By Joe Zhang
“If President Xi Jinping wants Chinese people to realise their own ‘China dream’, he must tame the credit monster. Shadow banking is only the shadow, not the monster waiting in the shadows.” Below, Joe Zhang argues that shadow banking is merely the tip of the iceberg, disguising the real, underlying problem: excessive credit expansion.
In China today, the term “shadow banking” has a negative meaning. Over the past three years, the China Banking Regulatory Commission has issued numerous policy directives to try to contain its explosive growth. Xiao Gang, the head of the Chinese securities watchdog, called shadow banking “a Ponzi scheme” in an opinion piece he penned last year while still serving as Chairman of the Bank of China.
But why is shadow banking still all the rage, despite the hostile regulatory environment?
In the past two to three decades, China has implemented an extremely inflationary monetary policy. Since 1986, for example, its money supply has grown at a compound annual growth rate of 21.1 per cent, and its bank loan balance by 18.2 per cent. Of course, Chinese citizens have not become richer as fast, and much of the growth is merely a monetary illusion.
Why did credit grow so fast for so long? Apart from a robust economy, the reason has been the regulated and negative real interest rate. Due to financial repression, demand for loans has been artificially boosted, as bad investments become feasible on subsidised credit. Indeed, it has been a vicious cycle.[ms-protect-content id=”5662″]
An Iterative Escalation of Credit and Inflation
First, the fast growth of loans worsens inflation, which weakens the purchasing power of money. To facilitate the same amount of business, corporate China needs more credit. And as more credit is released into the economy, the purchasing power of money shrinks further. I call this an iterative escalation of credit and inflation. There is a constant shortage of credit no matter how fast credit grows. The reason? Bank loans are impossible to refuse as they are heavily subsidised. Homebuyers and speculators know this all too well.
The Chinese government frequently talks about prudent monetary policy but does not really have the political will to tighten credit for fear of job losses and a recession. Even in April, the broad money supply (M2) had grown at 16.1 per cent compared to the same time last year. That is a very high rate on a high base. China is still inflating rapidly despite repeated declarations of credit controls by government officials.
The results of financial repression are visible everywhere, from industrial overcapacity to excess real estate construction, and the unstoppable growth of shadow banking.
Over time, the Chinese statistics (particularly on inflation) have lost credibility among citizens. Despite high inflation that is widely believed to be somewhere between five and ten per cent a year, Chinese depositors are paid an average of two per cent interest. Naturally, they want better deals. While many have chosen to speculate on property, others have embraced shadow banking, including microcredit and wealth management products. After consistently deflating for two consecutive decades, the domestic stock market remains very expensive, with banking stocks being the possible exception.
Negative real interest rates on bank loans constitute a subsidy for borrowers. Unfortunately, access to finance is neither equal nor fair. State-affiliated companies and well-connected private-sector borrowers take the bulk of funds for loans, leaving very little for small businesses. The underprivileged have to resort to the curb market, involving trading outside the official stock markets, pawnshops, microcredit firms and high-cost funds arranged by trust companies.
In other words, China’s shadow banking is a reflection of the financial repression. The high interest rates prevalent in shadow banking activities are a result of the low rates in the formal banking sector.
Financial repression has accentuated the uneven playing field for the two types of borrowers. Normal bank loans carry a six per cent annualised interest rate, while the shadow banks typically charge 15-30 per cent per annum.
If Beijing really wants to help small businesses, or deflate the property bubble, it should raise interest rates steadily. As a result, the growth rate of money supply will decline to 7-8 per cent within two to three years. Yes, this will risk an economic recession, but a recession may be exactly what is needed to avoid the next global financial crisis. This time, unlike in 2008, the crisis will be made in China.
China’s iterative escalation of credit and inflation has severe social consequences, too. Ordinary savers are punished, and are left further and further behind by the rising prices of assets such as property. If President Xi Jinping wants Chinese people to realise their own “China dream,” he must tame the credit monster. Shadow banking is only the shadow, not the monster waiting in the shadows.
Shadow Banking: A Scapegoat?
China’s shadow banking is opaque, huge and fast-growing. In the past year, it has managed to cause two interbank crises, a few small-scale bank runs and several high-profile defaults and near-defaults of bonds.
