China’s financial markets are under pressure for the second time this year. Interbank rates and bond yields have been rising steadily for several weeks and spiked recently when the People’s Bank of China abstained from accommodating seasonal demand for cash.
The PBoC then relented before last weekend and this week. The immediate outlook, while probably volatile, is most likely manageable without too much fuss but the crunch in financial markets symbolises a major and unpredictable policy struggle over the medium-term to tame rapid credit creation, and allow a market-determined cost of capital to emerge.
The simple place to start is the seasonal demand for funds, and normal “window dressing” by banks as they prepare for regulatory assessment. This could last a few weeks and until lunar new year at the end of January. Other factors have also contributed to the tightening of financial market conditions. For example, the build-up in government deposits in the banking system is not being run down as normal to finance government spending growth. This is in keeping with the more sober fiscal stance announced recently after the Third Plenum. Further, financial liberalisation is creating funding demand for initial public offerings in the equity market, with about 50 in the pipeline. It is also driving competition for deposits away from traditional banks and to the relatively new wealth management industry, which originates higher yielding, short-maturity financial products, many of which are up for renewal around this time of year.
The main worry, though, is that China’s financial markets are in the crosshairs of much bigger issues – the credit cycle and economic reforms. Serial tensions in financial markets may, therefore, become the norm, reflecting attempts to damp down a virulent credit expansion at a time when the political drive towards financial liberalisation and a greater role for markets are supposed to be picking up speed.
China’s credit boom is still in full swing. Total credit in the economy (total social financing) showed a 40 per cent rise in November over the prior month and is on course for growth this year of almost 20 per cent. It is continuing to expand at twice the rate of nominal, or money, gross domestic product, and according to official data has pushed the credit to GDP ratio up to 215 per cent in 2013, and most likely more. It is clear that banking institutions, state-owned enterprises and local government financing vehicles have remained relatively insensitive to, or been able to circumvent, higher interest rates and bond yields, central government curbs on the shadow banking sector, and the rampant real estate and infrastructure markets.
Financial reform, which lies at the heart of China’s reform wishlist, embraces the eventual liberalisation of deposit rates, and the determination of interest rate levels by markets. But it is hard not to conclude that the authorities remain conflicted. They are happy for the financial sector to experiment with new products on- and off-balance sheet, allowing the system gently to displace state allocation of capital through decreed interest rates, loan quotas, loan-to-deposit ratios and specific credit restrictions.
On the other hand, they disapprove of financial institutions taking advantage of financial innovation and bypassing administrative and regulatory measures governing capital adequacy and loan-to-deposit ratios. The interbank market, where the interest rate crunch has taken root, has been central to the expansion of loan assets outside the conventional remit of loan regulation, and has been an important conduit for the build-up in non-financial and financial leverage and liquidity needs.
We should also note that the PBoC is not experienced when it comes to managing modern, complex financial markets, which are gradually being opened up to market forces, and to external impulses, such as the recent US tapering decision. The scope for operational and strategic error is considerable. The major operational problem for the PBoC is how to deploy its tools between targeting interest rates, and bringing down the rate of credit expansion.
A hitherto strong focus on managing interest rates, even with the occasional liquidity squall, has meant that credit growth and leverage have continued to rise rapidly. This is prolonging economic growth at current levels, but could lead to a solvency crisis in which an even higher debt burden and non-performing loans would eventually threaten both economic growth and financial reform. If China switched its focus to controlling credit expansion, on the other hand, the consequences would be much higher and more volatile interest rates. It could turn into a full-blown liquidity crisis, if political nerves held, and inevitably a cost to economic growth and to balance sheets, But this might lead to a speedier and more effective economic adjustment. These are the big issues, hinted at by the current hiatus in China’s money markets.
The writer is an economic consultant and the former chief economist of UBS