Before discussing those rumors, I wanted to get some more general context on the issue of interest rates. In a very interesting September 16 speech on Japan’s post-bubble experience, Bank of Japan Masaaki Shirakawa argued among other things that “protracted low interest rates play an important role in preventing an economic downturn, but, at the same time, they tend to delay adjustment in excesses accumulated during the period of bubble expansion. In addition, they also tend to delay the rejuvenation of businesses.”
I think this is a very important point. By effectively taxing net depositors in the banking system (households) and using the proceeds to subsidize net borrowers (SOEs, large manufacturers, real estate developers, infrastructure investors, local and municipal governments, etc.), artificially low interest rates can prop up growth by increasing investment, but they do so by simultaneously encouraging overinvestment, especially in capacity, and discouraging household consumption. In China this process worsens the already horrendous domestic imbalance.
China needs to raise its interest rates, but to do so will be painful in the short run because too much Chinese investment and too many Chinese borrowers can only survive thanks to the enormous capital subsidy. Raising rates too quickly, in other words, will cause a surge in financial distress and rising unemployment. On the other hand, failure to raise rates will simply increase the domestic imbalances and raise the cost ultimately of any adjustment. This is not an easy trap from which to escape.
Toaster ovens, anyone?
And it is easy to see some of the consequences. Saturday’s Financial Times has what was for me a fascinating – if perhaps little noticed – article on a recent warning by the CBRC to Chinese banks:
Chinese regulators have publicly warned the country’s banks to stop chasing deposits by offering customers extravagant incentives such as prizes, free travel, paying children’s school fees and even providing jobs for relatives.
The China Banking Regulatory Commission issued a notice on Friday saying “a minority” of banks had resorted to such tactics since the start of this year to attract deposits from clients. It said banks and individuals involved would be strictly punished.
China’s central bank sets a ceiling on the interest rate that Chinese lenders can offer depositors, as well as a floor on rates that they can charge borrowers, a practice that avoids cut-throat competition among banks and guarantees them a healthy lending margin.
But even some senior Chinese bankers have attacked the perverse incentives this strict control creates. The chairman of Bank of China published an article in which he fretted about the unsustainable nature of a system that encourages banks to lend as much as they can in order to maximise profits.
Those Americans old enough to remember banking in the days before the passage in 1980 of Depository Institutions Deregulation and Monetary Control Act (DIDMCA) will know exactly what the Financial Times is talking about. Before 1980 the Federal Reserve Bank set the maximum interest rate US banks could pay on deposits (the once-famous Regulation Q).
For a variety of reasons during the inflation of the 1970s the deposit rate became too low and created a series of widening distortions in the capital allocation process. Among other things American banks, in order to compete for deposits but unable to do so by offering higher interest rates, resorted to a wide variety of non-monetary incentives – most famously offering toaster-ovens as gifts to anyone who opened an account. Depending on the size of your account you could also get free holiday packages, bicycles, and tons of other things – anything but money.
Chinese banks seem to be doing the same thing. Prevented legally from offering higher deposit rates, they are trying to increase their deposit base by providing either non-interest compensation (gifts) or they are illegally offering to pay higher rates.
Why should banks want to pay more for deposits? Because banking in China is a money-making machine that basically transfers income from depositors and tax payers to bank shareholders. The mandated difference between the maximum deposit rate and the minimum lending rate is so wide that banks make a huge profit on the spread as long as they don’t make risky lending decisions, and the way to avoid risky lending, of course, is simply to lend to SOEs and local governments (both of which are implicitly guaranteed ultimately by the household sector, via cheap deposits and taxes). This is the main reason why inefficient SOEs are flooded with cheap credit and the very efficient small and medium enterprises are starved of capital.
Towards the end of the section I cited the Financial Times article referred to an August 25 OpEd piece published Xiao Gang, the Chairman of the Bank of China, in China Daily. I found the article in some ways astonishing, but surprisingly little-discussed, and it is well-worth reading.
Although he didn’t come out explicitly and say that the recent lending boom is a big problem, Xiao Gang does say that it “neither assures the long-term sustainable development of the banking sector nor satisfies the need of a balanced economic and social structure.” Pretty strong words, I think, although as is often in the case of China, a little more circumspect than what might be said elsewhere.
Xiao’s basic point (the article is called “Don’t blame it on the government”) is that Beijing should not be held responsible for the recent lending spree.
As a chairman of a bank, I have never received any instructions from the government to lend money to any project. All decisions relating to business were made either by the board, or by the management.
Instead he argues, the incentive structure within Chinese banks is distorted in a way that makes every bank eager to gather in as many deposits as possible and to maximize the loan book.