This has all proven to be enough fun for the government, which in recent weeks has signalled a two-pronged response: tighten regulation and introduce a deposit insurance scheme. Unfortunately, both plans are misguided, in my view.
First, both are forms of prudential supervision, but shadow banking in China is largely a by-product of an ultra-loose monetary policy.
At the beginning of 2008, China’s money supply was equivalent to only 74 per cent of the corresponding figure in the United States. Just six years later, however, it is 61 per cent bigger, although the U.S. economy is still 83 per cent larger than China’s.
Apart from a currency translation effect, China’s rapid credit growth is the key reason behind this reversal. It has taken place despite the quantitative easing in the U.S.
If China is really worried about shadow banking, there is a neat solution: turn off the credit tap and/or raise interest rates on bank deposits by one to two percentage points.
Sadly, the government is reluctant to take the right action. Today, China’s money supply is still growing at more than 13 per cent off a very high base. Anyone who understands the power of compound growth should be concerned.
In March, Zhou Xiaochuan, the governor of the People’s Bank of China, said China would set interest rates free “within a year or two.”
We have heard similar words again and again in the past two decades. Do not hold your breath for a paradigm shift.
The government’s vow to strengthen regulation of shadow banking is nothing new. It is a habitual response when something unpleasant happens.
But regulating shadow banking is easier said than done. When hundreds of millions of citizens participate in shadow banking for legitimate reasons (chasing yields, or meeting needs neglected by the banks), the government’s risk control rhetoric rings hollow.
Introducing deposit insurance has long been a piece of the pie on the Chinese government’s very full plate. But why the sudden urge to actually implement it?
A Step in the Wrong Direction
My take is that the government wants to instil more public confidence in the very bloated banking system, and at the same time punish poorly managed banks.
This all sounds sensible, but it is a bad idea. In the past 65 years, the Chinese public has been well served by an implicit deposit insurance system.
It is true that this system rewards poorly managed banks and creates a “moral hazard” for depositors. But explicit deposit insurance systems seen elsewhere are equally troubled by moral hazard.
Charging different banks different insurance premiums on the basis of their risk profile sounds elegant, but no country on this planet has shown its capability to implement it well.
A cap on the insured deposit sums will simply force depositors to deal with multiple banks and shift money between the banks.
Moreover, self-confident regulators from the U.S. to Spain have consistently failed to spot troubled banks before a disaster hits. So why should we expect ordinary citizens to be able to do so?
My advice is that the government should not do something just to do something. The existing system of implicit insurance of deposits is just fine.
While it provides de facto blanket coverage for all deposits, the lack of an explicit guarantee is a constant reminder to all depositors that some caution is advisable on their part.
Sadly, that is all a deposit insurance scheme can realistically achieve anywhere in the world, no matter how elaborate it is.
Last month, the Chinese government issued a set of guidelines for banks to issue preferred shares. I think that is a step in the wrong direction.
It is true that rising bad debts may have eroded the banks’ capital cushion, but giving them more capital is adding fuel to the fire.
Without writing off bad loans, the banks will be emboldened and fooled by their suddenly higher capital adequacy ratios and extend even more loans. More loans, in turn, will lead to more bad debts and will require more capital replenishment.
The 18 publicly listed banks and thousands of unlisted banks have all gone through the same drill and gotten fatter and weaker along the way.
Now, a very un-Chinese approach is needed urgently. The banks must learn to downsize their loan portfolios (or at least slow the growth of them) to meet their capital ratios.
The capital markets inside and outside China price the Chinese banks at below book value despite their enviable operational and valuation ratios.
None of the troubles in China’s banking industry today are due to credit tightening, which is not in the Chinese government’s vocabulary. On the contrary, it is all due to excessive credit expansion.
Sensible lending opportunities cannot possibly grow at double-digit rates year in, year out, several decades in a row.
The rapid growth of credit naturally leads to lower standards, diminishing returns and rising bad loans. That’s the reality in China today.
The government must come out of denial and deal with the issue head-on, rather than diverting energy to tangential matters such as regulation, deposit insurance and preferred shares.
About the Author
Joe Zhang is Chairman of China Smart-pay, and the author of Inside China’s Shadow Banking: The Next Subprime Crisis?[/ms-protect-content]