But after a technical default between two small banks sent interbank lending rates soaring in early June 2013, Beijing refused to inject liquidity into the market, attempting to smash its implicit guarantee. This caused an almost cataclysmic new problem. Within days, interbank lending ground to a halt, sparking a liquidity crisis that began to spread into the rest of the economy. Beijing capitulated by the end of the month, intervening more forcefully to keep interbank lending rates stable.
Markets stabilized for the next two years, but the measures exacerbated other problems. By capitulating, Beijing erased any doubts about its implicit guarantee of off-balance sheet assets. And by reducing volatility in money markets, it only increased incentives for yield-seeking banks to further expand the shadow banking bonanza. By 2016, according to the rating agency Fitch, total shadow banking assets had surpassed 70 percent of GDP. Beijing’s attempts to crack down with new regulations mostly just pushed banking activities further into the shadows. Finally, in 2016, President Xi Jinping declared financial risk a priority on par with national security, and Beijing moved more decisively to bring the party to a close. Greater short-term volatility was allowed in money markets, making speculative lending less lucrative. China’s outdated regulatory apparatus was overhauled to close loopholes and eliminate arbitrage. Stringent new rules were announced, and Xi’s feared anti-graft drive was expanded to ensure compliance.
By most metrics, Xi’s measures appear to have worked, at least in terms of pushing lending back onto balance sheets. In 2018, according to Moody’s, the shadow banking sector, which had peaked at 87 percent of GDP, contracted for the first time in a decade, dropping back below 70 percent. Outstanding loans in the sector dropped 6.5 percent. New loans in the formal banking sector, meanwhile, increased 13 percent year on year. Yet, once again, the reforms have spawned new issues – ones that can’t be fixed painlessly.
Treating the Symptoms
For all the risks it spawned, shadow lending has helped keep credit flowing to areas where formal lending channels were falling short; the American Economic Association estimates that 80 percent of private firms in China have relied on shadow banking at some point. Without it, China is once again grappling with a credit crunch. Total social financing, a broad measure of credit and liquidity, contracted for most of 2018, until Beijing started boosting monetary stimulus toward the end of the year. According to Financial Times data, Chinese banks will need to raise some $260 billion in fresh capital over the next three years as they start to put informal loans on their balance sheets. Private firms, in particular, have been hit hard, accounting for 16 billion yuan of the 20 billion yuan in onshore bond defaults in China last year, according to Natixis.
The private sector now accounts for more than 60 percent of GDP, and it’s creating 90 percent of new jobs in China. But firms in the all-important coastal provinces are the most vulnerable to the trade war with the U.S. The problem is that newly risk-averse Chinese banks are simply ill-suited and poorly incentivized to meet the sector’s needs. It’s easier, less risky and often politically advantageous to prioritize state-owned enterprises – which banks can be sure won’t be allowed to collapse – rather than gearing up to make prudent assessments of scads of private firms in dubious financial standing.
Beijing has to find a way out of the credit crunch, but it’s trying to avoid another overcorrection. The measures announced at the NPC, particularly the tax cuts, are a relatively low-risk way to keep money in private sector accounts. Beijing also continues to pledge that it’s not about to flood the economy with stimulus on the scale of 2008. Senior regulators, meanwhile, are hinting they might be willing to allow the return of some “good shadow banking activities” – that is, anything that prudently channels money into the real economy. Whether they can really monitor activities that were designed to be hidden closely enough to distinguish between good and bad off-book lending (when even banks have struggled to do so) is another question.
Regardless, some fallout from these measures is inevitable, particularly as growth slows. At minimum, forcing banks to lend more to private firms will undermine the government’s parallel goal of limiting overall credit growth. More important, the underlying structural and political problems locking Beijing in this high-stakes game of financial whack-a-mole haven’t gone away. The new emphasis on financial supply-side structural reform suggests that Beijing may be gearing up for major surgery. The government today is certainly better equipped than previous administrations to spur reform among the entrenched interests opposed to painful restructuring.
But at this point, the proposed reforms are more an acknowledgment of China’s problems than a detailed plan for fixing them. Meanwhile, Xi has only deepened the role of state-owned firms in the economy and party influence over private firms. Similarly, keeping firms reliant on banks for financing rather than channels like investors and stock markets is another lever of the party’s power. When the choice is economic efficiency or control, Xi chooses control; state dominance of the economy is indispensable. There’s nothing to suggest China has any real intent or ability to build a liberalized, dynamic formal financial sector capable of meeting a dizzying mix of oft-conflicting political and economic aims.
To address moral hazard, meanwhile, Beijing has been desperately trying to persuade banks and investors that off-balance sheet instruments like WMPs are not government guaranteed, and the government refused to intervene during a spike in peer-to-peer defaults last year or amid the recent surge of private sector bond defaults. But neither of these posed systemic risks. What’s clear to the financial sector is Beijing cannot stomach the collapse in growth that would come with a widespread credit crunch. Neither can it stomach the political fallout of a cleansing financial crisis. Beijing can yell about prudence and moral hazard until it’s blue in the face; it’ll still be stuck searching for a way to let the economy drive itself – without letting it drive over the precipice.
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