Markets on Edge as China Moves to Curb Risky Lending
By NEIL GOUGH and KEITH BRADSH
HONG KONG — China’s financial system is in danger of becoming too big to bail out.
Official bank lending has more than doubled since the global financial crisis, growing nearly twice as fast as the overall economy. The even bigger problem, however, appears to come from the rise of a shadow banking system that has allowed a number of companies and individuals, often with political connections, to borrow from state-controlled banks at low interest rates and relend the money at much higher rates to private businesses desperate for credit at almost any price.
Now, in an effort to wean the banks and the economy off their addiction to such risky practices, Beijing has pledged to deliver what amounts to the country’s most sweeping financial overhaul in decades. Markets will play the “decisive” role in directing the economy, policy makers promised last month after a key plenum meeting of the Communist Party leadership. Interest rates are to be liberalized, cross-border investment will be welcomed and regional and bureaucratic protectionism will be curtailed, they declared.
But already, even relatively modest government moves are producing turbulence in money markets; just this week China’s central bank was forced to back off, at least temporarily, to avoid putting too much stress on the banking system and potentially drawing an angry reaction from powerful vested interests in China accustomed to paying very little for their loans.
“It’s been pretty clear since June, and especially clear since the plenum, that the new crowd is interested in tightening monetary policy and letting interest rates rise,” said Arthur R. Kroeber, the Beijing-based managing director of GK Dragonomics, an economic research firm. “The purpose is to reduce the rate at which credit is expanding, which has been a bit of a problem over the last couple of years.”
China has experimented twice this year with much higher, market-driven interest rates. As with a similar experiment in June, the central bank allowed rates late last week and early this week to soar to unsustainable levels. Instead of regularly scheduled open-market operations, the bank tried unconventional methods of guiding money markets.
That approach involved the central bank’s turning to posts on China’s Twitter-like social messaging service, Sina Weibo, to chasten banks to “make rational adjustments to the structure of their assets and liabilities, and improve their liquidity management using a scientific and long-term approach.”
But as in June, the experiment did not last long. On Tuesday, China’s central bank, the People’s Bank of China, provided a direct injection of fresh money after the market pushed seven-day interest rates to nearly 10 percent, double their earlier level. The central bank’s action eased pressure on the financial system and quelled fears of an immediate credit crisis. But rates remain elevated, and the bank may have only postponed the moment of reckoning for a few months.
“The key message from the current central bank-induced tightness is deleveraging,” said Stephen Green, the head of research for greater China at Standard Chartered. “We’ll see what happens when we see greater levels of corporate distress in 2014, whether Beijing buckles or not.”
A complex and loosely regulated network of financial go-betweens has sprung up to profit from repackaging and reselling China’s new mountains of debt, turning loans into investment products. Such products have become popular among ordinary investors in China because they pay much higher interest rates than deposits in savings accounts, where rates are capped by the government to protect the state-owned banking system from competition.
But loosely regulated financial businesses can make a dicey business model, as Wall Street learned in 2008. And they pose a particular threat in an economy where growth is slowing, as it has been in China for the last three years.
“The final users of the money will not be able to earn returns high enough to repay the money and promised interest,” said Yu Yongding, a senior fellow at the Institute of World Economics and Politics of the Chinese Academy of Social Sciences and a former member of the monetary policy committee at China’s central bank. “The chains of lending and borrowing can be long, just like the securitized subprime mortgages. The result can be devastating.”
Indeed, the real-life stress tests the central bank has been experimenting with are not without casualties. As markets became jittery in the run-up to the June credit crunch, two branches of the state-owned China Everbright Bank technically defaulted on 6.5 billion renminbi, or $1.1 billion, worth of short-term payments.
In a regulatory disclosure that was part of its $3 billion Hong Kong share offering earlier this month, the Everbright Bank explained that while it had sufficient financing and liquidity at the corporate level, “the branches did not manage to fulfill their obligations to repay short-term interbank loans.” Instead, the payments were settled a day late.
The bank said that in response to the episode and to the greater volatility in China’s bank-to-bank lending market, it had increased reserve levels and “emphasized among our departments the overriding importance of sound liquidity.”
The big risk for China’s cosseted banks is not necessarily bank runs of the sort seen in the early 1930s in the United States, with depositors lining up to withdraw money before a bank can fail. The Chinese authorities have made clear that they will not tolerate disorderly closures of banks, and over the years have reportedly rushed cash to banks that faced sudden withdrawals.
Instead, the greater worry has been what some experts describe as “a walk on the banks” — depositors steadily removing their savings from banks after losing enthusiasm for deposit rates that have long been set by regulation at levels often below the inflation rate and only occasionally slightly above it. That slow drain could imperil the banks’ ability to continue pumping ever-larger loans to state-owned enterprises and politically connected individuals, even when many of those loans appear to be for helping borrowers repay previous loans.
Banks in China have been able to stay profitable while lending at low rates only because the government has required all of them to pay even lower rates for deposits. Savers have had few alternatives to banks until very recently: Real estate prices are already stratospheric relative to incomes, the weakly regulated and highly speculative domestic stock markets are widely distrusted and shadow banking businesses are periodically reined in by the government.
Total credit in China, although growing fast, remains slightly smaller relative to economic output than in the West. The worry is that the eventual proportion of nonperforming loans may prove even higher than other countries have had to manage, while China’s less developed financial system may make it hard to bail out less regulated entities, even as the central bank retains tighter links to the four main state-owned banks.
While policy makers say they are worried about upsetting the delicate mechanisms of the current banking system, public criticism continues to grow, even within China’s elite. That suggests further market-oriented experiments could be coming soon.
“Banking in China has become like a highway toll system,” Yao Jingyuan, the former chief economist at the state statistics agency, said late last week during a speech at Nanjing University, according to numerous Chinese news reports. “Banks charge every time money goes through them.”
“With this kind of operational model,” Mr. Yao added, “banks will continue making money even if all the bank presidents go home to sleep and you replaced them by putting a small dog in their seats.”