Carl Walter: Going for broke: China stimulus blocks financial sector reform
In late June, China's official Xinhua News Agency reported that Premier Li Keqiang had assured the world that China would take "appropriate measures" to achieve the government's 7.5% economic growth target. Here, "appropriate measures" means more credit of all kinds to drive more investment. For Li this seems like a tough stance to take. In late 2010 he famously voiced doubts about the accuracy of China's gross domestic product figures. As recently as March he indicated that the government would be flexible in its approach to economic growth targets this year. Now for some reason, the premier finds he must rely on a pseudo-number that he knows his colleagues in the government will achieve by any means necessary, appropriate or not.
His policy reversal is easier to understand if job creation is substituted for GDP growth as the motive. As China's politicians unfailingly state, social stability is the key to continued success, and jobs are the key to stability. So the premier's anxiety must stem from his belief that job creation has slowed to unacceptable levels.
So, goodbye to the idea of transforming the economy to a consumption-driven powerhouse. Instead, say hello to the tried and tested approach of building high-speed railways and 100-story buildings by adding to banking assets that are already 2.5 times the size of the country's GDP. Amazingly, in the past four years China's banking system has surpassed its U.S. counterpart. It is now about to reach a size double that of the U.S., which it will supposedly achieve with almost no problem loans. Whatever "mini stimulus" the politicians whip up will mean that these already bloated bank balance sheets will continue to expand. It is this huge financial bubble, not social stability, that is the greatest risk to China economically and politically. But the premier's decision to chase GDP growth means that the likelihood of this risk being addressed any time soon is close to zero -- and that means there will be no real financial reform.
Banks account for 94% of China's domestic financial assets, banks that are owned by Chinese state agencies. Foreign financial institutions hold less than 2% of financial assets -- a number that is shrinking rather than growing. State-owned banks, in short, absorb almost all financial risk, including interest rate, market, credit and operational risks -- and anyone who thinks operational risks are less prominent should take a look at the huge losses that will flow from the current copper and gold lending scandals.
Bank balance sheets everywhere, at best, slowly adjust to changes in market conditions. But in China, where capital is priced administratively by the government, the adoption of market-based capital pricing would be very costly for the banking system. Bank funding costs would immediately ratchet up as banks competed for deposits. Interest rates would rise, as we have seen in the case of so-called wealth management products, and the banks would pass the increased costs on to borrowers. State enterprises and local governments would be hit hardest because nonstate borrowers are already paying what are in effect market rates. This looms as a major political obstacle to any reform, as well as a potentially serious credit issue.
The damage to bank balance sheets might be an even bigger problem. This is because the cost of deposits is the foundation on which these balance sheets are constructed. This cost has always been set by the central bank, which has also set a minimum lending floor. This arrangement has guaranteed bank profitability and made China's big state banks the most profitable in the world.
However, this means that China's banks have never had to develop the ability to price capital. In effect, these entities are not banks at all, if the term is taken to mean institutions that act as intermediaries between investors looking for a return and borrowers seeking to minimize their cost of capital. To succeed in such a role bankers must have a keen appreciation of how to evaluate risk and how to price capital. But China's banks are simply conduits for state monopoly retail and corporate deposits as directed, ultimately, by politicians. Bankers have never had to develop any appreciation of risk or its cost; the Communist Party leadership has done it for them.
This is what makes interest rate liberalization in China so difficult. Simply widening the band around a nonmarket interest rate paid for deposits does little to change the current framework. But a "Big Bang" change would lead to serious bank losses that might continue for some time. This would spell the end of any government economic stimulus package.
As an example, the average rate charged on loans by the top four state banks in 2013 was about 5.5%, compared with a funding cost of about 2.6%. The average rate earned on bond portfolios was much narrower at about 3.6%. To provide an idea of how much banks might lose should interest rates change abruptly, bank annual reports quantify the effect of a one percentage point uniform increase in the yuan yield curve with no change in deposit rates. For example, such a move for China Construction Bank would result in a loss of nearly $6.7 billion in interest income, based on its balance sheet at the end of 2013.
There are two problems with this calculation. The first is that there is no real yuan yield curve, the one being used by auditors to calculate this number is set administratively by the central bank. Secondly, if deposit rates were truly freed up, net interest margins for all banks would collapse as funding costs jumped. And there is virtually no way for the big state banks to lay off even a part of their interest rate risk: All other participants in the financial system are also owned by the state. Similarly, if the yuan were made convertible, Chinese investors would be free to seek higher returns elsewhere in the world; again, bank balance sheets would be threatened. Losses would go far beyond the $6.7 billion.
The central bank's reform agenda, which includes changes to the interest rate, currency and capital account frameworks, runs smack bang into the reality of these artificially constructed bank balance sheets. And the more "mini stimulus" programs there are, the more difficult and costly it will be to adopt the reform agenda. It would take a brave politician to admit that China's banks are fundamentally undercapitalized, rather than the world-beating powerhouses they appear to be. Cleaning up this problem will require a sustained commitment to a second round of bank restructuring and recapitalization, similar to that advanced by then Premier Zhu Rongji in 1998. It is obviously far easier for China's politicians to build megaprojects that aim to reflect the Chinese Dream.
Carl Walter worked as a banker in Beijing for 20 years and is now an independent commentator specializing in China economic and financial issues.