Earlier this month, China’s leading-party bigwigs announced a package of economic reforms. Alongside assurances to change the one-child policy and alleviate harsh residency laws, a number of financial measures were promised. State-owned banks face competition from the private sector, interest rates will be deregulated and capital controls relaxed. On paper, the reforms should satisfy the most ardent exponent of free markets, but their practical consequences might be less welcome.
Wall Street’s reaction has been nothing short of euphoric. One sellside economist writes that the reform package had “met 100 per cent of our already extremely bullish expectations”. Another investment bank hails the “most ambitious top-down economic reform initiative in the history of the People’s Republic”.
The consensus appears to be that the introduction of market-based reforms will lift China’s economic growth potential while simultaneously reducing macroeconomic risk.
As a general rule, when Wall Street gets excited it is best to keep a firm grip on your wallet. Let us consider the potential consequences of two significant reforms: interest rate and capital account liberalisation. Beijing has long maintained control over bank lending and deposit rates. While low deposit rates have reduced the income of savers, government-controlled businesses have enjoyed access to cheap credit.
The banks have also benefited from fat net interest margins, generating profits to offset the inherently poor business of lending to state-owned enterprises, which have a tendency not to repay their loans. Government control over interest rates, together with a near monopoly over deposit banking, allows Beijing to direct the country’s vast pool of savings to its own ends.
After Lehman’s collapse, a massive surge of bank lending to infrastructure projects helped maintain the country’s economic growth. Since that date, it has become addicted to cheap credit. As Charlene Chu, China bank analyst at Fitch, the rating agency, points out, over the past five years non-financial credit in China has grown by more than 65 percentage points relative to gross domestic product.
Liberalising interest rates would raise the cost of borrowing. Following the recent credit splurge, the cost of servicing debt at the national level is dangerously high. Furthermore, many of China’s state-owned enterprises are in a financially distressed condition. If interest rates were set by the market, and included a proper charge for credit risk, the insolvency of much of the corporate sector would be revealed.
In truth, China’s financial system has already experienced a de facto liberalisation. The banks are forced to compete for deposits with the shadow banking system, which offers higher rates on trust loans, wealth management products and other credit products. This year more than half of new credit creation in China will take place outside the traditional banking system. Banks are caught between a rock and a hard place. Their current lending practices are unsustainable, but it is difficult to introduce genuine reform without impeding the banks’ ability to generate new credit.
Wall Street is also hailing the promised liberalisation of China’s capital account, which many analysts believe will lead to large capital inflows and further currency appreciation. But it is easy to envisage the opposite occurring. Capital controls have trapped savings in China, forcing savers into low-yielding deposits or property speculation. In recent years, however, more and more people have been secreting their money out of the country. If capital controls were abolished, this trickle might turn into a flood.
Large-scale capital outflows would produce an unwelcome tightening of financial liquidity, as the central banks would have to sell foreign exchange reserves in order to protect the currency peg.
The risks attendant on opening China’s capital account have been rising. Corporates have lately taken to funding themselves with cheap foreign currency loans. Not only have they reduced their interest costs, but they have also benefited from the appreciation of the renminbi. The carry trade has proved profitable to date, but it leaves China dangerously exposed to the vagaries of international capital flows. When the Fed started its taper talk last summer, liquidity in the Chinese interbank loan market froze immediately. The Bank for International Settlements has warned that China’s banking system has large, and rapidly growing, net foreign liabilities.
It is comforting to think that Beijing’s mandarins are reading more Adam Smith than Mao nowadays. Unfortunately, their financial reform agenda arrives rather too late in the day. In the words of Ms Chu: “It would be very risky to embark on aggressive liberalisation in the midst of one of the biggest credit booms in modern history.”
Edward Chancellor is a member of the asset allocation team at GMO, the investment manager
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