Can China Slow Its Bank Lending?

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by: Leland Miller

For the past three decades, the Chinese economy has essentially been propped up by a steady stream of state subsidies disguised as commercial bank lending. In 2011, however, two things are becoming clear. First, the amount of lending has risen to levels far beyond what economists previously believed, to a point where the stability of the system may soon be threatened. Second, that even as Beijing begins to recognize the perils of such lending, it may no longer have the power to close the floodgates—nor even have a consensus on how to try.

In mid-February, China’s central bank announced that yuan-denominated lending in China had dropped over 15% to 1.2 trillion yuan ($182 billion) year-on-year in January 2011. But such “progress” in controlling lending is a mirage. Not only did Chinese banks significantly overshoot their lending ceiling for 2010 (by nearly half a trillion yuan), an additional 6.33 trillion yuan ($962 billion) was pumped into the economy last year by non-bank financial institutions. This “aggregate social financing” number, which the central bank decided to quantify for the first time this month, amounted to a massive 14.3 trillion yuan ($2.1 trillion)—higher than virtually any previous public or private sector estimate.

Many believe this is just business as usual in China. After all, non-performing loans (NPLs) have been an unavoidable byproduct of Beijing’s quasi-command economy from the very beginning. Predicated on maintaining social stability through the subsidization of its industrial base, Chinese banks funnel cheap loans to businesses, in most cases state-owned enterprises (SOEs), in order to manufacture artificial profit margins that keep Chinese goods competitive and employment maximized. While economists have long fretted about the long-term consequences of this managed approach—China has already undergone one major NPL crisis, forcing the government to bail out its banks to the tune of several hundred billion yuan last decade—policymakers have remained loath to tinker with the system because of the potentially cataclysmic repercussions of staunching the flow of free money.

While Beijing began to seriously debate the issue of “overheating” by the mid-2000s, a slowdown in exports brought on by the global financial crisis in 2008 actually caused China to retrench even further, this time by way of a massive 4 trillion yuan ($586 billion) stimulus package. Largely as a result of this lending, China registered an 8.7% GDP growth in 2009 and a sizzling 10.3% in 2010. While Western economies continue to struggle with low single-digit growth numbers, China accounted for roughly half of global growth in 2009 and 2010.

But this relentless growth has come with a price.

In the near term, this continued surge in bank lending is creating overcapacity, generating new NPLs, and further weakening bank balance sheets. The problem is magnified, however, by the non-convertibility of the currency, which forces the government to print increasing amounts of yuan to sterilize foreign exchange inflows (over the past two years, M2, the broadest measure of money supply, has surged by an astounding 55%).

With cheap credit and new money flooding into the economy, inflation over the past four months has jumped to alarming levels. Food prices are now soaring, rising 10.3% in January alone. So too non-food inflation, which rose last month to its fastest pace in more than a decade. Property prices, already deep into bubble territory, continue to skyrocket despite a concerted government effort to tackle them. This is partly because government-set bank deposit rates remain significantly under the inflation rate, meaning the average Chinese citizen loses money every day he keeps his money on the sidelines. All of these factors are contributing to a massively overheating economy.

But the heart of the problem remains China’s inability to control its bank lending.

Unlike monetary policy in the West, which relies principally on managed interest rates, China has traditionally relied on a more simplistic, two-pronged approach: Wielding the spigot and the mop. In theory, the central bank sets loan quotas to dictate the amount of loans (liquidity) it wishes to dump into the system, then soaks up any excess liquidity by ordering banks to park a certain percentage of their reserves with the central bank. (That rate—known as the reserve requirement ratio (RRR)—is currently 19.5% for China’s largest banks.)

While China has finally begun to reintroduce interest rate hikes as a policy tool—raising rates three times since October 2010, after not having done it previously since 2007—the loan quota coupled with the liquidity drain (the RRR hikes) have remained its tools of choice. Partly this is because interest rate hikes would stifle the flow of cheap credit to Chinese businesses. But it is also because the RRR hikes are a policy tool controlled by the central bank, unlike interest rate hikes which require further authorization (and thus overt political backing) by the State Council.

A combination of factors, however, has worked to undermine the efficacy of the loan quota system. First, Chinese banks typically hit their loan targets far before year end, leaving regulators the impossible (and perhaps dangerous) job of enforcing an almost total clampdown of credit at the end of the year. In 2010, for instance, Chinese banks hit their quota mark in November but still managed to loan a substantial 480 billion yuan in December.

Second, Chinese banks have learned to simply offload trillions in loans from their balance sheets by repackaging loans into investment products for sale to investors. These off-balance sheet vehicles have fostered a “shadow banking system,” which now rivals the formal credit issuance of China’s banks. As a result, the actual loan quota number—overshot by almost 100% in 2010 when shadow lending is included—has become essentially meaningless.

Next month, China will unveil its 12th Five Year Plan (2011-2016), and reducing out of control lending is likely to be deemed a key policy priority. But this does not mean Chinese bank regulators have come to a consensus on how to do it. Depending on which Chinese media source you follow, and on which day, the central bank has set a loan target for the year (or it hasn’t); has successfully imposed new customized reserve requirements for Chinese banks (or the State Council has vetoed the plan as “unwieldy”); or has turned over control over loan adherence to the central bank (or not). The only thing that seems clear is that even with a steady salvo of RRR and interest rate hikes in 2011, regulators will have a hard time simply keeping pace with rising inflation.

For decades, Beijing has been able to successfully manipulate its bank lending, and this micro-management probably allowed it to escape the crush of the recent global recession. But China’s economy is too complex to continue such puppeteering indefinitely. Unless China moves more quickly to liberalize interest rates and free its banks to react to market realities, it is only postponing what will inevitably be an even greater reckoning down the road.

Originally published at the Institutional Risk Analytics.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.