Curbing bank lending won't solve problem of China's financial system

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.