China's Partially Marketized Financial System
2013 has been a tumultuous year for the Chinese financial system. The first part of the year witnessed explosive credit growth not seen since the 2009 stimulus during the global financial crisis. Extremely rapid credit growth during the first part of 2013 led to growing unease in the People's Bank of China. The central bank later engineered a credit crunch in the interbank market, jolting financial institutions into recognizing their growing liquidity risks. Subsequently, the pace of credit growth slowed through the second half of the year but remained significantly faster than nominal GDP growth.
The immense variations in the growth of credit throughout the year have exposed a growing division within the Chinese financial system. The division is between financial products that respond to market forces and those that do not. First, let's look at the funding side for banks, traditional deposits, wealth management products, and the Shibor rate for interbank borrowing.
The two market-determined rates, the Shibor and the yield for wealth management products, show a steady tick up as credit conditions grew tighter during the course of the year. During the interbank credit crunch the Shibor rate is literally off the charts in the diagram above, peaking in the double digits. In contrast, the three-month deposit rate remained unchanged throughout the year.
This discrepancy between market-based and non-market-based financial products is also present on the lending side. Responding to tighter credit conditions in the second half of the year, yields on corporate bonds, treasuries, and bill acceptances all increased markedly. Loan rates, on the other hand, barely moved throughout the entire period.
What does it mean to have this type of split in the financial system? It's becoming increasingly important as the financial system becomes reliant on new credit channels. Previously, the flow of credit into the economy was highly loan-dominated, accounting for almost 100 percent of total social financing. That situation has changed rapidly over the past few years with non-loan financing accounting for close to 50 percent of new credit.
There are two ways to look at this. One viewpoint holds that having an increasing share of credit allocation influenced by market forces is a positive development. Savers now have the option of higher-yielding financial products, which help them escape financial repression in traditional deposits. The market-based lending rates will be more likely to go to underserved borrowers, those willing to borrow at higher rates because they are shut out of the financial system. All of this helps reduce the large distortions in the financial system.
An alternative perspective is that the creation of a bifurcated financial system is a recipe for disaster. The interactions between the marketized and non-marketized parts of the financial system are difficult to predict, and the space for regulatory arbitrage is immense. Because they are not being extended at market rates, loans may not be going to the most creditworthy or productive borrowers. At the same time, the growth of non-loan credit is taking place in a markedly inferior regulatory environment compared to traditional banking.
The truth lies somewhere in between these two viewpoints. The growth of market-determined financial products is a positive step towards a more diverse financial system. It is healthy for China's state-owned banks to not be the only source of financing in the economy. At the same time, the lack of response of loan and deposit rates to significant credit cycles and poor regulation of non-loan financial products are sources of concern. These issues raise serious questions over the quality of capital allocation during the past several years.
Half of all credit in the Chinese financial system is issued at market-determined rates but in an inferior regulatory environment. The other half of credit is issued at distorted interest rates, but is more closely regulated. China's peculiar bifurcated financial system is a risky proposition over the long run.