Without Interest Rate Reform, China Will Not Pull Private Lending Out of the Shadows
RGE has long argued that without interest rate reform, the People’s Bank of China (PBoC) will eventually lose control of the country’s money supply. This is probably a strange thing to bring up after what appears to have been a very successful tightening cycle in which M2 growth has slowed to 13.1% y/y in Q3, well below the 18.1% y/y increase in nominal GDP, and inflation is headed toward the government’s target of 4% y/y. But the recent credit crunch in Wenzhou should be seen as a warning to the PBoC that it cannot continue to rely on quantitative measures to implement its monetary policy. If the cap on deposit rates is not lifted, China’s economy will continue to grow unbalanced in ways that will prove uncontrollable for policy makers.
The regulatory cap on deposit rates means that households are legally forbidden from earning real interest on their savings when inflation is elevated, which naturally pushes savings into unregulated vehicles. We estimate that the size of the shadow banking system (trust companies, entrusted loans, bank acceptance bills and private lending syndicates) more than doubled in 2010 to about RMB13 trillion outstanding, and nonbank lending has maintained its share of total financing in 2011 even as trust companies have come under severe regulatory pressure. The PBoC has admitted that its money stock estimates are understated because of the growing shadow banking system, and its metric of Total Social Financing, set up only last year to better capture off-balance sheet lending is already out of date, since it led to new financial engineering feats to avoid regulatory detection. Shadow financing relies on complicated structures and short maturities which are prone to sudden stops when confidence concerns percolate up. Wenzhou famously relies on shadow financing to support its small, entrepreneurial, low-margin companies, but developers in Ordos and exporters in Guangdong are coming under similar stress.
As long as deposit rates are artificially repressed, banks will find it difficult to finance themselves, and SMEs will have to turn to private networks for funds. (The PBoC may approve a wholesale funding scheme for SME loans soon, though this would be risky for the banks, since they have been deposit funded to-date, and when BYD is considered a SME, it’s really a pointless exercise).
How high would deposit rates be if banks had to pay a market rate? That’s simple. The government naturally carves out an exception to the rule for itself and the Ministry of Finance regularly auctions off term deposits to the highest bidder. This year banks have been paying record rates for the pleasure of holding on to the government’s money. On October 25, the winning banks paid a yield of 6.83% for RMB60 billion of six-month deposits, higher than their 6.56% one-year lending rate. Put simply, if banks had to pay a market rate for deposits, they would be out of business. If they raised lending rates to compensate for the negative net-interest margin, their customers would go broke. The Economist writes, “A 2009 study by the Hong Kong Institute for Monetary Research found that if state-owned firms were to pay a market interest rate, their profits ‘would be entirely wiped out.’”
On the other hand, if banks are not forced to compete for deposits, the PBoC will increasingly see its influence over the credit channel disappear into the shadows.
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