Beijing needs to turn off the credit tap

Beijing must deal with shadow banking head-on rather than diverting energy to tangential matters such as regulation and deposit insurance

PUBLISHED : Monday, 02 June, 2014, 9:55am
UPDATED : Tuesday, 03 June, 2014, 1:04am

China's shadow banking is opaque, huge and fast-growing. In the past year, it has managed to cause two interbank crises, a few small-scale bank runs and several high-profile defaults and near-defaults of bonds.

This has all proven to be enough fun for the government, which in recent weeks has signalled a two-pronged response: tighten regulation and introduce a deposit insurance scheme. Unfortunately, both plans are misguided, in my view.

If China is really worried about shadow banking, there is a neat solution: turn off the credit tap

First, both are forms of prudential supervision, but shadow banking in China is largely a by-product of an ultra-loose monetary policy.

At the beginning of 2008, China's money supply was equivalent to only 74 per cent of the corresponding figure in the United States.

Just six years later, however, it is 61 per cent bigger, although the US economy is still 83 per cent larger than China's.

Apart from a currency translation effect, China's rapid credit growth is the key reason behind this reversal. It has taken place despite the quantitative easing in the US.

If China is really worried about shadow banking, there is a neat solution: turn off the credit tap and/or raise interest rates on bank deposits by 1 to 2 percentage points.

Sadly, the government is reluctant to take the right action. Today, China's money supply is still growing at more than 13 per cent from a very high base. Anyone who understands the power of compound growth should be concerned.

In March, Zhou Xiaochuan, the governor of the People's Bank of China, said China would set interest rates free "within a year or two".

We have heard similar words again and again in the past two decades. Do not hold your breath for a paradigm shift.

The government's vow to strengthen regulation of shadow banking is nothing new. It is a habitual response when something unpleasant happens.

But regulating shadow banking is easier said than done. When hundreds of millions of citizens participate in shadow banking for legitimate reasons - chasing yields, or meeting needs neglected by the banks - the government's risk control rhetoric rings hollow.

Introducing deposit insurance has long been a piece of the pie on the Chinese government's full plate. But why the sudden urge to actually implement it?

My take is that the government wants to instil more public confidence in the very bloated banking system, and at the same time punish poorly managed banks.

This all sounds sensible, but it is a bad idea. In the past 65 years, the Chinese public has been well served by an implicit deposit insurance system.

It is true that this system rewards poorly managed banks and creates a "moral hazard" for depositors. But explicit deposit insurance systems seen elsewhere are equally troubled by moral hazard.

Charging different banks different insurance premiums on the basis of their risk profile sounds elegant, but no country on this planet has shown its capability to implement it well.

A cap on the insured deposit sums will simply force depositors to deal with multiple banks and shift money between the banks.

Moreover, self-confident regulators from the US to Spain have consistently failed to spot troubled banks before a disaster hits. So why should we expect ordinary citizens to be able to do so?

My advice is that the government should not do something just to do something. The existing system of implicit insurance of deposits is just fine.

While it provides de facto blanket coverage for all deposits, the lack of an explicit guarantee is a constant reminder to all depositors that some caution is advisable on their part.

Sadly, that is all a deposit insurance scheme can realistically achieve anywhere in the world, no matter how elaborate it is.

Last month, the Chinese government issued a set of guidelines for banks to issue preferred shares. I think that is a step in the wrong direction.

It is true that rising bad debts may have eroded the banks' capital cushion, but giving them more capital is adding fuel to the fire.

Without writing off bad loans, the banks will be emboldened and fooled by their suddenly higher capital adequacy ratios and extend even more loans. More loans, in turn, will lead to more bad debts and will require more capital replenishment.

The 18 publicly listed banks and thousands of unlisted banks have all gone through the same drill and got fatter and weaker along the way.

Now a very un-Chinese approach is needed urgently. The banks must learn to downsize their loan portfolios - or at least slow the growth of them - to meet their capital ratios.

The capital markets inside and outside China price the Chinese banks at below book value despite their enviable operational and valuation ratios.

The banks do not need more capital. They need a smaller loan book.

None of the troubles in the mainland's banking industry today is due to credit tightening, which is not in the Chinese government's vocabulary. On the contrary, it is all due to excessive credit expansion.

Sensible lending opportunities cannot possibly grow at double-digit rates year in, year out, several decades in a row.

The rapid growth of credit naturally leads to lower standards, diminishing returns and rising bad loans. That's the reality in China today.

The government must come out of denial and deal with the issue head-on, rather than diverting energy to tangential matters such as regulation, deposit insurance and preferred shares.

Joe Zhang is the author of Party Man, Company Man: Is China's State Capitalism Doomed?