Cash crunch has shown that financial policy in China is not reliable

July 2, 2013 3:17 pm

Pity the banks after Beijing’s blunt move

By Simon Rabinovitch in Shanghai

Cash crunch has shown that financial policy in China is not reliable

It is unfashionable these days to take the side of banks, especially institutions that are mollycoddled by the state. China’s government-owned banking behemoths are among the most unlikely candidates for compassion. But they deserve more than a little sympathy after the cash crunch of the past three weeks.When the rate at which China’s banks lend to each other rose to more than 20 per cent and the credit market momentarily froze, commentators drew parallels with the subprime crisis and the way US banks had heaped on debt in a reckless quest for profit. Chinese banks have, after all, also been ratcheting up leverage levels by shifting loans off their balance sheets.

But in China, there is a good case to be made that banks were victims, not perpetrators, of the cash squeeze. Blindsided by a poorly communicated shift in policy, they now face a more uncertain future after Beijing tore up the road map that most had been faithfully following.

Until recently, Chinese banks had been treated with kid gloves, cloistered from foreign competition by barriers at the border and protected from domestic competition by juicy, guaranteed interest margins. Yet times have changed. Banks are being punished for heading down a path of greater market forces that regulators had steered them towards.

The remaking of China’s banking landscape, almost imperceptible at first, has been increasingly radical in its cumulative impact. The core of the banks’ business model has been whittled away as their guaranteed interest margins have been eroded.

Genuine market conditions have started to bloom most vividly in a segment of the industry known as wealth management products – investment products that have in effect deregulated deposit rates for savers. These products come with plenty of risks, particularly their limited disclosures and a worrying pattern of rollovers at maturity. But for all their problems, they are a marked improvement over the previous system that prevailed in China. They have ushered in a liberalisation of interest rates by stealth. Banks finally have to pay something closer to a reasonable market cost for a chunk of their funding.

The cash crunch, which began in mid-June and is only now starting to ease, threatens to undo much of that progress. The squeeze was directly administered by the central bank. By withholding regular short-term liquidity injections, it allowed money rates to rise to unprecedented heights. The central bank says the crunch served as a reminder to banks to improve their liquidity management and refrain from overextending loans. These seemingly prudent words are, in fact, unfair. Managing liquidity in an environment where the central bank allows benchmark overnight rates to nearly triple in three days from 4.8 per cent to 13.4 per cent would be a challenge for the world’s best financiers.

What is more, officials previously insisted they had the wealth management products and broader lending risks under control, and they had already guided banks away from the most dangerous loans. Tough new rules from the banking regulator had capped the riskiest of wealth management products to less than 4 per cent of banks’ overall assets.

There had been a surge in new lending at the start of June, but verbal “window guidance” from the central bank had always been effective before in curbing such excesses without causing collateral damage. A few smaller banks were exploiting their privileged access to the interbank market to obtain cheap funding, but regulators knew who they were and could have targeted them individually. The liquidity squeeze was a far blunter and more dangerous instrument.

Making matters worse, the central bank did a poor job of communicating its policy. It did not warn banks of the coming squeeze and was slow to explain what it was trying to achieve. In an interview with Reuters, Jiang Jianqing, chairman of Industrial and Commercial Bank of China, the country’s biggest bank, made revealing comments about how his institution was in the dark at the height of the panic. “Those few days, even for us, we were genuinely a bit tense,” he said.

Huang Haizhou, an executive with China International Capital Corp, a top investment bank, was even more direct. “The central bank has to increase its transparency,” he said at a public forum.

By triggering a cash crunch, the central bank had hoped to warn banks that markets are not predictable. But what it has done instead is show that financial policy in China is even less reliable.

 

 

July 2, 2013 4:48 pm

China’s curb on credit growth spells trouble

By John Plender

No policy watershed in central bank clampdown on liquidity, say officials

So what? That would have been the external response a decade ago to a crunch in China’s financial markets. Today is another matter.

With the capital account of the balance of payments only partially liberalised, the financial spillover in global markets from the recent spike in China’s interbank interest rates was admittedly minimal. Yet if the move by the People’s Bank of Chinato damp the credit bubble turns out to signal a more restrictive credit environment, damaging reverberations will clearly be felt by trading partners such as Japan, South Korea, Brazil and Australia. Slower economic growth in the world’s second-largest economy would also put further pressure on commodity markets.

In meetings I had in Beijing last week organised by the monetary think-tank Omfif, senior officials were emphatic that the PBoC’s refusal to provide liquidity to overstretched lenders did not mark a policy watershed. What seems clear is that the central bank was curbing credit growth and imposing a de facto stress test to encourage better liquidity management by the banks.

The fallout was greater than the PBoC probably bargained for because the move coincided with thetwitchy global market reaction to news of the US Federal Reserve’s potential retreat from quantitative easing. It also had the unintended consequence of increasing shadow banking activity as banks rushed to issue new wealth management products to raise cash.

