China Could Reform Its State Businesses by Stealth
Op-ed in the Financial Times
© Financial Times
Short-term interest rates in China's interbank market jumped to historic highs last week. As well as creating turmoil in markets around the world, the move raised questions about the competence of the country's management of monetary policy, its growth prospects, and the trajectory of economic reform under the new leadership of President Xi Jinping and Li Keqiang, prime minister.
While rates have since come down, a view has taken hold that the People's Bank of China (PBoC) was caught by surprise and was slow to react to the freezing up of short-term money markets. Some analysts even reckon there was a serious policy miscommunication—one that carries the risk of defaults on interbank payments and even the failure of some smaller financial institutions.
But such views are not well-founded. The central bank was signaling that credit growth was excessive well in advance of the rise in rates. And the China Banking Regulatory Commission was issuing new regulations to curtail the growth of shadow banking. In particular, it targeted controversial wealth management products—lightly regulated time-limited deposits with high interest rates—the financing of which is closely tied to the interbank market.
The PBoC deliberately allowed rates to rise as a shot across the bow of midsized financial institutions that were borrowing heavily in the short-term interbank market to finance longer-term loans. The consistent central bank message has been that banks need to better manage liquidity risk. Furthermore, the PBoC has a range of other instruments to increase liquidity. The risk of a financial institution failing as a consequence of tightening liquidity conditions is vanishingly small.
The episode should not further reduce expectations for China's economy. Growth was weak in the first quarter and is likely to have weakened further in the second for reasons that are well understood—moderating investment growth in the face of substantial excess capacity in many industries, weakening demand, and very modest export growth.
The sharp increase in rates has led to increases in other short-term rates and temporarily curtailed the growth of some types of longer-term credit. For example, a number of planned corporate bond issuances have been delayed. But the rise does not presage a sustained general tightening of bank credit and other longer-term sources of funding that would further drag down economic growth. Growth may well slow further but this will be more because of fundamentals than credit market developments.
Indeed, the episode is generally positive for the trajectory of economic reform under China's new leadership. Mr. Li in recent speeches has specifically rejected the view that a new stimulus program should be launched to counter slowing growth. He warns that the room for further stimulus is narrow and, in any case, would create new risks and problems. Rather, he has signaled that China should rely more on the market to sustain economic growth.
A key component of this reform program is the gradual adoption of market-oriented interest rates, which means eventually abolishing the ceiling on rates paid to bank depositors that has led to a low interest rate environment for the better part of a decade.
The implicit message of recent developments in China's money markets is that broader interest rate reform is coming and that the corporate sector, which has borrowed heavily, will need to cut costs and improve productivity in order to remain profitable.
This is particularly true for state-owned businesses, whose return on assets has fallen significantly in recent years and whose financial losses have grown substantially. While reform of state-owned enterprises is not specifically on the leadership's reform agenda, interest rate liberalization will force reform on them by stealth. Companies that cannot sustain profitability as rates rise will have to sell assets, be taken over by stronger players, or give up.
Simultaneously, interest rate reform will boost economic growth by increasing further the flow of credit to China's more creditworthy businesses. This will mostly favor the private sector, where the average return on assets is currently about three times that of state firms.
Of course the banks that have benefited from the cosseted interest rate environment of recent years will resist reform, as will the most heavily leveraged portions of the corporate sector.
Whether China's new political leadership will be able to overcome these and other vested interests will be the most crucial determinant of the success of planned reforms and the prospects for sustaining economic growth during the ten-year term of the new leadership.