Chinese Premier Li Keqiang has shown China’s bankers that he’s not to be trifled with. Since assuming office in March, Li has urged them to curb speculative lending, with little effect. In mid-June, he abruptly cracked down. The People’s Bank of China (PBOC)—which, unlike the Federal Reserve, takes orders from the government—broke with custom and didn’t supply funds to the banking system to offset a liquidity shortage. Interbank lending rates, the interest that banks charge each other for short-term loans, soared as banks scrambled to fill the hole in their balance sheets. It was the central banking equivalent of whacking a hog across the snout.
The hard-line approach contributed to the biggest drop in Chinese stocks in almost four years and alarmed investors worldwide. “Allowing liquidity to dry up to communicate your message strikes us as a dangerous game,” says Andrew Elofson, senior research analyst in Seattle at asset manager D.A. Davidson. Li relented the next week, but only a little. Late on June 25 the central bank announced it would act to ensure adequate liquidity. The next day the widely watched overnight repurchase rate was fixed at 5.6 percent—off its June 20 peak of nearly 13 percent, but well above its average of 3.1 percent this year. “Welcome to Li Keqiang’s surgery,” Stephen Green, head of Greater China research at Standard Chartered, wrote in a June 21 note.
Li and President Xi Jinping want to suppress speculation, end the overreliance on exports and investment, and build a consumption economy. In doing so, the leadership is taking aim at traditional lending as well as the shadow finance sector, whose assets have nearly doubled since 2010 to equal 69 percent of gross domestic product, estimates Haibin Zhu, chief China economist at JPMorgan Chase in Hong Kong. The industry operates with little regulation, getting funds from banks or individuals and using them to make loans, usually at high interest rates with short maturities. While the loans can channel capital to worthwhile companies, they also finance marginally useful projects. Trust companies package these loans into high-yield “wealth management” products for investors.
The government must tighten credit enough to curb speculation in real estate, but not so much that it triggers widespread defaults and bank failures—the very problems it’s trying to stem. China’s usual fallback when growth slows is to open the credit spigot to encourage investment. Yet it doesn’t want to this time because one aim of the reforms is to reduce unproductive overinvestment. “China needs to stop forcing [state-owned enterprises] to make lousy investments. Yet it is precisely the government’s ability to get the state sector to invest, regardless of the short-term outlook, that kept growth from being even weaker in the 2008 and 2012 downturns,” writes GK Dragonomics research director Andrew Batson.
Excessive credit has saddled China with factory overcapacity, empty apartment complexes and office buildings, and expressways that few cars use. “The debt snowball is getting bigger and bigger, without contributing to real activity,” Société Générale economist Yao Wei wrote on May 30. The firm estimates that the debt of corporations and local government financing vehicles is the equivalent of 145 percent of China’s gross domestic product. The annual cost of servicing that debt is a “shockingly high” 39 percent of GDP, he calculates.
Reorienting China’s economy requires defeating entrenched defenders of the status quo, including banks, state-owned enterprises, and mayors and provincial governors. The violence of the market’s reaction to credit tightening shows just how tricky the transition will be.
Bankers needed financing after they had supplied customers with a lot of cash ahead of the dragon boat holiday in early June. They also needed funds because a crackdown on false invoicing of exports, a common way of smuggling money into the country, had hit capital inflows. With growth slowing and inflation low, the banks had reason to believe the PBOC would accommodate them. Instead, the central bank sent a message that bankers must take responsibility for their own liquidity needs.
The PBOC has said that it intends a gradual reform of interest rates to make them more market-based. That would benefit savers, who earn low yields, and penalize currently favored borrowers. The June jump in rates can be seen as a first step toward normalizing rates in the face of political opposition, says Nicholas Lardy, senior fellow at the Peterson Institute for International Economics in Washington. It “does reflect substantial strength at the center” of China’s leadership, he says. “They didn’t cave in. They didn’t flood the market with liquidity as soon as rates went up.”
Li was the main supporter inside the Chinese government of the World Bank’s “China 2030” report, a sweeping call for economic reforms issued in early 2012. This year the central government has ordered the creation of seven broad reform “task forces,” reported Caixin Online, the English-language website of business and finance news, on May 16. Those include “finance; the fiscal system; land; production prices; trimming bureaucratic review; the income gap; and the household registration system.” They will be unveiled at the Third Plenary Session of the 18th Central Committee of the Chinese Communist Party in the fall.
Reforming state-owned enterprises is not on the plenum’s list of priorities. “Li Keqiang still does not have the power to restructure huge conglomerates,” says Willy Lam, a professor in the history department at the Chinese University of Hong Kong. “Many princelings are running these companies.”
Still, moving to market-based interest rates would pressure state-owned enterprises to become more efficient or shut down, says the Peterson Institute’s Lardy. Explicitly targeting those enterprises would cause them to “dig in immediately,” he says, whereas allowing borrowing costs to rise is “stealth reform.”
The state sector, though inefficient, has been the driver of investment-led growth and has benefited many officials. Banks that are told to be cautious with lending may decide the safest course is to reduce loans to private companies while continuing to lend to state-owned enterprises: They have implicit guarantees of support from Beijing. Moody’s Investors Service in a June 24 report wrote that “a prolonged credit crunch would threaten weak private-sector corporates.”
With enormous exchange reserves and a strong grip on the banking sector, the Chinese leadership can make sure things don’t spin out of control. Royal Bank of Scotland chief China economist Louis Kuijs wrote on June 24 that any difficulties in the shadow banking system probably won’t be “large and systemic enough to overwhelm macroeconomic and financial stability.” It will still take more than a whack on the snout to get China’s economy headed in the right direction.