Now the interbank market has stabilised. But in future the PBoC intends to grant liquidity support only to financial institutions that expand their loan books at a prudent pace and meet the requirements of industrial and macro-prudential policy in support of the real economy.

It is tempting, when looking at such events, to make comparisons with economic development in the US and Europe in the 19th century, when high growth was punctuated by sporadic bubbles and busts. Yet a conventional emerging market financial crisis is impossible in today’s China because a tightly managed capital account prohibits capital flight, while all the systemically important financial institutions are majority-owned by the state.

The consequence of excessive lending to real estate and infrastructure, together with the mismatch between these long-term investments and short-term funding by wealth management products and bank loans, boils down to an issue of fiscal capacity.

The fallout was greater than the PBoC bargained for because the move coincided with the twitchy global reaction to news of the US Fed’s potential retreat from QE

If China confronts a more serious slowdown than most forecasters now expect, policy makers still have room to engineer one last big fiscal splurge. That is somethingChina’s new leadership is desperate to avoid. The authorities have long recognised that their response to the financial crisis, which took investment from 42 per cent of gross domestic product to nearly 50 per cent, has resulted in a grotesque misallocation of capital. The priority of Premier Li Keqiang is thus to give impetus to plans to rebalance the economy towards consumption.

At the same time the local governments that have been responsible for the great majority of that investment have exhausted most of their borrowing capacity. The game whereby local officials have forced farmers to sell their land cheaply and put it into local government financing vehicles is coming to an end. Since land sales and property developments provide 30-40 per cent of local government revenues and local government is not allowed to borrow directly, this amounts to a fiscal watershed.

The other big watershed is in the corporate sector. For much of the past decade China maintained an undervalued currency. That has now gone, with unit labour costs rising rapidly over the past two years and Japan adding to the pain with its recent competitive devaluation.

At the same time producer price inflation has turned negative, so industry faces high real interest rates. The resulting squeeze on profits will deliver part of the rebalancing of the economy since capital spending will fall. The conundrum concerns household consumption. Can it fill the gap?

If China confronts a more serious slowdown than most forecasters now expect, policy makers still have room to engineer one last big fiscal splurge

Two obvious ways to shift income to households from companies are through higher wages and higher interest rates. Yet unit labour costs are already too high and the current regulatory ceiling on retail deposit rates is designed precisely to subsidise companies at households’ expense.

In due course both problems will be addressed through financial liberalisation and an open capital account. But higher interest rates will make China’s debt overhang more oppressive, while devaluation through capital account liberalisation will be tardy, being seen as the final move in the planned deregulation of the financial system.

Managing this momentous transition to slower, consumption-led growth will be extraordinarily tricky for China’s new leaders.

 

July 1, 2013 6:28 pm

China’s long march

Gloomy economic data should not lead to fresh stimulus

Markets sighed with relief at the gloomy economic data coming out of Chinayesterday. True, the purchasing managers’ index published by HSBC fell to 48.2 in June, a nine-month low. Yet, after last month’s cash crunch, in which interbank rates spiked to double-digit levels, investors had braced for even bleaker news. The stock market in Shanghai was unmoved, closing the day up 0.8 per cent.

China’s slowdown, however, is only going to get worse. The interbank lending market is functioning again thanks to the intervention of the People’s Bank of China. But the authorities are still determined to rein in credit, which has grown extremely fast so far this year. Indicators of companies’ borrowing costs are still higher than they were a month ago. Several analysts fear that China may miss its own gross domestic product growth target for 2013, which stands at 7.5 per cent.

Slower growth is a price worth paying to end China’s credit binge. A new monetary stimulus after the one in 2008-09 would offer temporary relief to the economy. But it would also lead to a new property boom. Local governments and, increasingly, retail investors are heavily exposed to the construction sector. Reinflating the bubble could have catastrophic outcomes.

After two decades of fast growth, however, the leadership will find it hard to manage a slowdown. The sheer size of the economy makes this task even tougher. Were property prices to fall too fast and investment demand to plummet rather than decrease gently, China would face a violent boom-and-bust cycle. There would be consequences for the solvency of local authorities, which the central government may have to bail out.

Beijing wants to rebalance the economy away from exports and investment and towards consumption. This is a sensible plan. But giving a greater role to individuals over large state-own enterprises will prove politically difficult. Demands for greater democracy are bound to get louder.

A bumpy slowdown in China would affect others too. Resource-rich countries, which have enjoyed a long boom thanks to China’s hunger for commodities, will have to find a different economic model. Western companies that have relied on strong Chinese demand to make up for slow growth in the US and Europe would also suffer.

Yet the longer the leadership waits before embarking on the transition, the harder it is to manage it. China is right to begin its march to a new model. The rest of the world should wish it well.