Repairing China’s Financial System

Includes: FXI, PGJ
by: Michael Pettis

The stock market had a bad day Wednesday, with the SSE Composite down 3.62%, mainly on rumors that banks will be seeking to raise equity capital next year in response to their loan surge this year. On Tuesday Bloomberg reported that the five largest banks were supposed to have submitted plans to regulators for raising money, after unprecedented lending eroded their capital.

I would argue that a more compelling reason to raise capital is the almost-certain surge in NPLs over the next three or four years. In fact I am pretty surprised that these rumors caught the market by surprise. Every time that banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs, and it would be pretty extraordinary if this time were any different. A refusal to raise capital levels would have been very imprudent, and it is pretty clear that the PBoC and the CBRC are already worried about the impacts of the credit expansion on the banking system.

Raising capital by selling equity is one way for banks to protect themselves from the consequences of bad lending, but I have been arguing for a long time that the main way banks have been recapitalized in the past has been the very wide spread between the PBoC-mandated lending and deposit rates. This was more or less confirmed in an interesting but perhaps little noticed speech last week by Governor Zhou. According to an article in Reuters,

China needs to maintain a certain spread between deposit and lending rates in order for banks to be able to support the economy, Zhou Xiaochuan, the governor of the People’s Bank of China, said on Friday. The central bank sets a ceiling on the rates banks may pay depositors and a floor on their lending rates. The built-in margin is a rich source of profit for Chinese banks that strengthens their balance sheets.

Speaking at a forum, the central bank chief also said China must ensure that its pro-investment policies do not lead to overcapacity, which he said was already plaguing some sectors.

The low deposit rates mean that Chinese savers are effectively being taxed to replenish bank capital. Although this may be necessary in order directly to maintain the health of the banking system, it indirectly undermines the banking system in another way. By forcing Chinese households not only to subsidize China’s very low cost of capital for producers and SOEs, but also to protect the banks from the effect of economically non-viable policy loans, Chinese households are bearing a pretty hefty share of the cost of China’s investment-led boom, and it is these same households whose surging consumption will be necessary to absorb the increased production resulting from the investment boom.

Given the increased financial burden being placed on them, I doubt that they will be able to do so. After all, it is because of lesser versions of these same policies in the past that the enormous gap between production and investment exists in the first place. And if they cannot raise their consumption sharply to absorb all this additional excess production, the banks will be stuck financing rising inventory and unprofitable companies. It’s a vicious circle.

There is no easy way to resolve this problem, and it is pretty clear that Governor Zhou understands this, at least this is how I interpret his warning about pro-investment policies leading to overcapacity. Interestingly enough around the same time as his speech the Financial News , a government newspaper, published a PBoC opinion piece that argued, according to an article in the South China Morning Post this week, that the “mainland should immediately halt some of its real estate stimulus policies, or risk inflating a bubble that in its bursting would wreak financial and even social trouble.”

On the same day the CBRC also struck. According to an article in People’s Daily,

China’s banking regulator on Monday asked the country’s commercial banks to better manage risks and avoid year-end volatility in lending. Commercial banks should ensure that lending increase was kept in a stable and sustainable pace, the China Banking Regulatory Commission (CBRC) said.

Financial institutions with low capital adequacy ratio and no practical remedy plans would face restrictions in various sectors such as overseas investment, branch increase and business expansion, it said. The CBRC called for enhanced inspections in financial system to detect problems after surging loan extends between the fourth quarter last year and the second quarter this year.

There seems to be a real tug of war. On the one hand much of China’s industrial and exporting sectors along with provincial and local leaders, are eager to see a continuation of the financial policies that have goosed employment and GDP growth at the expense of domestic consumption. On the other hand the macro and financial specialists are worried about the growing imbalances and their impacts on the financial sector. Professor Yu Yonding of the CASS Post-Graduate school, a former member of the Monetary Policy Committee and one of the smartest analysts on China, gave a speech in Melbourne yesterday in which he warned about China’s over-reliance on exports and investment and suggested that the imbalances are worsening, not improving. I strongly recommend that interest readers check out the speech for themselves.