Interestingly, the banks have revamped the remuneration schemes top-down, closely linking their employees’ emoluments and branches’ expenses to performance, in particular, to revenues and profits. The emoluments usually consist of two parts: one is the basic wage related to different posts, and the other is performance-linked bonus that generally accounts for 50-70 percent of the total emoluments.
Those who do not advocate issuing more loans (and therefore make more profits) are, of course, not so popular within banking circles. While expanding their loan portfolios, Chinese banks are smart enough to take the risk-averse approach and to focus on lending to large State-owned enterprises (SOEs). These SOEs often enjoy monopoly in their sectors and quasi-government credit ratings. This can, in turn, explain why Chinese banks have steadily improved their asset quality and reduced their non-performing asset ratios.
Since, in my opinion, the main incentive structures are the too-wide spread between the lending and the deposit rate and the socialization of most credit risk, and these are basically set by the regulators, I would argue that the government is indeed responsible for the lending boom, but technically Xiao is right. Notice that among other things he is also indirectly acknowledging that the “improvement” in the bank loan portfolios is largely a consequence of socializing the losses. This doesn’t mean that fewer bad loans are being made. It just means that the losses will be borne not by the banks but by the government (i.e. households).
All of this leads us to the topic of the day – rumors that there will be a change in the regulations in China that set the maximum deposit rate that banks can legally offer. In a Friday email my Shenyin Wanguo colleague and former PKU student Chen Long summarizes for me the recent rumors:
Last week it was widely said that Chinese authorities would allow banks to raise the household deposit rate by up to 10%. Actually this is not very surprising news. Xia Bin, a member of the PBoC monetary policy committee, first talked about the deposit rate floating experiment in Liaoning Province on Aug 30th.
This was backed by statements from the Chairman of the PBoC’s Shenyang branch on Aug 31st and by Governor Zhou Xiaochuan’s speech on September 9. On September 16, a CBRC official also said that the interest rate liberalization process would accelerate.
Many in the markets believe that this measure will come out very soon and some even say that the State Council has approved it. The only uncertain thing is when it will be announced and what is the detail.
One day earlier, Chen Long had sent me the following email:
Professor Li Daokui, a member of PBoC monetary policy committee, said in an interview that deposit rate hike is necessary as negative real interest rates reduce household income.
CCTV broadcast his interview and this became the top news today because of his role in the PBOC monetary policy committee. However, the monetary policy committee is only a consulting group for PBoC officials. They cannot decide monetary policy.
Professor Yu Yongding and Professor Zhou Qiren, former and current members of monetary policy committee, have long advocated an interest rate hike, but to little avail. In a forum held in Peking University in June, both of them argued that Chinese interest rates had long been too low but they also declared very clearly that they cannot decide the policy making.
What I think is more possible to happen is the floating or relaxing the deposit rate. Xia Bin, another member of the PBoC monetary policy committee, talked about the deposit rate floating experiment in Liaoning province and that was backed by Chairman of PBoC Shenyang branch on Aug 31st as well as Governor Zhou Xiaochuan’s speech last Thursday.
China still has many instruments with which to control the price level, like the loan quota, the money supply and open market operations. If Beijing really wanted to lift rates, they would have done it several months ago when they oversaw a possible CPI rise. Considering that CPI growth is likely to slow down in Q4, they have little incentive to do it. Deposit rate relaxation, a more gradual reform measure, will be their preferred option.
So will we see a change in the rate banks are allowed to pay depositors? There are many good reasons to expect this. Aside from distorting banking incentives and encouraging cheating, very low deposit rates are, at least in my opinion, the single biggest form of hidden tax that transfers resources from the household sector to subsidize producers and investors, and so are also the single biggest cause of the imbalance between domestic production and domestic consumption (I calculate that, thanks to artificially low interest rates, 5-10% of GDP is transferred every year from households to net users of capital). Raising the deposit rate is a necessary part of rebalancing, and I am glad to see that Chinese commentators are increasingly making this argument.
Not so easy to do
But it is not as easy as all that. If you raise deposit rates, what do you do about lending rates? On the one hand, you can raise lending rates by an equal amount so as to keep the spread constant. This, of course, will do little to address the distortions in incentives, and by mandating such a profitable spread, it doesn’t change the low eagerness of banks to make riskier loans to entities that are more economically viable.
More importantly, I have argued many times that a very large portion of new lending has gone into toxic investment – in excessive infrastructure, excess capacity, in real estate development – that is only viable by virtue of the implicit debt forgiveness that automatically accompanies artificially low interest rates. Any serious attempt to reduce this debt forgiveness by raising interest rates will almost certainly see an increase in financial distress. In some cases it would lead to stopped projects and bankruptcy, and so to rising unemployment. That makes it difficult to raise the lending rate significantly.
