Last week, Chinese banks ran out of money. As they were scrambling for more funds to meet the regulatory requirements, the overnight interbank borrowing rate briefly topped 30 per cent. The ripples went around the world, sending stock markets tumbling like dominos. It immediately focused attention on the health of Chinese banks, and the calls for reining in bank credit are getting louder.
But this time, the solution may not be with the debt financing itself, but equity financing.
Let's first put this episode into perspective. It was not a banking crisis. It was merely a hiccup caused by commercial banks' mismanagement of liquidity and their underestimation of the central bank's determination to force them to keep lending under control.
A more important question is: what has made banks lend so aggressively? A simple answer is: because they can. For years, investment growth has been high and demand for bank loans even higher. This is because investment growth has consistently outstripped the pace at which companies can accumulate equity, either through internally generated earnings or outside equity financing. Firms therefore turn to borrowing. Increased lending by the banks, however, creates an ever-higher debt-to-equity ratio for the whole economy, and this higher leverage cannot be sustained forever.
To lower the risk of high leverage, there are two alternatives: lower the debt or increase equity. The latter should be wiser, especially in the long run. To force deleveraging right now may do more harm than good. Banks still have very tolerable non-performing-loan ratios and are well capitalised. Currently, there is no loan crisis in China.
Furthermore, the real economy remains sound and investment is still needed. A sudden withdrawal of bank credit would inevitably affect productive investments and undermine future growth.
The real problem is the lack of equity capital, and institutions and incentives to foster equity capital formation. Despite rapid economic growth and the government's repeated emphasis on building a "multi-layer capital market", China has yet to make equity financing a priority. Chinese companies have, for years, also lacked incentives to seek equity financing, except from the two stock exchanges.
Companies that make investments faster than their own ability to raise equity capital rely heavily on debt financing, either from banks or the underground financing system. The ever-expanding balance sheets of both the central bank and commercial banks have pumped abundant credit into the real economy. After the 4 trillion yuan (HK$4.5 trillion at exchange rates then) economic stimulus in 2009, bank credit reached a "permanently high plateau". Since Chinese companies can raise money cheaply with debt, why bother with expensive equity? This behaviour is common among private companies and state companies alike, inside the formal financial system and outside it.
Things came to a head in the 2011 financial crisis in Wenzhou . While superficially it seemed to be a debt crisis caused by the credit crunch of the underground banking system, two important facts suggest something different.
First, the crisis coincided with China's tightening of bank credit, and this indicates a link between the formal banking system and the informal one: the banking sector must have provided credit to the underground system, albeit indirectly.
Second, given how stringent monitoring of the underground system in Wenzhou must have been, the crisis probably had less to do with reckless lending than with reckless investing supported by overleveraging.
In the absence of overleveraging, overinvestment alone can cause only limited damage; it will not bring everyone else down with it. On the other hand, when debt is high for a large number of companies, the impact will be transmitted far and magnified across the economy. Indeed, the damage will be huge and won't discriminate, as we have witnessed in the 2008 global financial crisis.
Increasing equity capital can not only lower the overall financial risk but also change the incentives for companies to invest. For example, it will discourage entrepreneurs from gambling with other people's money and encourage them to accumulate equity capital for the long term. When equity holders have more skin in the game and are limited by their own means, they will be more selective and careful in investing.
Although banks can gather funds from depositors, raising money this way means risks tend to fall on the banks. Equity financing, on the other hand, makes risk more tolerable by spreading it among many investors. The recent bank liquidity panic adds to the need for new equity financing policy initiatives. Bank credit cannot continue to grow without limits. Equity capital must increase.
China has accumulated great wealth in recent years, and still has a very high savings rate. This wealth needs to be channelled properly between debt and equity when financing future growth.
There are many things China can do to encourage equity financing. Lower corporate tax would allow companies to plough back more earnings into equity. The government should also re-examine its role in deciding which companies can go public and when, and let the market decide instead. The equity markets outside the two stock exchanges should also be vastly expanded, while national pension funds should be managed more actively to support equity investment.
The current financial risk remains quite manageable. By increasing equity financing, China can lower its financial leverage ratio gradually, deflate the financial risk and continue to support growth. It is not time to retreat from debt financing. It's time to accelerate equity financing.
Xiaozu Wang is a professor of finance at Fudan University's School of Management. The views expressed here are those of the author