Joe Zhang On The Liquidity Crunch, Microcredit, And Systemic Risk

Includes: FXI, PGJ
by: CFA Institute Contributors

By Samuel Lum, CFA

For the latest installment in our China's Liquidity Crunch series, we spoke with Joe Zhang (张化桥), chairman of Wansui Micro Credit in Guangzhou, China. From 2006 to 2008, he was Chief Operating Officer at Shenzhen Investment, and before that he spent 11 years at UBS. From 1986 to 1989, he worked at the People's Bank of China. He has two popular books to his credit in Chinese, one on the pitfalls in the stock market and the other reflecting on his decade-long career as an equity analyst. In May, he published a book in English on shadow banking in China, comparing it to the U.S. subprime crisis.

CFA Institute: To what extent was the Shibor squeeze in June linked to the so-called "shadow banking" activities in China?

Zhang: There are two parts to shadow banking in China. Outside the banks, there are the curbside lenders, microcredit firms, pawnbrokers, intercompany loans, and trust companies. Inside the banks, there are the wealth management products (WMPs). But why do the banks shoot themselves in the foot by offering savers WMPs at 5 to 6% annual returns? It's simple. The 2% regulated interest rate on bank deposits are clearly below inflation, and savers want a better deal. Banks, in a bid to keep deposits, have caved in, and WMPs are essentially the banks' way to keep customer assets.

In the lead-up to June, some banks had played their WMP portfolios a bit too aggressively — allowing the asset-liability mismatch to widen and used leverage much more than normal, contributing to credit tightness in the system. But other parts of shadow banking had nothing to do with Shibor. In my view, these other parts of shadow banking pose no threat to the financial system and do not lead to systemic risk.

In fact, shadow bankers perform a useful function to society by making credit available to small business and underprivileged consumers, whose access to credit is denied by the mainstream banking system. Muhammad Yanus of Bangladesh won a Nobel Prize for founding the Grameen Bank, and microcredit initiatives in some developing countries have won accolades from the U.N. or others for their service to the underprivileged and contribution to society.

CFA Institute: How extensive are bad debts in China and was the liquidity crunch in June in part a reflection of a bad debt situation in the country?

Zhang: Yes. The credit crunch was partly related to rising bad debts, which was a function of two factors. First, when the economy slows, skeletons in the closet are more likely to get revealed. Secondly, in the past two to three decades, Chinese monetary policy has been far too inflationary and accommodative. As a result, the balance of bank loans has grown at a compound annual growth rate, CAGR, of 18% for 27 years. [Editor's note: This data is in Joe Zhang's Shadow Banking book.] That is excessive. True, the economy has been growing fast in the meantime, but sensible lending opportunities are simply not growing nearly as fast.

That means banks have lowered their lending standards along the way, knowingly and unknowingly. Over time, they go from prime loans to normal loans and subprime loans. Due to regulated interest rates, many mediocre investment projects get funded. As a result, there is massive industrial overcapacity, empty airports, and a real estate property bubble.

As state-owned and well-connected private companies squander most of the available credit, small businesses are starved of finance and have to turn to more expensive alternative credit sources at the shadow banks. Finally, asset prices become inflated by negative real interest rates. This, in turn, worsens social inequality, which potentially threatens social stability — a key concern of the central government.

CFA Institute: What do you see as the key problems or risks in China's financial system? Do you see the problems of the financial sector infiltrating into the real economy to become a key contributing factor for GDP growth being much slower than the central government's announced target?

Zhang: The financial sector is an integral part of the real economy, and it exists to serve the real economy. The biggest challenge for China at present is to find a way to end financial repression without causing a major economic crisis. Ending financial repression requires liberalization of interest rates, and this means that interest rates will go up substantially under current circumstances and in the foreseeable future, such that real interest rates return to positive territory. This will provide more disposable income to consumers and help boost the economy. At the same time, state-owned enterprises and well-connected private companies will reduce their demand for credit from the banks, making room for small and medium size businesses — which had to resort to shadow banking in the past — to begin to have reasonable access to bank credit.

For far too long, China's GDP growth has been propped up mainly (or at least partially) by fiscal and monetary stimulus. However, that stimulus is not sustainable, as negative consequences — such as high real estate property prices, consumer price inflation, misallocation of resources — are becoming unbearable. Many have talked about China's GDP growth moving to the 3 to 5% range as the economy rebalances from less investment spending and exports to more domestic consumption. This rate of growth is still relatively high compared to most OECD economies, and there is not necessarily any problem with that, as long as employment levels can be maintained. The central government, since the time of the 12th 5-year plan through to the 18th Party Congress, has been making efforts to guide down public expectations of GDP growth.

Going forward, a critical policy issue for the government is how to make solid but measured progress in liberalizing interest rates to end financial repression and return wealth to households while the economy rebalances, and making sure that economic activities and employment levels will not be unduly hampered.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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