China

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China

China

Asia Pacific Economic Outlook, July 2013

China’s banking system is at a crossroads. It is going through a traumatic shift brought on by a government determined to alleviate financial imbalances, even at the temporary cost of slower growth.

APAC_July13_spot2_webThe Chinese economy appears to be faltering. At a time when the global economy is showing signs of very modest acceleration, China is shifting in the opposite direction. In the process, it is taking other countries such as Taiwan and South Korea in a negative direction as well. In June, a purchasing managers’ index (PMI) for manufacturing, published by Markit, shifted further into negative territory, indicating that the critical industrial side of the Chinese economy is actually in decline. A separate PMI for the services sector showed anemic growth at best.1 While domestic demand continues to grow, it has benefitted from relatively loose credit market conditions, which now face reversal. Indeed, China’s banking system is at a crossroads. It is going through a traumatic shift brought on by a government determined to alleviate financial imbalances, even at the temporary cost of slower growth. The new leadership has indicated that stimulus is not in the offing. Rather, fundamental issues will be addressed.

Out from under the shadows

Interestingly, the economy is slowing despite the fact that credit is growing rapidly. Indeed, Chinese authorities are concerned that credit growth is not translating into economic growth, and that credit growth is creating risks to the economy. In the first quarter, credit was up 58 percent, but real GDP growth was a very modest 7.7 percent. The authorities are worried that too much credit is flowing into activities that contribute nothing to growth, including considerable speculative activity. As such, the central bank has taken steps to cool down credit markets, including cracking down on illegal capital inflows, tightening conditions in the mortgage market, and providing closer scrutiny of the shadow banking system.

The shadow banking system has been the center of attention. It has developed largely because of restrictions on commercial banks. They remain state-owned and face interest rate regulation—that is, the rate they pay depositors is capped, and the rate they charge borrowers is capped as well, providing the banks with a predictable and favorable profit margin. Their borrowers are mainly state-owned enterprises and local governments that get cheap credit and, as a consequence, invest excessively. Everyone else, including private sector businesses and households, lacks substantial access to bank credit.

In order to profit from the excess demand for credit, banks have bundled loans into “wealth management products” (WMPs), which are essentially securitized assets. They sell these WMPs in order to shift assets off the books and raise funds that can be loaned at higher interest rates through off-balance-sheet vehicles known as trust companies. The result has been an explosion of credit outside normal banking channels and outside the purview of regulators. This credit explosion has enabled the banks to maintain a very low non-performing loan ratio, even if many of the loans they have made (especially to local governments) have actually gone bad.

The WMPs are similar to bonds in that they have a maturity date, usually less than three years and sometimes as little as six months. When they become due, banks must pay back the investors. If the loans behind the WMPs have failed, the banks must somehow raise funds to service the WMPs. This has generally meant issuing new WMPs, often at even higher interest rates. To grease this market, much interbank lending has been taking place. WMPs are not the only part of the unsupervised shadow banking system, but they are the most noteworthy. They tend to be bought by wealthy individuals who want a better return than can be obtained through banks.

Default on a WMP would mean that individual investors would lose their money—which is hardly desirable. So the banks continue to fund the WMPs, often borrowing from one another to raise the short-term funds needed to pay owners of WMPs.

Indeed, China’s banking system is at a crossroads. It is going through a traumatic shift brought on by a government determined to alleviate financial imbalances, even at the temporary cost of slower growth.

How did we get to this point?

One of the things that enabled the dramatic increase in credit recently has been continued growth of money supply. This was partly due to the need to monetize inflows of capital. Such inflows were fueled in part by the illegal practice of faking export invoices. Exporters would do this in order to borrow money from overseas to invest in China, all while falsely treating these inflows as export revenue. This “carry trade,” if not monetized, would have put upward pressure on the currency. To avoid currency appreciation, the People’s Bank of China (PBOC), China’s central bank, purchased foreign currency, thus maintaining the exchange rate and boosting money supply. Yet when the government recently cracked down on fake invoicing, capital inflows slowed dramatically. This in turn meant that the PBOC was no longer providing as much liquidity. Yet the demand for interbank lending continued apace. Without support from the PBOC, interbank lending rates started to rise. When the PBOC initially failed to intervene to suppress rates, investors panicked, thereby driving rates up to unusually high levels.

Ultimately, the PBOC intervened to prevent banks’ failure. Yet the episode offered a glimpse at government thinking. The new leadership has spoken publicly about getting the shadow banking system under control. Recent events suggest that the government is trying to find a way out of the current situation. Yet unless it allows free movement of interest rates, the situation could get worse. Moreover, the lack of transparency in the system means that potential risks may be hidden and could explode at any time. While a Lehman-type event is unlikely, given that the government owns the banks, a serious credit crunch is possible, which would have negative ramifications for economic growth.

Most analysts expect that the government will bail out banks and absorb losses should the need arise. They would probably place restrictions on credit growth, but not too much lest they slow the economy dramatically. The result could be continued credit growth, fueling the continuation of economic growth through investment in infrastructure. This means an increasingly distorted economy with huge financial imbalances, rising investment, and declining GDP growth. It would be better of course to liberalize financial services and create a more efficient system.

Endnotes

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  1. Markit Economics, “Press releases,” http://www.markiteconomics.com/Survey/Page.mvc/PressReleases, accessed July 17, 2013.

About The Author

Dr. Ira Kalish

Dr. Ira Kalish is director of global economics, Deloitte Research, Deloitte Services LP.

Asia Pacific Economic Outlook, July 2013: China
Cover Image by Jessica McCourt