Part 2: Financial Reform in China – Don’t Bank It!

Part 2: Financial Reform in China – Don’t Bank It!

photo: David Dennis

The Chinese brand of state corporatist model based on credit driven investment is designed to deliver growth. The strategy requires the government to exert significant power over the economy, with the ability to intervene in economic activity and allocate resources. In practice, this is done through the SOEs and especially control of the banking sector. 

Political economist Victor C. Shih in his 2008 book Factions and Finance in China described the process as follows:

“…the banking sector became an important means of political survival in China. With its vast store of money from increasingly prosperous depositors, the banking sector became a victim of its own success as the party leadership… increasingly saw banks as a bountiful source of political resource… the political elite’s need for a highly fungible policy and political resource – money – led to a persistence reluctance to liberalise the banking sector beyond state control. Banking policies were made to bolster the short-term strength of both generalist and technocratic factions with little regard to long-term consequences”.

This means reform of the financial system is particularly important.

Can’t Bank On It…

Rebalancing China’s economy from investment towards consumption and the private sector requires reform of the banking system, in particular deregulation of deposit and lending rates to improve the allocation of capital. 

First, low rates, frequently below inflation rates, reduce household income. It also perversely increases saving rates to achieve a target level of financial assets. Chinese saving rates have increased to around 24% of income from a low of 12-15% around 20 years ago. Companies have also increased surpluses, contributing the bulk of domestic savings. 

Low or negative rates on savings transfer wealth from savers to banks and borrowers. Over the past decade, nominal interest rates in China have been well below nominal GDP growth rates. Assuming that Chinese interest rates have averaged 4-6% below the required rate, this equates to a net transfer from savers of around 5% of GDP each year.

Second, controlled lending rates prevent proper pricing of risk, driving banks to lend to SOEs and government sponsored projects. This limits access to credit for other businesses.

Third, it has encouraged the development of the shadow banking system, which has increased the complexity and system risk of the financial system.

Banking reform, such as deregulating interest rates, increasing the limited range of investment products and allowing the entry of new banks, is under consideration. But there are significant problems in implementing changes.

First, the Chinese economic model requires keeping China’s cost of capital low to facilitate its investment strategy. Reform would increase capital costs as credit risk would be priced correctly, undermining the low profitability and solvency of many businesses. Higher rates would create stresses for many borrowers at a time when the cost of debt servicing debt at the national level is high reflecting rapid credit growth. 

Second, Chinese banks need to manage rising bad debts on loans extended to borrowers and projects which are unlikely to be able to meet commitments. Rating agency Fitch has argued that Chinese banks may have unrealised losses in excess of that reported due to improper treatment, such as restructuring loans to avoid recognizing them as non-performing. These losses may be greater than the total capital and reserves of Chinese banks. 

Third, Chinese banking crises resulting from bad debts is traditionally dealt with by maintaining access to deposits, low rates and a guaranteed high spread between borrowing and lending costs to generate sufficient profitability to absorb losses over time. Deregulation would destabilize this process of transferring wealth from savers to help cover the non-performing loans made by banks.

These factors dictate that reform will be slow.

Money Matters….

The reform process also requires changes in Chinese monetary and currency policies.

Monetary policy, which is increasingly ineffective and destabilizing, is affected by China’s inflexible exchange rate policy. 

The problem derives from the fact that China’s capital account is partially open. Foreign direct investment, including for short term periods, by “qualified” investors is allowed within specified limits. In addition, local and foreign businesses and investors have access to a variety of unofficial techniques to undertake capital transfers, although these are slow, cumbersome, expensive and potentially illegal. 

This creates tensions between domestic policy objectives and the management of the value of the currency. Large foreign capital inflows require the People’s Bank of China (“PBOC”), the central bank, to undertake money market operations to remove excess liquidity whilst maintaining the desired value of the currency.

Like deregulation of interest rates, Chinese authorities have committed to removal of controls on capital flows, albeit on an unspecified time scale. But the risk of deregulation is significant. 

Reforms may affect the banks’ ability to fund and also interest costs, which would affect the flow of credit in the economy affecting domestic demand. Capital flows also affect the ability of the PBOC to use the level of the Yuan as a policy tool. 

In recent years, speculative capital inflows have been strong, seeking to benefit from the perceived undervaluation of the Yuan requiring action to avoid the currency appreciating. More recently, China has experienced large capital outflows, some of it flight capital. Domestic investors are seeking alternatives to low-yielding bank deposits or speculative property, diversify their investments or seek protection against political and social instability. Foreign investors are worried by China’s diminished prospects and risks.

Large capital outflows have resulted in the tightening of domestic liquidity and higher interest rates, setting off financial instability and a domestic contraction.

Charge It…

Reform of the financial system is particularly difficult because it reduces the government’s power and control over the economy. 

The Government needs access to the deposits in the banking system to direct investment to promote activity in targeted areas or provide short term apparent boosts to the economy. It also needs to assure depositors of the safety of their savings to maintain the supply of funds. 

Deregulation that allows banks to direct loans in line with purely commercial considerations and at market prices is inimical with this approach. Similarly, the willingness of the government to pay “coffin money” to compensate retail depositors for deposit losses may create moral hazards but is justified as ensuring trust in the banks and access to the supply of savings. 

These concerns mean that authorities are hastening slowly with reforms. Changes to regulation of banks, interest rates, capital flows and the currency are likely to be modest, for the foreseeable future. For example, decreases in controls over the capital account are likely to entail revised bureaucratic restrictions as well as price-based limits such as taxes on foreign holdings. Recent volatility may even dictate a reversal in already modest liberalization measures.

The Chinese government is reluctant to undertake aggressive liberalization of the financial system as a result of external pressures. The after effects of an unprecedented credit expansion and other increasing economic challenges may now defer financial reform into the never never.

© 2016 Satyajit Das

Satyajit Das is a former banker and author of The Age of Stagnation (Prometheus Books).

One Response to "Part 2: Financial Reform in China – Don’t Bank It!"

  1. agilfarma   May 22, 2016 at 10:24 am

    China, China, China everywhere. They are now transforming into giant economical country that ready to eat any small country (Like Indonesia). We must defend ourself by upgrading our abilities and united our power. And of course the goverment has their responsibilities for this too