Question

An article in the Wall Street Journal in 2017 noted, "China now has one of the highest [required reserve] ratios in the world, economists say, even though many businesses are starved of credit." a. What does the article mean by Chinese businesses being "starved of credit"? b. Is there a connection between the Chinese central bank imposing a higher required reserve ratio on banks and Chinese businesses being starved of credit? Briefly explain.

Short answer

Chinese businesses being 'starved of credit' refers to a situation where they find it difficult to secure loans or credit from banks. A higher required reserve ratio mandated by the central bank can starve businesses of credit because this policy confines the available capital that banks can lend, as they must keep a larger proportion of their deposits as reserves.

Step-by-step solution

Comprehension of 'Starved of Credit'

'Starved of credit' means that Chinese businesses are finding it hard to procure loans or credit from banks for their ongoing operations or new investment plans. This can occur due to multiple reasons such as strict lending regulations, high-interest rates or low availability of funds with banks.

Understanding the Concept of Required Reserve Ratio

The required reserve ratio is a central bank regulation, employed by most, but not all, of the world's central banks. This is the portion of depositor's balances banks must have on hand as cash. It's to prevent banks from running out of cash. Hence, if the required reserve ratio is high, banks are obligated to hold a larger proportion of their deposits as reserves, leaving less amount for providing credit/loans to businesses or individuals.

Connecting Higher Required Reserve Ratio and Starvation of Credit

By increasing the required reserve ratio, the central bank is effectively limiting the amount of money banks can lend out. With more of their money held in reserve, banks have fewer funds available to lend to businesses. This can result in businesses being 'starved of credit.' Therefore, there is a direct connection between a higher required reserve ratio and credit starvation for businesses.

Key concepts

Credit Availability

Credit availability refers to the ease with which businesses and individuals can access loans and other forms of credit from financial institutions. In a healthy economy, credit should flow freely to support business operations, innovation, and expansion. When entities are 'starved of credit', it indicates a scenario where obtaining financial support through loans becomes challenging. This can have a considerable impact on the growth and sustainability of businesses, as they rely on credit for everything from purchasing inventory to expanding their facilities.

Factors influencing credit availability include interest rates, economic conditions, and more importantly, banking regulations like the required reserve ratio. As seen in the Chinese context, stringent reserve requirements can constrain the funds that banks have at hand to lend, thereby tightening the flow of credit in the market. Lower credit availability can lead to reduced business investments, stunted economic growth, and sometimes even contribute to a broader economic slowdown.

Central Bank Regulations

Central bank regulations play a paramount role in maintaining financial stability and influencing economic activity. Regulations can include setting interest rates, controlling inflation, and ensuring a stable banking system. One of the key tools in the regulatory arsenal is the required reserve ratio, which dictates the percentage of deposits that banks must retain, rather than loan out or invest.

When the central bank raises the required reserve ratio, it typically aims to curb inflation or stabilize the banking system. However, a higher ratio also means that banks have less money to disburse as loans, potentially leading to a credit crunch, where businesses and consumers face difficulty in obtaining loans. Thoughtful calibration of these regulations is vital because overly restrictive measures can inhibit the availability of credit, impacting business operations adversely, which aligns with the situation highlighted in the 2017 Wall Street Journal article regarding China.

Loan Procurement

Loan procurement is the process through which businesses and individuals obtain loans from financial institutions. It involves several steps including the evaluation of the borrower's creditworthiness, agreement on loan terms, and the provision of collateral if required. This process is integral for the circulation of funds within an economy, enabling businesses to initiate new projects and manage operational costs.

However, high required reserve ratios can make loan procurement more arduous. Banks, taking into account the necessity to keep higher amounts in reserves, may tighten their lending criteria, increase interest rates for the loans they do give, or approve fewer loans. This scenario negatively impacts potential borrowers, in particular businesses, who often need ready access to funds to respond to market demands and opportunities swiftly. Thus, when credit is scarce, even viable businesses might find it difficult to secure loans, leading to reduced investment and, potentially, a downshift in economic activity.

Banking System Liquidity

The liquidity of the banking system is indicative of the availability of liquid assets, like cash, that banks have to meet immediate demands, such as customer withdrawals or loan requests. If a bank has high liquidity, it implies that it can easily cover these obligations without suffering financial strains. Conversely, inadequate liquidity can have severe repercussions, potentially leading to bank runs and financial crises.

In regulating liquidity, central banks use tools like the required reserve ratio to ensure that banks maintain a safe level of reserves. But, as liquidity is crucial for banks to perform their primary role of lending, excessively high reserve requirements can tighten liquidity. This restricts banks' ability to extend credit, thereby affecting the entire economic ecosystem. For businesses trying to procure loans, a banking system with compromised liquidity could mean reduced credit availability and more stringent borrowing conditions. As such, the central bank must strike a delicate balance between safeguarding banking system liquidity and fostering an environment where credit can be accessed by those who need it.