By Philip Lagerkranser

July 17 (Bloomberg) -- China's banking regulator told policy makers that forcing banks to increase reserves has hurt the industry's ability to repay debt, according to a person with knowledge of the matter.

The People's Bank of China raised its reserve ratio requirement to a record 17.5 percent last month to rein in loan growth and inflation. The China Banking Regulatory Commission has warned against ordering further increases, the person said, declining to be identified as he isn't authorized to speak publicly on the matter.

China's push to remove funds from the banking system resulted in the slowest loan growth in more than two years last month. The risk is that more banks will fall below the minimum requirement for short-term financial strength, the person said.

``While helping to control liquidity, further RRR hikes run the risk of repressing the financial system,'' wrote Sun Mingchun, a Hong Kong-based economist at Lehman Brothers Holdings Inc., in a July 15 note to clients. China may be approaching ``the limit where further hikes do more harm than good,'' he said.

CBRC's recommendations were sent to the State Council, China's cabinet, the person said. China's state radio said yesterday that the nation needs a ``tight'' monetary policy, citing the legislature's Financial and Economic Affairs Committee.

The central bank has boosted the reserve ratio requirement by 3 percentage points this year, freezing up an estimated 1.3 trillion yuan ($191 billion) of bank funds. Meanwhile, it has left interest rates unchanged after six increases in 2007.

Lehman's Sun forecast the reserve ratio will rise by another 2.5 percentage points this year.

Liquidity Threshold

The number of Chinese banking institutions whose liquidity ratio, a measure of ability to meet short-term funding needs, had dropped below the 25 percent regulatory minimum increased by 85 to 392 in the five months to May 31, the person said.

The so-called excess reserve ratio at Chinese banks -- the share of bank deposits that lenders voluntarily lodge with the central bank in addition to required reserves -- dropped to 1.95 percent in June, the lowest since at least 2001, reflecting the strain on banks' finances, according to Sun.

Efforts to drain surplus funds from the financial system should focus on measures such as issuing central bank bills, the banking regulator told the State Council, according to the person. The central bank auctioned 15 billion yuan of one-year bills on July 15 and mopped up 20 billion yuan through repurchase agreements.

Further interest rate increases could exacerbate declines in stock markets and real estate prices, the banking regulator said. The nation's benchmark lending rate stands at 7.47 percent, more than two percentage points higher than in neighboring Hong Kong.

Bad-Loan Rebound?

In its proposals to the State Council, the regulator called for exempting some smaller banks and rural credit cooperatives from more reserve ratio increases, or even lowering the proportion of cash they must keep in reserve, the person said.

So-called special mention loans at Chinese banks, credits that may become non-performing unless amended, increased by 35.8 billion yuan in the first five months of the year to 2.16 trillion yuan, according to the regulator. That may be a precursor to a rebound in bad loans, as shrinking corporate profits in some industries erode companies' ability to repay debts, the person said.

Chinese banks' bad-loan ratio dropped to 7.5 percent at the end of May, down 1.74 percentage points from a year earlier, the person said. Total non-performing loans fell 5.3 percent to 2.25 trillion yuan.

``There's no need for further reserve ratio hikes in the near term as lending controls have been effective,'' said Samuel Chen, an analyst at JPMorgan Chase & Co. ``Liquidity risk at Chinese banks remains relatively low at present, but it's good for the regulator to prepare for rainy days.''

To contact the reporter for this story: Philip Lagerkranser at lagerkranser@bloomberg.net