Beijing is only treating the symptoms, not their cause

Artificially low interest rates have stored up trouble for the mainland's economy, and no regulatory quick fix will be sufficient to address it

PUBLISHED : Monday, 01 April, 2013, 12:00am
UPDATED : Monday, 01 April, 2013, 4:04am

Last week the authorities in several of China's biggest cities slapped a 20 per cent capital gains tax on homeowners who sell their properties.

Their latest attempt to rein in runaway property prices comes just days after regulators launched a new crackdown on China's ballooning shadow banking system.

At first glance, these twin initiatives make it look as if Beijing is finally getting to grips with the financial risks that threaten China's future growth trajectory.

In reality, however, the authorities are merely tinkering. At best their efforts will be ineffectual. At worst they could backfire. Either way, as long as policymakers fail to tackle the underlying problem, the dangers to China's economy will continue to mount.

On the surface it might look as if imposing a capital gains tax could be an effective way to curb property speculation and restrain rising prices.

Certainly the threat of its imposition triggered a quick flurry of sales among homeowners anxious to book their profits before the new tax came into effect.

But in the longer term, a 20 per cent capital gains tax will do nothing to deter speculative buyers.

To see why, imagine you are buying a property as an investment. If you are expecting to sell it again in a year's time at a profit of, say, 15 per cent, you are not going to be put off by the prospect of making a gain after tax of a reduced 12 per cent, especially if you are a cash buyer and the interest rate on your bank deposit is negative in inflation-adjusted terms.

If you doubt that, the world's most successful investor might persuade you. In an August 2011 letter to The New York Times, Warren Buffett declared: "I have yet to see anyone - not even when [US] capital gains rates were 39.9 per cent in 1976-77 - shy away from a sensible investment because of the tax rate on the potential gain."

If anything, the capital gains tax could exacerbate China's property market problems. While it won't put off buyers, it might deter investors from selling unless they can pass on the cost of the tax in the form of higher prices.

The latest attempt to crack down on China's shadow financial system could also have unintended consequences.

Last week, regulators ordered banks to stop pumping the money they raise by selling "wealth management products" into undifferentiated pools.

These wealth management products are unguaranteed short-term notes, usually with maturities of one to three months. Banks sell them to savers who want higher rates of return than they can earn on their deposits.

The banks use the proceeds to finance high-risk, off-balance sheet loans to private companies and local governments. However, because the loans are long term - often three years or more - the banks pool the funds, using the money they raise by selling new wealth management products to pay out investors in their maturing notes.

As a result, around 80 per cent of these products, with a face value of between 8 trillion and 10 trillion yuan (HK$9.88 trillion to HK$12.35 trillion), have a structure that is entirely opaque and risk levels that are impossible to assess.

The regulators are rightly concerned. But by requiring sellers to tie new products to specific assets, they may cause problems for banks that need to pay back investors in maturing notes. That could create a crisis of confidence and trigger a collapse of the entire market.

In short, Beijing's latest efforts to control the property market and the shadow banking system could end up doing more harm than good.

The reason is the same in each case. The authorities' new measures are an attempt to deal with the symptoms of China's financial problems without tackling their common cause: artificially low interest rates.

In an economy growing at a nominal rate of around 10 per cent a year, interest rates should be set at roughly the same level.

Instead benchmark rates are between 3 and 6 per cent. As a result, savers are desperate for higher returns. Meanwhile, capital is too cheap and credit is artificially rationed.

The consequences are China's fast-rising property prices and its ballooning shadow banking market. One is propelled by investors buying flats as a store of value. The other is driven by savers seeking higher returns and borrowers excluded from the formal system jumping at the chance to obtain credit even at premium prices.

The only solution is for the authorities to press ahead with much-delayed plans to liberalise interest rates. Until they do, Beijing will only be treating the symptoms of its financial problems, not their cause.