Chinese officials are far better at self-criticism than their counterparts elsewhere.
Ten years ago, then premier Wen Jiabao declared that the country’s economy was “unstable, unbalanced and unsustainable”. Last month, the governor of China’s central bank, Zhou Xiaochuan, blasted the country’s financial system as, if I were to paraphrase, “messy, shaky and risky”.
These are all music to the ears of some China watchers who have maintained a 12-month rolling forecast of a major crisis.
But is the financial system really as bad as some would have us believe?
In his published essay, Zhou highlighted two major problems in the financial system: rapid growth of credit, and dangerous activities in the financial sector in general and subprime credit sector in particular.
Rapid growth of credit has long been an issue for China. Analysts have examined all sorts of metrics: ratios of GDP to money supply and to credit, and total debt in the corporate and household sectors. All these are off the charts in China when compared to other countries and the its own historical records.
The only things that are missing are “the cracks on the wall”, so to speak. On a theoretical level, no one has convincingly explained how a high credit ratio will inevitably lead to the collapse of the banking system, or how high a ratio is too high.
Over the past four decades, China’s typical response to any headache in the economy has been to throw fiat money at it. It has worked, at least so far. The quantitative easing the European and US governments have resorted to in the past decade has only given Beijing’s economic planners some vindication.
I spent the past six months looking at the country’s fast-growing subprime credit. To my surprise, I came to a generally positive conclusion.
It is true that many fraudsters have taken advantage of regulatory loopholes to fatten their pockets, and that millions of retail investors and borrowers have been taken for a ride. However, the activities in the non-bank financial sector are helping make the banks safer and more profitable.
Almost every segment of the non-bank financial sector is growing rapidly in China: trust loans, wealth management products, private funds, and peer-to-peer lending. However, they have drawn more and more subprime customers to their orbit, leaving the banks with only the prime customers: the state sector, big businesses and prime quality consumers.
Moreover, they often team up with the banks in structured deals that give the lenders the senior tranche, and themselves the riskier subordinated tranche. In risky loans, they invariably act as the banks’ deal originators, servicers and guarantors.
If the central bank is really concerned about the rapid growth of the shadow banking industry, it should know what action to take: it should tackle the problem at the origin, that is, it should liberalise the long regulated interest rates of bank deposits.
For too long, returns on bank deposits have mostly been set below inflation rates, creating strong incentives for the saver to look for better deals elsewhere. Money market funds offer 4 per cent annualised returns compared to 0.3 per cent for demand deposits at the banks. State-owned commercial entities’ wealth management products yield 5-7 per cent a year, and peer-to-peer lending platforms give retail investors about 10 per cent.
Naturally these financial products are less safe than bank deposits, but the big yield gaps have made them very popular, leading Zhou to sound alarms.
Retail investors are not as naive as the government thinks they are. Despite sensational media reports of the demise of Ponzi schemes and frequent warnings about the high risks of the shadow banking products, hundreds of millions of retail investors flock to them. And their losses in the shadow banking sector are nothing compared to their sufferings in the state-favoured stock market.
In the meantime, the regulated prime lending rates in the banking sector are too low and create a huge subsidy to the privileged borrowers such as the state-owned enterprises and well-connected businesses. Low rates stimulate demand for credit and encourage wasteful investments including white elephants and real estate purchases. Unmet demand in the banking industry spills over to the shadow banking sector, fuelling what Zhou described as the illegal and dangerous liaison between the banks and non-bank institutions.
To be sure, China is not on the verge of a banking crisis but the frantic activity in the shadow banking industry accentuates unfair competition, corruption and inequality. Liberalising bank deposit rates will go a long way towards reducing credit growth and shrinking the shadow banking sector.
The writer is the author of the book, Chasing Subprime Credit: How Fintech Is Thriving in China.