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  • Dec 21, 2014
  • Updated: 1:26pm
BusinessBanking & Finance

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?


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Right now, in the US, and in Europe as well, the banks are always encouraged by their central banks or their governments to turn on the credit taps, for obvious reasons.
But in China, her banks are instead advised to turn off the credit tap --- what a difference !
And this when many China’s SMEs are starving of fund and are trying to get the very-high-cost loans in the shadow banking markets --- if only they could ever get enough of what they really want !
This shows that there must be something wrong with China’s formal bank-lending mechanism.
Both bank lending and bond issuance are needed for a healthy debt market in China.
Direct and indirect lending should complement each other.
One cannot walk efficiently with only one foot.
Similarly, both expansionary monetary and fiscal policies are needed in the US to prop up the economy.
It takes two to tango.
Expansionary monetary policy alone, in the form of 3 rounds of QEs, fail to quickly recover the Main Street.
The extra liquidity seems to benefit only the Wall Street, as reflected by the lack of high quality employment growth in the country--- many newly created jobs are low-pay or part-time jobs, instead of high-pay full-time jobs.
It can be said to be a fake recovery.
The job condition in Europe is even worse.
The European austerity programmes enacted in the periphery countries further depress the already low wage rates of the workers there --- how can they spend their way back to recovery ?
As for debt financing, there are at least two types: bank lending and bond issuance.
China’s bond market development seems to lag far behind that of the real economy.
Hence the businesses’ reliance on the bank credit.
China’s banks have become so powerful that their performance directly affects that of the overall stock market.
It is suggested that China should fully open up her capital account, partly to invigorate the country’s financial markets.
To me, this is like putting the cart in front of the horse.
Instead of the horse pulling the cart, right now the horse has to push the cart forward --- ‘reverse coercion’ once again.
If this works, wow !
So far as the development of a deeper bond market is concerned, Hong Kong cannot really give a helping hand to China --- our own bond market is small and not very well developed.
Problem is, our government seems to have no plan to change this status quo (the derogatorily-termed dim-sum bond market aside), but she still claims the city to be one of the world’s global financial centres !
The Americans are walking with one very big foot and one small foot at present, given her extreme expansionary monetary policies (QEs) and her tempered fiscal policy (perhaps as a result of her massive fiscal debt accumulated over the years).
In Hong Kong, we are also walking single-footed financially--- with a big stock market and an insignificant bond market (perhaps as a result of our government's very-low-debt history).
Before 1997, the Hong Kong government continued to accumulate fiscal surpluses so as not to burden Britain, but does she need to do the same after 1997 ?
Burdening China ?
No kidding !
You know what? The Hong Kong government is now paying the price of not having developed a big enough domestic bond market for the citizens in the city.
Long Hair’s pension fund filibuster in the Legislative Council is caused by the government’s refusal to satisfy his demand for a 50 billion-dollar universal pension fund to be launched before 2017. (****www.scmp.com/business/article/1472157/long-hairs-pension-fund-filibuster-grand-idea)
If now there is already a deep enough iBond market here in Hong Kong, a great part of the city’s residents can plan on their retirements accordingly, by investing in those iBonds, without relying too much on the the government’s coming policies of assisting the retired people.
(Chinese readers: ****blog.ifeng.com/article/13109450.html)
What about the MPF Schemes of the Hong Kong working population ?
Well, if the expected final fund supplied by the Schemes is really enough to satisfy the genuine needs of most of the retired people, the filibuster wouldn't have occurred to begin with.
The yuan’s internationalization and the full opening-up of the country’s capital account are only technical issues --- they can be done overnight if they are allowed by the Chinese authority.
The big question is whether China is now fully ready to do so.
Of course not.
We may have to wait another 70 years.
In 1872, the GDP of the US already surpassed that of Britain, but not until 1945 could the US dollar fully replace the British pound as the world’s dominant currency.
It took the US 73 years to finish doing the job.
In fact, the dominance of the British Empire lasted until 1956, when the Suez Crisis broke out in that year.
(From the Chinese book ‘How does the US dollar kidnap the world economy’)
I always feel that, as a Hongkonger, I was born at the right time;
but as a Chinese, I was born too early !
History shows that, as far as a city’s rise to the global financial centre status or a country’s rise to world hegemony are concerned, the insult is that it really took a very long time to finish doing these jobs.
The complement is that it also took a very long time for the city or the country at the top to go into decline and to be replaced by their rising competitors.
It’s a bit like the dominant male monkey constantly harassing a maturing young male monkey in the same herd in the African forest.
The young male keeps on using a relatively low-key approach until one day, he suddenly ...
So, from the point of view of China, patience is the name of the game.
I think the Tokugawa shogunate, the last feudal Japanese military government which existed between 1603 and 1868, was established partly thanks to the extreme patience manifested by its founder, Tokugawa Ieyasu.
There are at least two types of financing for the businesses: debt and equity financing.
But whenever there is a new wave of IPOs in China, the country’s stock markets react negatively.
And Alibaba chooses to list abroad, not in her own country.
These show that there must be something wrong with the Shanghai stock exchange.
In India, the Mumbai stock exchange performs satisfactorily, because it has to face competition from the country’s other regional stock exchanges.
So it is said that without competition from the other regional stock exchanges, the Shanghai stock exchange performs poorly as a result.
Well, the Hong Kong Stock Exchange is also a monopoly, but it has been performing well over the years.
Hopefully, the coming Shanghai-Hong Kong through-train arrangement can ‘reverse-coerce’ the Shanghai stock exchange to perform better than before.
As a result, at present, China’s businesses have to rely mainly on debt financing.
This partly explains the country’s relatively high overall business leverage.
We know that, in the world, including China, the private enterprises are the most efficiently organized economic entities.
Even in India, her financial system can allocate scarce resources according to the principle of efficiency.
But not in China !
In China, ignoring the foreign enterprises, most big businesses are SOEs.
The SOEs become big enterprises not because they are competitive or efficiently run, but because they are given the status of monopolies by the central government, so that they could manage the country’s most valuable resources, like the oil fields, telecommunication networks, and above all, the savings assets of the Chinese households.
Most policy banks’ lending are given to the SOEs (and foreign enterprises), but not to the most efficient and innovative SMEs.
The problem is aggravated by the local governments' preference for the foreign enterprises and their discrimination against the domestic businesses.
If the PBOC allows the banks to lower the RRR across the board, as is advocated by so many China observers right now, this stimulative monetary policy will only benefit the SOEs, making them even more powerful than before, but the SMEs will not be allocated their sorely-needed scarce capital.
What’s wrong with the Chinese formal bank-lending mechanism is that it cannot allocate scarce resources to the most-valued uses.
Hence Zhang’s advice to turn off the credit tap --- China’s M2/GDP ratio is almost 2, perhaps the highest in the world.




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