China’s decision to liberalize bank lending rates has raised suspicions that it reflects official concerns over possible loan defaults and is aimed at helping out heavily indebted state firms and local governments

China’s rate reform may serve to shield indebted state firms

4:27am EDT

By Wayne Arnold

HONG KONG (Reuters) – China’s decision last week to liberalize bank lending rates, though widely applauded, has raised suspicions that it reflects official concerns over possible loan defaults and is aimed at helping out heavily indebted state firms and local governments. China’s central bank announced on Friday that banks could now lend at whatever rate they liked, enabling them to compete for new borrowers with cheaper credit at a time when the world’s second-largest economy is slowing markedly. But some investors said the move was symbolic and likely represented, in the short term at least, relief for heavily indebted state-owned enterprises (SOEs), big private-sector employers and local government financing arms. “I’m a little skeptical of the appraisals that this is a big, big reform move,” said Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management in New York and formerly a professor at Beijing’s Tsinghua University. “My concern in the short run is that what will happen is that a bunch of local government financing vehicles will get lower interest rates,” he added.The announcement by the People’s Bank of China (PBOC) was welcomed by economists and came as G20 finance ministers and central bankers met in Moscow, where Japanese Finance Minister Taro Aso described it as a step in the right direction.

“We see today’s announcement as a signal of the PBOC and the new leaders’ commitment towards interest rate liberalization and more market-oriented reform,” wrote Jian Chang and Joey Chew, economists at Barclays, in a note to clients.

However, they and other economists said that, with China’s growth slowing, the banks — including major lenders such as Industrial and Commercial Bank of China Ltd (601398.SS: Quote, Profile, Research, Stock Buzz), China Construction Bank Corp (601939.SS: Quote, Profile, Research, Stock Buzz), Bank of China Ltd (601988.SS: Quote, Profile, Research, Stock Buzz) and Agricultural Bank of China Ltd (601288.SS: Quote,Profile, Research, Stock Buzz) — were unlikely to take advantage of the opportunity.

As it is, only about 11 percent of loans extended by China’s biggest banks are below the just-scrapped 6 percent official rate, despite having had some leeway to stray from it. Most are in fact priced well above that.

Instead, economists say, the PBOC’s move signals Beijing’s determination to forge ahead with capital markets reform to remove the conditions that helped fuel China’s property-led credit bubble.

In the short term, though, international bankers and investors active in China say the timing of the reform – coming roughly a month after the PBOC cracked down on lending in the shadow banking sector – may be less about banks issuing new loans than about keeping old loans from going into default.

“They’re getting very concerned about the slowdown and the potential for non-performance or defaults,” said a senior European banker in Singapore, who asked not to be named to avoid jeopardizing the bank’s relationship with Beijing.

“The only firms that would get any kind of break are the preferred SOEs already getting discounted loans.”

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Foreign bankers and investors draw parallels with Japan in the 1990s when banks avoided restructuring loans to their biggest borrowers and refinanced them at lower rates — an “extend and pretend” policy that helped create so-called zombie companies and was blamed for Japan’s two decades of economic stagnation.

Few question the need for China to liberalize interest rates. Until Friday, commercial banks were allowed to lend at rates no lower than 70 percent of the government benchmark of 6 percent, or roughly 4.2 percent. At the same time, the rate banks could pay depositors was capped at 110 percent of another benchmark rate of 3 percent, or about 3.3 percent.

The result was that banks were virtually guaranteed a 0.9 percentage point profit margin on every loan. Though designed to ensure the health of lenders, the policy fuelled unsound lending. To maximize profitability of a fixed margin, banks lent primarily to only the lowest-risk borrowers — big state-connected companies. And with rates below the rate of inflation, depositors looked for better returns on investments elsewhere.

That has produced over-lending by banks to big companies and an explosion of unregulated non-bank lending to small and medium-sized firms. Standard & Poor’s estimates China’s shadow banking sector grew into a $3.7 trillion business last year.

Big companies stacked with cheap credit have begun re-lending those funds as well. Their issuance of so-called entrusted loans and bankers’ acceptance notes more than doubled in the first four months of this year to 1.6 trillion yuan ($260 billion). If their borrowers default, they could in turn default on what banks have considered the country’s safest loans.

This ballooning credit has created what economists and the International Monetary Fund see as unsustainable over-investment in property, infrastructure and industrial capacity. The IMF said in its latest annual consultation on China that the country needed to push through reforms to make growth more sustainable, rein in credit growth and liberalize interest rates.

The next, more difficult step to open banking to competition would be to remove caps on deposit rates, a move economists say would prompt lenders to allocate capital more efficiently, helping rebalance the economy toward less wasteful investments.

Beijing has signaled its intention to make the necessary reforms, even as it has cut its target for economic growth this year to 7.5 percent from 8 percent, which would mark the economy’s slowest pace in 23 years.

China’s challenge then, said Paul Gruenwald, chief economist at Standard & Poor’s in Singapore, is to pull off what neither Japan, South Korea, Chile nor the United States, to name just a few, have failed to do: deflate a credit bubble and reform the economy without triggering a financial crisis.