What ails China is not the cost or availability of capital, but the allocation of it. So cutting interest rates in China always carries the risk of compounding the problem of cheap money creating asset bubbles and delaying structural rebalancing (and Beijing just cut interest rates twice recently, in June and July this year). The good news is that Beijing seems to be recognizing the problem and is implementing some reforms that amount to interest rate and financial liberalization, albeit indirectly. This is structurally positive for Chinese asset value in the long-term. The bad news is that these measures are implemented at the margin of the system, at least for now, and there is a risk of moral hazard in the implementation process. Only time will tell if the incoming new Chinese leaders will follow through with more determined reforms to put China on a sustainable growth path.
New financial reform initiatives
China started its first wave of financial reforms in the years between 2004 and 2006. In particular, the banks’ lending rate ceiling was scrapped and they were allowed to lend at interest rates up to 10 percent less than the PBoC’s benchmark rate. This was the first interest rate liberalization. There were also other reform measures implemented to encourage capital market development. The reform agenda has then gone quiet, as policymakers have focused on shortterm survival policies to deal with the global and regional financial crises set off by the US subprime crisis.
Recently, Beijing has started another wave of financial reforms. Though these are small steps, they show Beijing’s willingness to address some of the structural flaws in the system. In particular, the recent changes in the domestic interest rate structure, the gradual opening up of the domestic bond market and the emergence of the trust companies all represent steps to financial liberalization.
In the two interest rate cuts in June and July this year, Beijing also allowed banks to offer deposit interest rates up to 10 percent higher than the official benchmark rate (it was not allowed to deviate from the official rate before) and offer lending rates up to 30 percent below the official benchmark rate (while the initial floor was only 10 percent below). This was the first interest rate liberalization since 2004.
Meanwhile, regulatory reforms have facilitated the growth of the domestic bond market, which saw bond issuance up 60 percent YoY by volume in the first half of 2012 when all other forms of financing were sluggish. China has three bond regulators, who have long and cumbersome approval procedures for bond issuance. The National Development and Reform Commission (NDRC) controls corporate bond issuance by the SOEs, the PBoC oversees commercial paper and medium-term notes issuance and the China Securities and Regulatory Commission (CSRC) manages bonds issued by listed companies and traded on the Chinese stock exchanges. Approval by the NDRC, for example, could take up to a year.
But this has started to change recently, spearheaded by the PBoC which has simplified and sped up the approval procedure, and this has put pressure on the other two regulators to follow suit. The CSRC, for example, has fast-tracked approval for some issues to less than two months. The CSRC also launched a high-yield bond market in June 2012 by adopting a registration not approval system. Despite all this effort, China bond market development remains nascent, with corporate bond financing accounting for about 17 percent of all new bank loans1.
The emergence of trust companies competes with banks for deposits, and has prompted many banks to develop wealth management products (WMP) to attract/retain deposits by paying higher yields than saving deposits. Though WMPs account for only about 12 percent of total bank deposits and the total assets of the trust companies are only about 4 percent of total banking assets2 , they are already creating competitive pressure on challenging the banks’ dominance. All these are not big changes, but they do suggest that China’s financial landscape might be in for some structural changes.
On the interest rate liberalization front, the cost to the banks is significant. The fact that Beijing still pushes it through suggests that it might be serious in reforming the banking system. On the surface, the two rate cuts in June and July only cut banks’ margin by 6 bps (Table 1). However, since banks are eager to lend amid slowing credit demand, they are motivated to lend at the floor rate. Banks are also in competition with trust and mutual fund products for funds, so they are motivated to offer deposits at the ceiling rate to attract funds. Lending at the floor rate and paying deposits at the ceiling rate means that the banks’ margin has effectively been squeezed by a total 150 bps (Table 1), not 6 bps (Chart 1).
In fact, banks’ average margin has been cut to 294 bps from 332 bps since the first interest rate liberalization in 2004, if they have lent at the floor rate at all times. The point is that significant margin squeeze should prompt the Chinese banks to improve efficiency. Greater interest rate flexibility, by China’s standard, should also help improve capital allocation.
The creation of a high-yield (junk) bond market and the advent of the trust companies and WMPs offer nonbank funding avenues (that are not subject to loan quota restrictions) to the unprivileged non-state firms and help improve capital allocation. The junk bond yields are market driven. The Chinese trusts extend loans or make equity investment and package them into fixed-income products, while the WMPs sold by banks are loans repackaged as short-term investment products. Both products eschew the official deposit rate cap and offer higher yields to savers. Thus, they are indirect ways to liberalize interest rates and help ease financial repression.
Risk of moral hazard
The government has implicitly guaranteed all local bonds, including the LGFV (local government financing vehicles) borrowing, by directing banks to bail out companies on the brink of default. So there has not been any domestic bond default so far. This has encouraged a belief that debt defaults are impossible; just like the belief earlier that IPO prices would always rise after listing. While this makes the newly created junk bonds, WMPs and trust products attractive to investors, it also creates moral hazard among investors/savers, bond issuers and product distributors.
The ultimate goal of financial liberalization is to have market-driven interest rates and efficient capital allocation to both the state and nonstate companies. But these will involve root changes to China’s economic management model, which is why they will not go fast. If the recent financial reforms are deepened, they will be strong structural underpinning for Chinese asset prices in the long-term. Whether the reform glass is half- full or half-empty, time will tell. Indeed, China’s future reform process is at crossroads, which argues that Beijing’s past practice of small-steps and gradualism may need to change to adapt to the changing domestic and external structural dynamics.BM
1 As of the first half of 2012.
2 As of the first quarter of 2012.