Reforming the Financial Industry
The Eighteenth Party Congress’ Third Plenary Session’s Decision of November 2013 lists a new round of financial reforms aimed at introducing more market forces into the economic system. Two of the most important facets of this stage of reform are market-determined interest rates and permitting the value of the RMB to float. Both are a necessity for the leadership to attain the goal of making the yuan a world reserve currency to rival the U.S. dollar. But looks can be deceiving. Forces are arrayed on both sides of the question of reform, with uncertainties about China’s future economic growth rate. As a result, implementation of these financial reforms is likely to come in fits and starts, but the changes could end up being significant.
China faces the same conflicting pressures that other countries do. Polices are needed to stimulate growth but debt and deficit financing must be kept in check. China’s financial system must support growth by providing credit to companies and funding investment by local governments, but it also must manage resulting deficits and debt. For years, capital costs have been subsidized for state companies and governments by fixing interest rates. Now the People’s Bank of China, China’s central bank, has been advocating market-determined interest rates to improve the allocation of investment capital by conveying the true cost of borrowing. Rates would likely rise, however, which would dampen new investment, affect growth, and raise the costs of refinancing outstanding loans. The construction industry has been a main driver of domestic growth, but it is sensitive to the cost and access of loans. Hence, numerous interests within China are wary of moving in this market-oriented direction.
To make matters more complicated, China is in a period of slowing economic growth, which enhances the risk to some projects. Slow sales of housing, commercial property, and manufactured goods have increased the chances of default on related loans. Property prices in many parts of China have softened. For some, this sounds all too similar to the beginning of the U.S. financial crisis when housing prices began to fall in mid-2006.
Market-determined Interest rates
One difference between China and the U.S., however, is that China’s key financial prices are not yet fully market determined. For example, interest rates for loans in China are capped in the formal banking sector, as are deposit rates. Because there is more demand for loans than banks are willing, or can, offer, there is a thriving “shadow” banking sector where the costs of borrowing are much higher. This sector has grown substantially over time, and even state banks and large companies have diverted funds to these channels to earn higher returns.
Reforms envisioned in the Decision would lessen the need for shadow lending. While the shadow sector has served a useful purpose—supplying capital to many companies that would not have access otherwise—there is a strong argument for letting the formal credit market determine rates. As the cost of borrowing in the formal sector would most likely rise, this would focus borrowers on good quality, reasonable risk projects, since they would have to pay more for access to credit. This should help investment efficiency by improving the quality of projects in China’s domestic economy.
To achieve the reforms laid out in the Decision, the development of new financial products carrying different rates of return will be essential. For example, banks are experimenting with offering certificates of deposit to individuals and corporations at higher interest rates than savings accounts. Another major step is allowing corporations to offer corporate bonds to individuals and companies, rather than just to financial institutions. Pursuing these reforms would help create the conditions for interest rates to vary according to demand. Chinese banks currently hold large household savings deposits that could potentially be used for investment, and holders of the deposits could earn higher returns, if they were willing to take on more risk. Certificates of deposit would open new sources of investment funds for banks, and expanding the scope of corporate bond issuance would take pressure off banks to make loans at a time when concerns about are intensifying about bad loans on bank balance sheets.[i]
Evidence of demand for new investment products by households can be seen in services being created by Alibaba and the telecom companies to offer a return on funds held by these companies for deposits. Alibaba began its online investment service in 2013. China Unicom is planning to offer a similar service, starting with its Shenzhen contract phone customers.[ii] The rates of return are higher than those offered by banks on savings accounts. For example, Alibaba advertises a five percent annual return and China Unicom has said its service will earn six percent, while a one-year term deposit at the commercial banks is capped at 3.3 percent.[iii]
Currency Rates and International Capital Flows
A related piece of China’s financial market liberalization is the value of the yuan, or RMB. As long as the RMB value is fixed by the People’s Bank, and not by the market, the Central Bank cannot use the money supply as a policy tool. For example, in the current fixed exchange rate system, if the Central Bank decreases the money supply by raising banks’ reserve requirements—which would raise interest rates—there would be upward value on the RMB, and the Central Bank would simply have to increase the amount of RMB in circulation again to keep the RMB value stable. Hence, an important aspect of the Decision is a set of changes leading eventually to a market-determined exchange rate and more policy leverage for the Central Bank.
With a market-determined exchange rate, the value fluctuates with the relative demand and supply of that currency. This will mean volatility in the currency’s value. Chinese policy makers have thus far not been willing to accept such volatility, in part because China’s finance system does not have adequate tools to help companies hedge this type of risk. The Decision emphasizes making changes in an “orderly way” along with establishing risk management systems. The specifics of these challenges are not addressed explicitly.
Another risk factor in play here is the flow of money into and out of China. So far, access to foreign exchange or RMB for trade in goods and services is open and does not need special permission; however, access to currency for investments in China or in other countries is highly restricted. Again policy makers are concerned about volatility of capital flows, especially the possibility of “hot money” flowing quickly in and out of China to take advantage of short-term portfolio investment opportunities. These types of short-term portfolio flows add to currency and equity value volatility and have caused serious problems for many countries such as in Mexico in 1994 and Thailand in 1997.
