Michael Pettis has a rather interesting article up on the website for the Carnegie Endowment for International Peace, discussing China’s banking system and how it needs to be reformed. While I agree with his general conclusion that the Chinese banking system is dysfunctional, I think he’s somewhat oversimplifying how the Chinese banking system works, which is leading him to exaggerate some of the macro-risks in the system.
Pettis describes the Chinese financial system as:
Acting largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Typically the key objectives in this kind of banking system are rapid elite-directed growth and overall financial stability… In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors.
While everything he says above is true, it doesn’t accurately reflect how the Chinese banking system operates within the Chinese economy. Chinese banks act more as secondary form of central banking. Because the Central bank has fairly little control over monetary inflows and outflows due to chronically low interest rates and a fixed currency, total money supply is disproportionately determined by reserve requirement ratios, and direct lending caps. The banking sector makes lending decisions, but it has far less control over final capital allocation than Western banks do because of China’s extremely large number of secondary sources of capital. A few examples:
1. State-owned enterprises often act as guarantors of capital, even for projects far removed from their traditional mandate.
2. Private businesses are almost always funded through the savings of networks of private entrepreneurs. In this way you can understand the Chambers of Commerce of Chinese cities as sorts of lending institutions. As well as a variety of unofficial networks.
3. Southern China sports a gigantic unofficial financial system.
In my conversations with Chinese entrepreneurs, my experience is that far and away the largest source of funds for the private sector, even fairly large companies, is the second method (For example, the boss of Gree, the largest air conditioning company in the world, often brags that he has never taken a bank loan). State-owned companies, which are the largest recipients of direct bank lending are primarily focused on lowering costs for the private sector through the acquisition of commodities and the development of infrastructure, and their effect on the macro-economy should be understood as such.
The situation is rather more complex, as there is cross-over between the domains of the unofficial and the official banking sectors, but accounting for the secondary banking system goes a long way towards understanding why:
1. China has an abnormally high savings rate.
2. Private Chinese companies have found it exceptionally difficult to develop into large scale multi-nationals.
3. Chinese investors are particularly interested in easily liquidated hard assets, such as gold and real estate (because of the relative ease of getting home-equity loans).
4. China has maintained high growth despite having a dysfunctional financial system.
Obviously a more Westernized financial system would be much preferable to the current system, which contrary to Pettis I believe is relatively unstable (regular asset bubbles and an unstable corporate environment are hallmarks of the Chinese economy). But interest rates reform, Pettis’ primary proposal, might not have the desired effect. Because China uses direct quantitative monetary controls, interest rates have little to no effect on capital allocation. Higher interest rates increases deposits, which does “cool” the economy, but a large scale liberalization of interest rates probably will not have the effect of decreasing misallocation of investment in the corporate sector, and may actually increase it.
What’s needed is quite a bit larger. China needs to liberalize its currency so it doesn’t need to use quantitative monetary controls. It needs to privatize its economy so lending isn’t a matter of switching money between government pockets, and once those two things are accomplished it can raise interest rates in order to profitably integrate the informal and formal banking system.
Though China has already begun liberalizing its currency, the entire process will take a fairly long time. Luckily, in the meantime the informal banking sector is keeping the macro-economy in rude health.