A Better Way to Solve China’s Debt Problem

By Nathaniel Taplin

China tweaked its dysfunctional interest-rate system in late August, but held off on the deeper reforms needed to solve its bad-debt problem. Investors hoping for more radical change could be in for a long wait.

One reason is that fundamental reforms risk seriously damaging already-shaky bank balance sheets—and at a point when Beijing’s drive to replenish bank capital in the markets is under threat.

August’s rate “reform” was mostly an acknowledgment of changes that have already taken place. China’s central bank is phasing out its old benchmark lending rate, which banks were supposed to use as a basis price for loans, and replacing it with a “loan prime rate” derived from bank quotes. But the old benchmark had in effect been abandoned already. The People’s Bank of China hasn’t adjusted it since 2015, and banks are free to lend far above it. Weighted average lending rates midyear were 5.66%, compared with a benchmark of 4.35%.

To conduct monetary policy since 2015, the central bank has instead relied primarily on tweaks to banks’ reserve-requirement ratios and on special lending facilities. Loan prime rate quotes are now supposed to be based on the most important of these: the PBOC’s medium-term lending facility, which sported an outstanding balance of 3.4 trillion yuan ($476 billion) in August, up from zero in mid-2014. That huge balance means banks’ funding costs, and the rates at which they lend, already depend significantly on MLF rates. The new prime rate simply formalizes this.

The real problem for China isn’t bank lending rates, which have been more or less liberalized for years, but deposit rates. Banks can’t freely raise these to compete for deposits without running afoul of central bank guidance. That means regional banks that dominate small business lending struggle to attract funds, because retail depositors perceive them as less safe than bigger peers.

Banks are free to lend at interest rates far above the PBOC’s old benchmark. Photo: jason lee/Reuters

Cheap deposit funding instead flows to bigger banks, giving them little incentive to lend to private-sector borrowers. They can earn nearly risk-free money by funneling funds to inefficient state-owned companies. These can’t afford higher rates but are also highly unlikely to go bust.

Fully freeing up deposit rates would help solve both problems. Private enterprise would get a boost, and so would small banks that otherwise have to rely for funding on risky high-interest wealth-management products, “structured deposits” or other dubious workarounds.

Unfortunately, this reform would also mean that a lot of infrastructure and other state-owned loans made at too-low rates couldn’t be refinanced and would have to be written down, damaging bank capital. And banks might struggle to recapitalize themselves by selling equity-like perpetual and convertible bonds, as Beijing would like, because of problems at small lenders like Bank of Jinzhouand Baoshang Bank.

Uncertainty regarding creditor payouts after Baoshang Bank’s takeover by regulators this summer caused a brief panic in China’s money markets in June. On Sunday, Bank of Jinzhou announced it was withholding a year’s worth of interest payments on “contingent convertible” dollar bonds. Future buyers of such bonds may require significantly higher rates, if they are interested at all.

China needs deeper interest-rate reforms to win its continuing battle against bad debt and wasteful investment, but it also needs a lot more bank capital. Until the state steps in more forcefully to deal with the problem, aggressive—and much-needed—reforms to the way banks lend will probably remain on hold.

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