In part the debate resolves around the issue of financial sector reform, especially of the banking system. This is an extremely important topic because most economists and analysts, including me, believe strongly that financial sector reform will be one of the most important steps forward for the healthy development of the Chinese economy. The Chinese financial system misallocates capital on an heroic scale.

A few days ago I was in a debate with a friend of mine about whether or not there has in fact been financial sector reform and liberalization in China, even after the US financial crisis gave anti-reformers what seemed like an unanswerable argument against financial liberalization. My friend argued that instead of taking the easy way out and backtracking, China has in fact deepened financial sector reforms. In support he referred to numerous statements by regulators to this effect, and other moves to liberalize finance in China. For example there is no question that the Chinese bond market is growing. According to an article in Tuesday’s Financial Times,

Emerging east Asia’s local currency bond markets have tripled as a proportion of the global market since the Asian financial crisis, but remain plagued by poor liquidity, according to a report published on Tuesday by the Asian Development Bank. It says the region’s local currency bonds outstanding accounted for 6.2 per cent of the global total in the first quarter of this year, compared with 2.1 per cent in the fourth quarter of 1996, on the eve of the 1997-98 Asian crisis.

The $3,658bn of bonds outstanding amounted to nearly seven times the value in 1996, reflecting efforts by governments in the region to strengthen and deepen local bond markets to avoid the pitfalls of extensive borrowing in foreign currencies.

The bulk of the increase reflects a surge of local currency bond issuance in China, which accounted for 3.7 per cent of the global market in the first quarter of 2009, from just 0.2 per cent in 1996. China remains the fastest-developing market for local currency corporate bonds, growing 87.7 per cent year on year, but the Philippines was second, with 65.8 per cent growth year on year, according to the ADB’s Asia Bond Monitor.

Perhaps more excitingly, foreign firms are likely to be welcomed into China’s domestic bond markets. Rumors about this started on Monday with a CICC report and then seem to have been confirmed in an article in today’s People’s Daily:

Foreign companies may be able to sell bonds in China within a year as the government expands its domestic capital markets, according to China International Capital Corp (OTCPK:CICC), the No 2 underwriter of yuan debt this year. ”The first group of future international issuers is likely to be blue-chip companies,” John Cheng, CICC’s investment banking managing director, said in an interview on Tuesday.

Overseas “firms will increase their presence in China and they’ll need to match their growing yuan assets with instruments in yuan, be it debt or equity,” he said. China is urging domestic companies to tap bond and equity markets for funding and reduce reliance on banks after regulators said record loan growth poses risks. Authorities will consider allowing sales of high-yield corporate bonds to provide new sources of funding, People’s Bank of China Deputy Governor Hu Xiaolian said on Nov 18.

But in spite of the good noises, I am very skeptical about whether there has been real reform or liberalization in the financial sector, especially during the past year. Why? Because for me this would involve two main types of reform, on neither of which has there been any advance. First, interest rates would have to be decontrolled and liberalized in order to remove the financial repression implied by extremely low interest rates. I see no evidence that this has happened. Interest rates are as controlled, and as much a policy tool, as ever.

Second, there needs to be substantial improvement in bank governance, so that the lending and investment decision is a function of economic rather than non-economic factors. This is another way of saying that there must be a reduction in the process that leads to such massive capital misallocation.

Although there have been a series of baby steps in that direction, I would argue that these were completely undermined – reversed, in fact – by the surge in lending this year. Any chance that the financial system is getting better at making the capital allocation decision was blown away by the events especially of the first half of this year. The Chinese financial system, I would argue, is less liberalized, and certainly less efficient, today than it was one year ago and even five years ago. This may sound like an outrageous statement, but reform has to be more than tinkering on the side. To matter it must address the fundamental problems in the financial sytem – which I believe to be distorted interest rates and weak governance – and I don’t believe either has been addressed.

Finally, I want to mention two additional recent papers that have come out on the Chinese economy. First is my misnamed “Brief” for the Carnegie Endowment, which discusses the tug-of-war between rising US savings and persistently high Chinese savings and what the consequence are for the global balance and international trade. Second is a paper called “Overcapacity in China: Causes, Impacts and Recommendations,” released today by the European Union Chamber of Commerce in China. Full disclosure: I was involved partially in the preparation of the paper.

And for those who celebrate my favorite holiday: Happy Thanksgiving.