China needs four yuans of debt to create one yuan of growth!

The new reforms announced over the summer and at the conclusion of the Third Plenum of the 18th Party Congress are supposed to change all this. But they have a long way to go

Laws are meant to be obeyed. So when politicians, bureaucrats, and even central bankers have a problem they simply publish a law and assume that people will fall in line. This is basically what the Chinese have done for many years with interest rates. But there is something that doesn’t obey laws: markets. Now the Chinese have decided to reform their financial system by publishing a new law. They may be in for some surprises.


China’s financial system is still true to its communist roots. All property belongs to the state. This included all of the money in banks. So the state has the right and duty to decide how that money is used. As a result the government told the state owned banks what to charge borrowers and what to pay depositors.


This system has worked rather well. It is particularly useful after a recession. During the last recession about 12 years ago, the banks had huge amounts of bad debts on their books as high as 25%. These debts were never collected and basically never written off. The losses were made good over the years on the spread between the low interest rates paid depositors and the higher rate charged borrowers. Both of these were set rather low to encourage economic growth. Depositors bore much of the burden. But they had few other investment choices. They could put money in the banks for a meagre return or, if they were more fortunate, invest in real estate.


The consequence of this system was predictable. The low interest rates for borrowers spurred investment mostly in a rising property market, while depositors’ return was insufficient to increase consumption. The Chinese economy became notoriously imbalanced. It relied on export, which has been weak. It also became addicted to cheap credit which made firms especially state owned firms inefficient. So much so that it takes four yuan of debt to create one yuan of growth. The property market rose to bubble territory. Many newly constructed towns do not even have residents.


The new reforms announced over the summer and at the conclusion of the Third Plenum of the 18th Party Congress are supposed to change all this. But they have a long way to go.


In the US the central bank, the US Federal Reserve (Fed), has a number of tools it can use to set interest rates. But there is a major difference between what the Fed does and what the Chinese have done. The Fed uses its tools to manipulate the market. The Chinese have simply told the market what to do.


For example one way the Fed influences interest rates is through open market operations. Once the Fed decides on what it believes to be an appropriate interest rate, they buy US government bonds to increase the money supply to make interest rates fall or sell government bonds to decrease the money supply to make interest rates rise. They also have the power to increase or decrease the reserves that banks hold. If a bank does not have sufficient assets to meet this requirement it can borrow from the Fed at its discount window. The Fed will charge a rate appropriate to help it meet its interest targets.


This does not mean that the Fed always gets its way. Last May when the Fed announced that it was considering the famous ‘taper’ of its bond buying extravaganza known as QE, interest rates on the market shot up. The rate for 10-year US government bonds went from 1.63% on May 2nd to 2.97% almost 3% on September 5th. They have come down some to 2.75%, but nowhere near the previous low which the Fed would undoubtedly prefer. The market gets its way.


Last July, the Chinese central bank, the People’s Bank of China, decided to gradually reform its system. The PBOC said that they would no longer set a ‘floor’ or a minimum interest rate that banks could charge corporate customers. In theory this will increase competition between banks for customers. While this was interesting, what was more important is what the government didn’t do. It did not lift the cap or ceiling on what the banks can charge. It did not change the cap on what banks can pay depositors.


Recently the PBOC made another ‘reform’. It established a ‘prime rate’. It used to set a bench mark rate, but since it had already set caps and floors for borrowers, that rate was essentially meaningless. It has not been changed since last year. In contrast the new prime rate is to be set by the markets. It is to be calculated daily through an official price quotation system and be based on a weighted average of rates from nine domestic commercial banks. The old bench mark was 6%. The new prime rate was initially set at 5.71% for one year loans.


While an official ‘prime rate’ will be welcome, the market has already created SHIBOR. SHIBOR is the rate Chinese banks charge each other. It is sort of a Chinese version of LIBOR. What is interesting about SHIBOR is that it does not show a normal yield curve. Most western banks charge more for longer dated loans. For example the yields for US Bonds with three month and six months maturities are 0.05% and 0.08% respectively. The yields SHIBOR for three and six month terms are 4.71% and 4.22% respectively. In fact the highest yield is for one month at 6.37%, far higher than the one year which has been stable since June at 4.40%


The difference in rates could reflect the uncertainty surrounding the PBOC’s injections of money into the system. The PBOC requires banks to maintain reserves. In the past, if a bank ran short, the PBOC would automatically inject money into the system by buying bonds through repo agreements. However in June, the PBOC did nothing.


Banks were so desperate for money that the overnight loan from one bank to another briefly hit 30%. On Friday November 14th it spiked again opening a full percentage point higher than its close on Thursday. Also, on Friday, the PBOC auctioned off 50-year bonds at 5.31% also over a 100 basis points higher than the last auction. In essence the PBOC is signalling tighter monetary conditions.


So far the reforms have been limited. A reform liberalising of deposit rates will have to wait for the creation of a deposit insurance system to protect depositors in case of a bank failure, a very real possibility for some smaller banks. But like SHIBOR, the market hasn’t waited. Depositors already have a choice. They can put money in the shadow banking system and get much higher rates by purchasing Wealth Management Products or WMPs. It is the source of nearly half of the credit growth this year. The higher rates for investors mean higher rates for borrowers often in double-digit interest rates, even for the highest quality borrowers. To profit from such transactions requires the borrowers to speculate on real estate transactions.


Any reform of this system by liberalising deposit rates could have a disastrous impact. It would lead to surging lending rates. It would impact not only the real estate bubble, but also the entire economy. The end of QE in the US might have a similar effect in China due to the carry trade.


The Chinese government is well aware of these risks. As part of the reform package of the Third Plenum, president Xi Jinping will set up a “national security commission” which will allow him to take direct control of domestic security. He will also tighten control over the internet.


The market originally celebrated the introduction of the reforms. But as they take shape and the market regains control, some of the distortions created by the rules could disappear in a rather violent way. Whether the equity markets will be so optimistic then will be something to seen.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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