When the global financial crisis began the Chinese government stimulated the economy. It worked. Chinese banks took on risk, and the economy continued to grow. But in recent months China’s investment climate has gotten out of control.In the shadow banking sphere banks have increased sales of trust and wealth management products, which promise high returns and are often invested in questionable assets, such as white liquor or luxury apartments in impoverished regions. Because the products are sold by banks, customers are often unaware that these products are not ultimately backed by the government. While the China Banking Regulatory Commission (CBRC) has tried to rein in these sales by forbidding bank sales of trust products, in reality trust companies continue to sell their wares. Wealth management products continue to be sold by a number of companies, and customers, attracted by unusually high returns, are often blithely unaware of what they are investing in.
So on 17 June the People’s Bank of China acted. The Bank increased interbank interest rates while at the same time strategically injecting liquidity into institutions that would be most affected by the liquidity tightening. China’s interbank lending ‘crisis’ was actually engineered by its central bank. The central bank’s website said that it needed to manage liquidity risks that have resulted from credit expansion, including investment risks taken by local governments, excessive property investment, and lending within the shadow banking sphere. Banks, trusts, real estate trusts, and local governments are thus overleveraged, often on weak foundations.
The shadow banking sector certainly needs to be deleveraged. But whether monetary policy is the best method to accomplish this is questionable. Monetary policy, which controls liquidity in the financial economy, is a broad sword: it cuts down risky investment but it also constrains lending to businesses which need funding for everyday activities. But deleveraging through regulation has been shown to be ineffective — there is so much shadow banking activity occurring that the CBRC is unable to enforce its regulations. So officials have turned to monetary policy as a means of reining in all types of speculative activity. Although this is not a practical long-term solution since it is not targeted toward risky lending practices (long-term policy should include the creation of a more effective risk-monitoring mechanism), in the short run it is the only viable option.
Shadow banking poses enormous risks to China’s economy. As in the US subprime mortgage crisis, shadow banking products are leveraged off risky assets that will almost certainly fail. Now the government is caught in an awkward position. Although it has stated it will not back shadow banking loans, systemically important financial institutions will almost certainly have to be bailed out if the shadow banking system fails.
Shadow banking is also closely connected to lending to the real economy. With recent credit tightening, manufacturing and small business activity has slowed even further. China’s new credit-tightening policy comes as demand for China’s manufactured goods abroad has slowed due to the ongoing crisis, and fiscal stimulus has come to an end. It will surely impact economic growth.
This has quite unpleasant ramifications on the ground, but consider this: if the US Federal Reserve had tightened monetary policy to target risky lending before the subprime crisis arose, the global crisis might have been stopped at its source. No doubt there is real and financial pain in China right now, but perhaps some moral credit is owed to the Chinese leadership for deflating asset bubbles before they burst. Recent experience tells us that a sudden leverage deflation after a very long expansion would be far more painful and prolonged.