Volatility concerns need to be considered. However, access to RMB and to foreign currency is increasingly important to the development of Chinese companies as global players. In addition, the RMB can potentially become one of the important international currencies, but this cannot happen without cross-border access to the currency.
Dealing with financial and public debt
Related to the growth equation is the issue of debt. According to one estimate, China’s bank credit to GDP ratio rose by 69 percent of GDP between 2009 and 2012.[iv] And although non-performing loans currently are not seen as a crisis issue, they have been rising for several years.[v] In tandem with this concern are worries about the financial health of local governments. Local officials have been major players in supporting growth since the early days of China’s reforms. Vigorously responding to incentives to develop their cities, towns, counties, and provinces, they had to manage with major constraints in access to capital. Public finance reforms implemented in the mid-1990s left them with larger expenditure responsibilities than local revenue could support. According to the Asian Development Bank, local governments’ share of revenue is 50 percent or less of total revenue collected but they are responsible for 85 percent of the expected government expenditure.[vi]
How has this been possible? Local governments have worked with development corporations that can borrow funds for local projects on the governments’ behalf. The Asian Development Bank estimates that local government debt is about 30 percent of GDP and is rising.[vii] According to Public Finance International, local direct and indirect debt is about 50 percent of GDP as reported by Moody’s.[viii]
To partially address this issue, the Decision includes reforms to allow local governments to issue municipal bonds to raise needed funds instead of relying on the indirect loans from non-bank entities. This would be another financial instrument that would affect interest rates and investment options across the economy. There is also a call to clarify center-local expenditure responsibilities. In addition, instituting real estate taxes has been discussed for some time now, both to increase local governments’ revenue streams but also to help manage the demand for housing, and this is included in the Decision.
Opening financing to the private sector
The slowing of China’s economy adds to the risk of default on outstanding loans held by both the public and private sectors. This brings us back to the delicate balance between trying to stimulate growth but not by increasing new loans too much or too fast. One of the goals of the Decision is to give more help to the private sector to increase its role as a driver of growth. During the summer of 2014, the Central Bank made a concrete move in this direction. The Bank exempted smaller banks from an attempt to slow loans by raising banks’ reserve requirements. In fact, a “targeted cut” was proposed for banks that lend to rural and small companies. In other words, those banks could lower their reserve requirements and thus increase their loans.[ix] Talk of helping the private sector is not new in China, but there have not been many concrete measures. This policy may not make a large difference to small, private firms, but it is at least in their favor and may be a sufficient incentive for banks to loan to them.
Financial reforms, growth and deficit/debt reduction represent a triplet of policy challenges that will not easily move forward together. Ultimately which one dominates in the short-run will be influenced by the need for political leaders to ensure growth above all. Annual growth estimates vary but tend to be between seven and 7.5 percent. If the actual growth falls much short of this, reforms will likely be put on a back burner, given the political sensitivity to a slowing economy. As of this writing, official growth rates are holding. Second quarter growth in 2014 was 7.5 percent—up from 7.4 percent in the first quarter.[x] The good news underlying these figures is that growth has not collapsed as some had predicted, and no doubt many others feared in silence.
Still, these growth targets do not allow for much experimentation. Most likely the interest rate pilot reforms will be the most robust, followed by exchange rate values determined increasingly by demand and supply of the currency. A completely open capital account will likely be the last step in China’s financial system development, but is certainly being discussed as a long-term goal along with the market determination of the currency. (See “China’s Currency Reforms from a Banker’s Perspective,” China Currents Vol. 13, No. 1, 2014.)
[i] Jiang Xueqing, “CD Liberalization ‘A Step Forward,’” China Daily, May 27, 2014, Business & companies p. 15, and Jiang Xueqing, “Analysts urge broader range of channels for sales of domestic corporate debt,” China Daily, May 24-25, 2014, business weekend, p. 10.
[ii] Meng Jing, “Telecoms dialing up financial products,” China Daily, May 27, 2014, Business & Companies, p. 16.
[iii] Jiang Xueqing, “CD Liberalization ‘A Step Forward,’” China Daily, May 27, 2014, Business & companies p. 15.
[v] Zheng Yangpeng, “Watchdog sure of nation’s bad-loan figures,” China Daily, May 31- June 1, 2014, p.2.
[vi] Takehiko Nakao, “The road to public finance reform,” China Daily, March 25, 2014.
[viii] Vivienne Russell, “Chinese local government debt risks stability of public finance,” publicfinanceinternational.org, January 6, 2013. Accessed June 10, 2014.
[ix] William Kazer, “China’s Central Bank Unveils Cuts in Reserve Ratios for Some Banks,” The Wall Street Journal, June 9, 2014, online.wsj.com. Accessed June 11, 2014.
[x] Michael J. Casey, “In China, Warnings Flash Despite Better Data,” FX Horizons, The Wall Street Journal, July 27, 2014. Online. Wsj.com. Accessed July 28, 2014.