The next phase of China’s fi­nan­cial deep­en­ing

Financial Mirror (Cyprus) - - FRONT PAGE -

The Peo­ple’s Bank of China (PBOC) has re­duced of­fi­cial in­ter­est rates for the first time in more than two years, cut­ting the one-year lend­ing rate by 0.4 per­cent­age points, to 5.6%, and the one-year de­posit rate by 0.25 per­cent­age points, to 2.75%. The net in­ter­est mar­gin – the spread be­tween what banks pay for de­posits and what they charge for loans – has thus nar­rowed by 0.15 per­cent­age points, to 2.85%. The decision, taken after more mod­est at­tempts at mon­e­tary eas­ing failed to in­crease bank lend­ing and pri­vate-sec­tor bor­row­ing, re­flects a re­newed fo­cus on boost­ing eco­nomic growth.

The PBOC’s move also high­lights de­clin­ing in­fla­tion­ary pres­sures. China’s pro­ducer price in­dex has been fall­ing for 32 months, re­flect­ing ex­cess ca­pac­ity and weak ex­ter­nal de­mand, while the con­sumer price in­dex has de­clined from 3.2% to 1.6% over the last 12 months. More­over, the hous­ing price in­dex for 70 ma­jor Chi­nese ci­ties has dropped from 9.6% in Jan­uary to - 2.6% last month. With the price of oil and com­modi­ties also drop­ping, the risks of de­fla­tion and a growth slow­down far out­weigh the threat of in­fla­tion.

Pol­i­cy­mak­ers and fi­nan­cial reg­u­la­tors lately have been seek­ing to re­duce fund­ing costs for busi­nesses, which have been pil­ing on risky debt in re­cent years, as in­suf­fi­cient ac­cess to of­fi­cial loans has pushed them to the shadow bank­ing sys­tem. In this sense, the in­ter­est-rate cut pro­vides wel­come re­lief.

But ad­dress­ing debt risk in China – where so­cial fi­nanc­ing (a broad mea­sure of credit, cov­er­ing of­fi­cial and shadow bank lend­ing and eq­uity) rose from 130% of GDP to 207% early this year – is far from straight­for­ward. In­deed, China’s macroe­co­nomic struc­ture and poli­cies com­pli­cate mat­ters con­sid­er­ably.

The first prob­lem is the frag­men­ta­tion and dis­tor­tion of the price of cap­i­tal. As it stands, there are con­sid­er­able dis­par­i­ties be­tween the one-year fixed de­posit rate (3%); the of­fi­cial lend­ing rate (6-8%) re­served for state-owned en­ter­prises (SOEs), large cor­po­ra­tions, and mort­gages; and the mar­ket lend­ing rate (10-20%) paid by pri­vate business and lo­cal- gov­ern­ment projects that rely on shadow bank­ing.

This seg­mented credit mar­ket means that mon­e­tary pol­icy works very dif­fer­ently in China than in the ad­vanced economies. In par­tic­u­lar, the pri­vate sec­tor – es­pe­cially small and medium-size en­ter­prises (SMEs), which are most of­ten driven to the shadow bank­ing sec­tor – would ben­e­fit more from credit re­lax­ation than from a cut in of­fi­cial in­ter­est rates.

The sec­ond com­pli­ca­tion stems from the struc­tural im­bal­ance be­tween the bank­ing sec­tor (or the debt mar­ket) and the stock mar­ket. In 2008-2013, to­tal eq­uity fi­nanc­ing from do­mes­tic stock mar­kets ac­counted for only 3% of to­tal so­cial fi­nanc­ing, most of which was al­lo­cated to SOEs and large cor­po­ra­tions.

In fact, fears that new stock is­sues would de­press eq­uity prices were so strong that pol­i­cy­mak­ers closed the mar­ket for ini­tial pub­lic of­fer­ings for more than a year, be­gin­ning in 2012. Be­cause the non-bank as­set-man­age­ment in­dus­try re­mains small rel­a­tive to the bank­ing sec­tor, there are limited funds avail­able to in­ject eq­uity to en­able cor­po­rate bor­row­ers, es­pe­cially SMEs, to delever­age, de­spite high do­mes­tic sav­ings.

