China’s Communist Party leaders say they’re learning to love free markets. The world is about to learn how much. With an economy at risk of sagging under the weight of surging debt, the government seeks to restrain a financial system built to fuel runaway growth. Its stated method: Give markets a “decisive” role in setting prices and interest rates. Its unstated challenge: Doing it without triggering a global financial crisis or weakening the party’s 64-year grip on power.
The tensions between state control and the forces of supply and demand are on dramatic display in China’s money markets. As the government gradually eases regulations on borrowing costs and deposit rates, it is plagued by bouts of volatility. In January, the seven-day repurchase rate spiked above 6 percent for the third time in eight months. The People’s Bank of China injected more than $74 billion into the banking system to relieve funding pressures through the Lunar New Year holiday. In June, it added undisclosed amounts to mitigate the worst cash crunch on record after the seven-day rate surged to 10.77 percent. Some of the turmoil appears intentional: The central bank said in a Feb. 8 report that the market must tolerate “reasonable rate changes” as a way of “modifying behavior.” China is trying to rein in a credit boom and a shadow finance system that has led to an explosion of risky investment products outside the reach of its regulators. The swings have exposed the fragility of the system and sowed confusion among investors who debate which rate really reflects current market conditions, leading to calls for more transparency.
China’s failure to control interest rates raises the specter of a panic like the turmoil that began in 2007, when money markets seized up in the U.S. and the rest of the world as hidden risks became apparent. While the U.S. Federal Reserve and other central banks were able to intervene to halt the turbulence, they couldn’t prevent the pressures that culminated in the Lehman Brothers bankruptcy and a global recession. China’s buildup of credit has evoked comparisons to Japan’s debt surge before its bubble burst in the late 1980s. China removed the floor on most lending rates last year, though it’s waiting longer to phase out caps on deposit rates, a move the central bank says is riskier. Interest-rate liberalization is just one of many fronts where China is balancing the need to expand freedoms while maintaining control. It has allowed more trading of its currency across borders while keeping strict limits on the amount of yuan that can flow out of the country. It takes in more than $100 billion a year in foreign investment while state media attack companies including Starbucks, Apple and Audi for unfair practices, ensuring they know their real master in China is the party, not shareholders.
The debate centers on whether the pace of change is fast enough to defuse the risks of a blowup as economic growth is reined in to a more sustainable pace of 6 or 7 percent. The authorities are well aware that moving too quickly to loosen control of interest rates, or mishandling the process, may spur turmoil. If rates are not freed up, debt could continue to grow unchecked, especially at local governments and other entities that don’t need it. Then there are vested interests like big state-owned banks and companies that resist the changes, which can squeeze their profits and influence. In November, China’s leaders set a 2020 goal to meet the road map for reform. The world will know well before then how serious they are.