On the other hand you can leave lending rates unchanged. This would probably improve the incentive structure – if bankers were no longer able to mint gold effortlessly thanks to guaranteed profits determined by the regulator, presumably they might be more likely to make more profitable lending decisions. It would also raise household income.
But what would it do to bank capital? The regulators have made it very clear that they want Chinese banks to increase their equity bases. One possibility is for banks to issue equity in China or abroad, but I doubt that there is anywhere near the appetite, especially for the smaller banks who are likely to have much of the garbage debt. A second possibility is for the kind of inane round-tripping that was much-discussed until recently but has, I hope, been shelved. Government entities like Central Huijin can borrow money from the banks and use the proceeds to buy bank equity. Of course this does little for systemic bank capital.
Ultimately the main source of capital for the banks is likely to be retained earnings. The very wide spread between deposit and lending rates has guaranteed bank profitability – albeit at the expense of the struggling depositor – and has done more to raise equity capital than anything else.
If the regulators raise the deposit rate without raising the lending rate, in other words, they are undermining their own professed determination to raise bank capital. Presumably raising bank capital is necessary in order to deal with an expected surge in non-performing loans.
Will they do this? I doubt it. My guess is that we might see some tinkering with deposit rates at the edge, but that deposit rates cannot be deregulated and will not be allowed to rise enough to make much of a difference. Any change is likely to be small.
Raising interest rates is all the less likely, by the way, in the context of the increasingly tough trade conversations around the world. Remember that an undervalued currency is one way of getting a trade advantage, but repressed interest rates are an even more powerful way.
If China is forced to raise the RMB by any significant amount, it will probably want to counteract this by expanding credit and reducing, not increasing, real interest rates, which is what China did after 2005 and Japan after 1985. As those two examples make clear, lowering the real cost of capital to counteract an appreciating currency will create a whole different set of problems.
This all goes to show that there is no easy way of eliminating the deep imbalances and distortions in the Chinese financial system. It will have to be done slowly and determinedly, and will require many years of a very cooperative global environment. Unfortunately I am very pessimistic about our chances of seeing any of these conditions, especially the latter.
Before closing, let me suggest a few pieces of news worth noting. First, Martin Wolf at the Financial Times has a piece (“Wen is right to worry about rebalancing”), which purely out of vanity I will recommend.
Second, this week the People’s Daily had two articles, one aimed at the US and one aimed at Europe, warning of the consequences of trade war. It is clear that there is a lot of concern in China, but it is not clear that everyone in Beijing understands what are very legitimate complaints from China’s trading partners. I was at a meeting yesterday between a senior EU trade representative and someone close to Beijing policymakers and I was frankly surprised (even shocked) both at the hectoring tone of the Chinese representative and at his total failure to understand the trade issues, or at least to understand the European view.
China is right to be concerned about protectionist measures abroad, and has some very legitimate complaints, but unless it understand the very equally legitimate complaints over Chinese trade-related policies, it is hard to imagine that we will arrive at any sort of optimal solution. As an aside I wonder what will be the effect of the announcement yesterday that Larry Summers is leaving the White House. My impression is that he has been a real bulwark against rising US protectionism, and his departure may change the tone in Washington substantially.
Third, the Telegraph published a very interesting story about some very strong and angry statements by the former British chancellor. “The euro has been permanently damaged,” they say, “by Germany’s failure to intervene swiftly during the sovereign debt crisis earlier this year, Alistair Darling has said in an unusually frank attack.” As part of the overall deterioration in global trade that I have been writing about for two years, I have always expected that China-bashing was soon going to be rivaled by Germany-bashing. In a world of contracting global demand, the high savings high surplus countries are going to be lambasted for predatory policies. I am not sure there is much that can be done to reverse this process.
Fourth, Marshall Auerbach has a post on Naked Capitalism (an excellent blog that I read regularly) that forcefully describes the criticism of Chinese policies on the global economy, albeit with an unfortunate and unnecessarily incendiary title.
And finally, Li Hong at People’s Daily states the Chinese position as to why China’s behavior has not been predatory but has in fact prevented global economic conditions from getting worse. The fact that the Auerbach and the Li pieces have almost no overlap indicate how difficult this “debate” is likely to be.
Happy Mid-Autumn Festival, everyone. My amazingly-talented-at-everything graduate student Gao Ming is taking me off to dinner now — and i hope he doesn’t have mooncakes.