The third prob­lem con­cerns China’s growth model. Wan­ing ex­ter­nal de­mand has un­der­mined the ca­pac­ity of China’s old man­u­fac­tur­ing- and ex­port-based growth model to sus­tain ex­tremely high growth rates. But the on­go­ing shift to­ward ser­vices- and con­sump­tion-led growth is boost­ing de­mand for liq­uid­ity, while the ac­com­pa­ny­ing cre­ative de­struc­tion is gen­er­at­ing con­sid­er­able un­cer­tainty.

In other words, fi­nan­cial deep­en­ing in China is not sim­ply a mat­ter of ad­dress­ing fi­nan­cial re­pres­sion. In or­der to en­able the cor­po­rate sec­tor to man­age the tran­si­tion to a mod­ern knowl­edge-based econ­omy, China must also re­bal­ance the fi­nan­cial sys­tem by car­ry­ing out a shift from bank and short­term fund­ing to­ward eq­uity and long-term bonds.

China is ready to ini­ti­ate this re­bal­anc­ing. With shadow banks’ lend­ing rates run­ning as high as 20% an­nu­ally, in­ter­est rates in the pri­vate credit mar­ket are al­ready lib­er­alised, with many SMEs able to cope.

More­over, though the price-earn­ings ra­tio on China’s main boards re­main low rel­a­tive to the ad­vanced economies, the ra­tio of Shen­zhen’s SMEs and ChiNext boards for smaller and newer com­pa­nies ex­ceed 30 and 50, re­spec­tively. Clearly, China’s re­tail in­vestors have the risk ap­petite to par­tic­i­pate in SMEs.

It is time for China’s lead­ers to en­cour­age a struc­tural shift, by chan­nel­ing do­mes­tic sav­ings to­ward long-term projects with high so­cial re­turns. This should oc­cur, first and fore­most, through pen­sion and in­surance funds, which in China amount to less than 3% the size of the bank­ing sys­tem, com­pared to more than 60% in the ad­vanced economies.

Mean­while, in­creased eq­uity would ad­vance cor­po­rate­sec­tor delever­ag­ing, help­ing to cush­ion the fi­nan­cial sys­tem against shocks and de­liv­er­ing higher real re­turns to savers. As it stands, China has only 2,500 do­mes­ti­cally listed com­pa­nies, com­pared to more than 5,000 in the United States and 8,000 in In­dia. At the same time, in­ef­fi­cient, waste­ful, and in­com­pe­tent com­pa­nies – es­pe­cially those that are gen­er­at­ing high lev­els of pol­lu­tion, de­plet­ing nat­u­ral re­sources, and cre­at­ing ex­cess ca­pac­ity – should be en­cour­aged to exit the mar­ket, with mod­ern and in­no­va­tive com­pa­nies tak­ing their place. As Alibaba, Ten­cent, and other ris­ing tech­nol­ogy gi­ants demon­strate, China is mov­ing rapidly to­ward e-com­merce and e-fi­nance. But th­ese com­pa­nies are listed out­side of China and are un­avail­able to do­mes­tic in­vestors.

If the real sec­tor can­not de­liver high re­turns to in­vestors, there is no value cre­ation. Given this, China’s lead­ers should fo­cus not only on chan­nel­ing fund­ing to­ward in­no­va­tive in­dus­tries; they must also ramp up their ef­forts to weed out ex­cess ca­pac­ity and en­ergy-in­ef­fi­cient ac­tiv­ity in the sta­te­owned sec­tor. And they must ini­ti­ate a sim­i­lar process to weed out in­ef­fi­cient bor­row­ers from the bank­ing (and shadow bank­ing) sys­tem.

Fi­nan­cial deep­en­ing is a mar­ket process. But it must be un­der­pinned by a reg­u­la­tory and pol­icy frame­work that en­cour­ages risk-tak­ing and in­no­va­tion.

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