How interest rate controls created a shadow banking system in China

Gregory C. Chow says by easing its control on bank deposit rates, China would not only boost market efficiency but also rid the economy of the created problem of a shadow system

PUBLISHED : Friday, 26 July, 2013, 12:00am
UPDATED : Friday, 26 July, 2013, 2:35am

It is well known that the interest rate commercial banks can pay to depositors is controlled by the government. As of February this year, the rate was only 3 per cent per year, while the consumer price index increased by 3.2 per cent , providing depositors with a negative real return for their deposits.

As a result, some depositors would like to receive a higher rate. At the same time, some borrowers and banks are willing to pay higher rates, because they can still make a profit on the higher rates. Thus the policy has created a shadow banking system paying a higher rate of interest than the official rate.

An article in The New York Times reported on how such a market works. Financial products are offered - through text messages on mobile phones - by some of China's biggest banks to raise cash for lending outside the scrutiny of bank regulators.

The policy has created a shadow banking system paying a higher rate of interest

This is causing concern that these wealth management products are being used to "repackage old loans and prop up risky companies and projects", and that "shadow banking is helping drive the rapid growth of credit in a weakening economy, which could lead to - in the worst situation - a series of bank failures", the report said.

Let us apply the tools of supply and demand to understand this phenomenon. The supply and demand of deposits depends on the rate of interest. The higher the rate of interest, the more money people will deposit in the banks; the lower the rate of interest, the more the banks will accept deposits. The equilibrium interest rate is that rate which makes the quantity supplied equal to the quantity demanded.

In a free market, the interest rate will reach this equilibrium rate. If the rate of interest is arbitrarily set below the equilibrium rate, the amount that the depositors are willing to supply is less than the amount that the banks wish to obtain. This results in a shortage of deposits in the market.

When there is such a shortage, some banks are willing to pay a higher interest rate to attract more deposits, for them to lend to borrowers who are willing to pay an even higher rate. This institution, known as the shadow banking system, helps to eliminate the shortage of loans. It benefits the economy because both the depositors and the lenders get what they want.

In conclusion, it is the government's control of the interest rate that causes the shortage of money available for projects that require the loans. The shadow banking system solves the shortage problem. In a market economy, demand and supply determine price in equilibrium and leads to an efficient allocation of resources, bank loans in this case. Any interference inevitably decreases economic efficiency.

Here I would like to address four possible criticisms against the shadow banking system.

First, in China people are competing for loans possibly by illegal means such as bribing the loan officers. If the interest rate is market-determined, there is no need to bribe to get loans. If a loan officer asks a potential borrower to pay him bribes, the borrower can go to another bank because there is competition among the potential lenders to reach a market equilibrium.

Now assume that there is an interest rate ceiling and the "black market" rate of interest in shadow banking is higher than the equilibrium rate. Borrowers in the market of shadow banking will not need to bribe because the interest rate in the black market is also in equilibrium with competition among the lenders.

However, if you want to borrow from the legal market at the lower-than-equilibrium interest rate, you will need to bribe because more people want such low- interest loans. In conclusion, when there is an interest-rate ceiling, borrowers need to bribe to get loans from the legal market but do not need to bribe in the shadow banking system.

Second, inefficiency is said to occur when bribes are paid in fund allocation. But as I have explained above, when there is an interest-rate ceiling, allowing the borrower to borrow money in the shadow bank system at a higher interest rate requires no bribes. Free exchanges between lenders and borrowers, as exchanges taking place in shadow banking, always enhances efficiency.

Third, there are financial risks associated with trading in the shadow banking system. However, risk-taking is a part of efficient economic activities. For example, buying stocks is risky because one can lose lots of money but no one thinks we should abolish the stock market.

Fourth, there are many people objecting to a "black market", and shadow banking is considered a black market because it is against the law. But in this case it is the law that is inappropriate, or the regulation of the interest rate that is inappropriate. This regulation creates the black market or shadow banking.

In conclusion, I have to ask, what is the rationale for controlling the rate of interest, especially when a recent policy announcement of the Chinese government is to let prices be determined by the market?

In its announcement, the government called for an expansion of the role of private enterprises. Allowing the market to determine the rate of interest should be a part of this policy.

If the interest rate is market-determined and not regulated, then the shadow loan market will disappear.

Under this circumstance, any criticism of this market will no longer exist, including the criticisms discussed above.

Gregory C. Chow is Class of 1913, Professor of Political Economy, Emeritus, at Princeton University. Professor Shen Yan of Peking University and Professor Niu Linlin of Xiamen University helped in the preparation of this article