Rising rates will help cure China’s credit addiction; The government must act before the bubble bursts

January 12, 2014 3:08 pm

Rising rates will help cure China’s credit addiction

By Joe Zhang

The government must act before the bubble bursts, writes Joe Zhang

In June and December last year, China’s interbank interest rates jumped from their normal level of about 3 per cent to peak as high as 9 per cent a year. The shockwaves did not stop there. Banks scrambled for deposits and pushed up interest rates on their wealth management products. Funding costs in the vast shadow banking sector also moved up, while stocks and bonds suffered falls.Observers at home and abroad expressed concern about bad debts and the fragility of the banking industry. Some even called it China’s “Minsky moment” – a term coined during the Russian debt crisis of 1998 to describe the turmoil that arises when overstretched investors must finally repay their debts. Some fear that tighter credit markets could cause asset prices to collapse and precipitate a meltdown of the banking industry. But as someone who worked at China’s central bank in the 1980s, I am encouraged by the government’s willingness to tackle the country’s 35-year addiction to cheap credit.

Central banks are usually thought of as lenders of last resort. But in the 1980s and 1990s, the People’s Bank of China was the first port of call for banks whose lending ambitions were larger than their deposit bases could sustain.

I participated in the banks’ bargaining, not just in the loan quota-setting sessions that took place at the beginning of each year but also in ad hoc negotiations that unfolded in smoky boardrooms. It was a common scene in the dark and narrow corridors of the People’s Bank: a mayor or a governor from some province would sit patiently, sometimes for hours, waiting for an opportunity to lobby my senior colleagues for a bigger loan ration for banks in his province or city. Even junior officers such as me found ourselves on the receiving end of their entreaties – and freebies.

Instead of lending out 60 or 70 per cent of their deposits, the banks would lend out more than 100 per cent. The extra money came from the central bank’s printing press.

Official data show that the banking sector’s loan-to-deposit ratios had been well above 100 per cent for a few decades until the mid-1990s. Since then, the central bank has forced down loan-to-deposit ratios. But the flow of easy money has not ended. In fact, it has swelled.

In part, that is because the reduction of the loan-to-deposit ratio was more than offset by the recapitalisation of the banking system with the creation of four
so-called “bad banks”. This enabled lenders to extend new loans, which, once placed in borrowers’ bank accounts, lifted deposits and made way for yet more lending.

A further source of capital was provided by the public listings of the 16 largest banks, together with subsequent share placements. As a result, total credit growth accelerated from roughly 8 per cent in 1999-2000 to a compound annual rate of about 17 per cent since then.

Today there are three major restrictions on the banks’ credit expansion: the very high reserve requirement ratio of 20 per cent (far higher than in any other major economy); the 75 per cent cap on the loan-to-deposit ratio; and credit quotas for each bank. It all adds up to a picture of regulatory prudence.

The bucket is leaking, however. The banks have easily circumvented these restrictions by selling “wealth management products” that serve some of the same purposes as deposits. And their lobbying efforts continue unabated. In 2012 I found myself advocating on behalf of a regional lender. Sitting opposite me were my former colleagues from the central bank, and I felt very uncomfortable.

The recent interest rate jumps were far from unprecedented. In the 1980s and 1990s, overstretched banks regularly found themselves without money to meet withdrawals. There was no panic at the time, as the media never reported these things and there was no interbank market.

The central bank stepped in to provide emergency loans. These had become commonplace, and some banks began deliberately using the tactic as a matter of routine, to extract more loans from the central bank. Although the banks would receive a slap on the wrist in punishment for their misbehaviour, this did little to deter repeat offenders. Bankers and local politicians would jokingly say: “The thrill justifies the sin.”

The rapid growth of bank loans after the early 1980s, coupled with lax credit standards, resulted in non-performing loans that accounted for 30-40 per cent of loan books by the late 1990s. To prevent a repeat of that episode, the central bank is now playing tough. It is to be hoped that the rules of the game will change over time.

China needs higher interest rates to cool its property bubble, reduce wasteful investments and minimise the extent to which ordinary savers subsidise business. The government remains reluctant to undertake a full liberalisation of the credit market. But even before it does, market forces are driving interest rates higher.

The writer is the author of ‘Inside China’s Shadow Banking: The Next Subprime Crisis?’

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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