The next phase of China’s financial deepening
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.