China's rebalancing act will require major reform of the banking system

Das Capital: China has committed to removing controls on capital flows, but the risk of deregulation is significant

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Rebalancing China’s economy from investment towards consumption and the private sector requires reform of the banking system, particularly continued deregulation of deposit and lending rates to improve the allocation of capital.

Controlled bank rates have several problems. First, low rates – frequently below inflation – reduce household income. Low or negative rates on savings transfer wealth from savers to banks and borrowers. Assuming that Chinese interest rates have averaged 4 to 6 per cent below the required rate, this equates to a net transfer from savers of about 5 per cent of GDP each year.

Second, controlled lending rates prevent proper pricing of risk, driving banks to lend to state-owned enterprises and government-sponsored projects.

Third, they have encouraged the development of the shadow banking system, which has increased the complexity and systemic risk of the financial system. The reining in of this parallel financial system has proved difficult as borrowers have been confronted with a liquidity squeeze impinging on growth.

But there are significant problems in implementing banking reforms.

First, the Chinese economic model requires keeping the cost of capital low to facilitate its investment strategy. Reform would increase capital costs as credit risk would be priced correctly, undermining the low profitability and solvency of many businesses.

Second, Chinese banks need to manage rising bad debts on loans extended to borrowers and projects which are unlikely to be able to meet their commitments. The ratings agency Fitch has argued that Chinese banks may have unrealised losses in excess of that reported due to improper treatment, such as restructuring loans to avoid recognising them as non-performing. These losses may be greater than the total capital and reserves of the banks.

Third, Chinese banking crises resulting from bad debts are traditionally dealt with by maintaining access to deposits, low rates and a guaranteed high spread between borrowing and lending costs to generate sufficient profitability to absorb the losses over time. Deregulation would destabilise this process of transferring wealth from savers to help cover non-performing loans.

The reform process also requires changes in Chinese monetary and currency policies.

Monetary policy, which is increasingly ineffective and destabilising, is affected by Beijing’s inflexible exchange rate policy.

The problem derives from the fact that China’s capital account is partly open. Foreign direct investment, including for short-term periods by “qualified” investors, is allowed within specified limits. In addition, local and foreign businesses and investors have access to a variety of unofficial techniques to undertake capital transfers, although these are slow, cumbersome, expensive and potentially illegal.

This creates tensions between domestic policy objectives and the management of the value of the currency. Large foreign capital inflows require the People’s Bank of China, the central bank, to undertake money market operations to remove excess liquidity while maintaining the desired value of the currency.

As with the deregulation of interest rates, the Chinese authorities have committed to removal of controls on capital flows, albeit on an unspecified time scale. But the risk of deregulation is significant.

Reforms may affect the banks’ ability to fund and also interest costs, which would affect the flow of credit in the economy, in turn affecting domestic demand. Capital inflows could boost the value of the currency,  increasing imports and at the same time reducing export competitiveness.

In recent years, speculative capital inflows have been strong, seeking to benefit from the perceived undervaluation of the renminbi. However, the authorities fear destabilising outflows if the capital account is liberalised and the currency trades at fair value. Outflows might be exacerbated by flight capital. Trapped domestic savings may flow out as investors seek alternatives to low-yielding domestic banks deposits or speculative property. There are signs that this process has started.

These risks are exacerbated by the increasing scale of the China carry trade. Investors have bought yuan investments financed in foreign currency to benefit from higher Chinese interest rates. Chinese domestic borrowers have increasingly borrowed in foreign currencies (US dollars, Japanese yen and euros) to reduce interest costs. Both investors and corporations have also sought to benefit from the expected appreciation of the yuan. In addition, a variety of derivative strategies to take advantage of the carry and currency movements have also been implemented.

Interestingly, the Bank for International Settlements (BIS) has warned that China’s banking system has large net foreign liabilities. Yesterday, BIS revealed that, after growing rapidly since 2013, it dropped off sharply in the last quarter of 2014.

Large capital outflows would result in these strategies suffering losses and being reversed. This would reduce domestic liquidity and bring in higher interest rates, setting off financial instability and a domestic contraction.

These concerns mean that authorities are hastening slowly with reforms. Changes to regulation of banks, interest rates, capital flows and the currency are likely to be modest for the foreseeable future. For example, relaxed controls over the capital account are likely to entail revised bureaucratic restrictions and price-based limits such as taxes on foreign holdings.

Perhaps wisely, the Chinese government is reluctant to undertake aggressive liberalisation of the financial system as a result of external pressures, just as a period of unprecedented credit expansion is reaching its end.

Satyajit Das is a former banker and the author of ‘Extreme Money’ and ‘Traders, Guns & Money’