy loosening or tightening the bank reserve requirement influences often mainly boils down to increased or reduced barriers to medium- and small-sized enterprises, since large banks have always a sort of "paternalism" toward state-owned enterprises. This concept was discussed by János Kornai in his famous 1980 work Economics of Shortage.

The irony is that such a two-tier financial structure, as a legacy of the state's centrally planned economic system, twists macroeconomic policy effectiveness. For example, recently emerged disintermediation and shadow banking activities in China showcase how repressed market forces can get through policymakers' tightening cycles and make Keynesian macroeconomic policy blunt. Even worse, a two-tiered financial structure with underpriced capital compounded by local government debt via urban development investment vehicles can evolve into a subprime lending crisis (albeit one with Chinese characteristics) if it remains intact. The de facto two-tier financial structure with a negative real interest rate not only helps us better understand China's "stop-go" pattern of business cycle, but also lets us see how financial repression could possibly make a counter-cyclical policy be pro-cyclical.

Given the current economic conditions and looming financial risk, the PBOC's move to lower reserve requirement is worthy of applauder. It is now time to start paying attention to structural issues and getting them out of the way for more healthy and effective macroeconomic management.

Dr Wu Ying is Professor of Economics at Salisbury University and 2010-2011 Fulbright Lecturer in China.

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