For China, 2012 will be spent reacting.

China will have to react to pressures from the United States as politicians in the world's largest economy use the value of the renminbi as a political tool before the presidential election in November.

China will have to react to the debt crisis in Europe that could turn from bad to worse and possibly plunge the global economy into another recession. China will have to react to the overhang of bad debts from lending in 2009 that threaten to swamp the banking system with non-performing loans.

To deal with these events and ensure that GDP growth comes in above the targeted 8 percent and employment remains stable, monetary policy must be flexible and banking sector liquidity must be ample. While officials have said that monetary policy will remain prudent, in practice it will be loosened as policy is fine-tuned to support growth. Such fine-tuning has already begun. The People's Bank of China, the central bank, cut the reserve requirements ratio by 50 basis points in December to support banking sector liquidity and greater lending. At the same time, the government has begun a number of tax reforms, and 1.2 trillion yuan ($190 billion; 150 billion euros) went on fiscal spending in December.

The main factors that will allow monetary policy to be loosened are a more benign outlook for inflation and a muddled outlook for growth. Although inflationary pressures still exist in China, the main inflationary input this year, newly printed renminbi used to buy foreign exchange from the banking system, is gone.

From October 2010, about the beginning of the second round of quantative easing, until September 2011, China's central bank printed an average of 350 billion yuan a month to buy foreign exchange from the banking system, a 50 percent year-on-year increase. With CPI running high throughout the period, the central bank did not want this liquidity in the financial system and chose to sterilize it by increasing the reserve requirements ratio nine times, with each increase removing about the same amount of money from the system as was added through foreign exchange purchases.

However, in the past three months there has been a reversal of this trend, with yuan positions for foreign exchange purchases falling 25 billion yuan, 28 billion yuan and 100 billion yuan in October, November and December. The switch from inflows to outflows now means that the Chinese central bank can begin cutting the reserve requirements ratio to support greater bank lending and economic growth.

As a result, bank lending this year will surely surpass the 7.5 trillion yuan lent last year.

Greater bank lending is also being supported by the delay of key banking sector reforms. The China Banking Regulatory Commission previously planned to implement new capital requirements from the beginning of this year but implementation has been delayed until at least the second half of the year to cut costs and allow banks to lend more. Other reforms, such as implementing deposit insurance or steps to marketize interest rates, will also be delayed.

Of the potential reforms, interest rate liberalization would be the most substantial. The central bank recently said that conditions for interest rate reform are "basically ready". There is no doubt that China's economy would benefit greatly if the government engaged in interest rate reform, as small businesses that have been crowded out of the formal banking system would see greater lending as large State-owned borrowers turned to debt markets for financing against the backdrop of more expensive loans.

But despite the apparent commitment to interest rate reform from the central bank this year is unlikely to be a big one for change. Uncertainty over global growth means Chinese authorities need to ensure that, should it be needed, banks are able to lend to support growth as they did in 2009. However, interest rate reform could prevent this as smaller banks offer higher deposit rates to win deposits from large banks, reducing the amount of funds available at large State-owned banks.

Rising interest rates due to competition for deposits would also mean that the spread of Chinese interest rates over US and European rates would continue to increase, potentially leading to renewed capital inflows that could bring new inflationary pressures and again force the central bank to tighten monetary policy at a time when it should be loosened to support growth.

However, the expected monetary policy loosening will be primarily achieved through a reduction of the reserve requirements ratio and not through cutting interest rates. Real deposit rates are expected to remain negative this year as CPI stays above 4 percent, putting continued pressure on banks to attract deposits and maintain the ability to lend.

By how much the reserve requirements ratio is cut and how much bank lending exceeds last year's levels depends primarily on the outlook for the European economy and Chinese exports.

If Europe avoids any major catastrophe and the economy simply continues to limp along, monetary policy will be loosened gradually, bank lending will reach 8-8.5 trillion yuan this year and authorities will engage in a number of other reforms, such as deepening equity and debt markets, increasing use of the yuan outside China and further appreciation of the renminbi against the US dollar (which would also quieten the US political commentary).

The other scenario, where at least one and potentially a number of European countries default and financial institutions collapse, would be reminiscent of 2009, when the global economy faltered in the wake of the financial crisis and the Chinese government embarked upon a 4 trillion yuan stimulus package that involved bank lending of 9.6 trillion yuan. Net exports had a negative 38.9 percent share of GDP growth for all of 2009, with growth being replaced by credit-driven investment, as record levels of new yuan loans meant gross capital formation accounted for 91.3 percent of GDP growth.

Given the negative consequences of the 2009 stimulus, including asset price inflation and what could become as much as 2-3 trillion yuan of non-performing loans from those extended to local governments, China should be cautious about another stimulus. Banks and regulators have yet to deal with the current round of bad debts, making it ill-advised to begin the process again.

The author is a financial analyst at North Square Blue Oak, a London-based brokerage house. The views do not necessarily reflect those of China Daily.

(China Daily 01/20/2012 page10)