Zhou Risks Turmoil With Easing of China Rate Controls

China central bank Governor Zhou Xiaochuan faces an obstacle in his efforts to tame financial market volatility: his own plans to free up interest rates.

The benchmark money-market rate remains above the average for January even after the People’s Bank of China this week injected more than $62 billion following the biggest jump since June. At the same time, Zhou’s planned removal of interest-rate controls may make volatility tougher to prevent, with Standard Chartered Plc economist Stephen Green saying that crisis is a “rule of financial liberalization.”

Zhou, reappointed last year to oversee China’s financial transformation, is working to free up rates to push the nation toward a more sustainable and market-driven model for economic growth. Moving too slowly raises dangers of a crisis from shadow banking outside of regulations, while mishandling liberalization risks worsening debt burdens and sparking turmoil seen in nations from South Korea to Sweden and the U.S.

“China is facing a dilemma,” said Dong Tao, chief regional economist for Asia excluding Japan at Credit Suisse Group AG in Hong Kong. “If interest rates are not liberalized, shadow-banking activities spread like wildfire. If rates are freed up, it will worsen problems for existing debt.”

The seven-day repurchase rate rose today following a two-day drop after the PBOC injected cash to relieve funding pressures ahead of the week-long Lunar New Year festival. The rate advanced 5 basis points to 5.3 percent, according to a daily fixing compiled by the National Interbank Funding Center, compared with the month’s 4.66 percent average.

Net Injection

The PBOC added 120 billion yuan to markets via 21-day reverse-repurchase agreements today, taking this week’s net injection via open-market operations to 375 billion yuan, the most since February 2013.

The central bank’s action earlier this week spurred market gains globally. The MSCI World Index of stocks gained about 0.3 percent over the past two days before falling 0.2 percent as of 3:01 p.m. in Shanghai. The Standard & Poor’s 500 Index in the U.S. has advanced 0.3 percent this week.

Money-market rates in China typically rise before the week-long Lunar New Year break, which begins Jan. 31 this year and is a period in which cash gifts are made and families get together for celebratory feasts.

Allowing markets to set deposit and lending rates should be a top priority as part of efforts to generate new sources of growth and stop financial risks from building up, the International Monetary Fund said in its annual report on China in July. A private index of Chinese manufacturing today signaled a contraction for the first time in six months.

Fully Realize

Zhou, who turns 66 this month and has been PBOC chief for a record 11 years, wrote in a November article that China will “fully realize market-based interest rates” in the “medium term.” The Communist Party has pledged to give markets a “decisive” role in allocating resources as part of the broadest policy transformation since the 1990s.

The PBOC in June 2012 let banks for the first time pay a premium over government-set deposit rates. Authorities in July 2013 scrapped a floor on borrowing costs while saying that further changes to deposit rules were the “most risky” part of liberalization. The PBOC’s next step, in December, was to authorize the trading of certificates of deposit on the interbank market.

Shadow Banking

Increasing competition for bank deposits may help curb shadow banking estimated by JPMorgan Chase & Co. at 69 percent of China’s 2012 gross domestic product. The industry encompasses entrusted loans, wealth-management products and other resources where borrowers can obtain funds unavailable through banks and depositors can get higher returns.

China’s rapid buildup of credit has evoked comparisons to Japan’s debt surge before its lost decade and to that in Thailand and Malaysia ahead of Asia’s financial crisis. China’s credit-to-GDP ratio rose to 187 percent in 2012 from 105 percent in 2000, compared with Japan’s increase to 176 percent in 1990 from 127 percent in 1980, JPMorgan said in a July report.

“The best sign of how fragile the system is, is what’s been happening in the interbank market,” said Charlene Chu, a former analyst at Fitch Ratings who warned that China’s debt could spark a crisis. Officials should “address the underlying fragility in the system” to minimize risks of turmoil from rate liberalization, Chu said in an interview yesterday.

Avoid Mistakes

Zhou and Chinese officials are trying to avoid repeating mistakes that fueled crises in other nations when rate controls were eased.

Finland, Norway and Sweden liberalized interest rates in the late 1970s and early 1980s without taking steps to regulate lending or tighten monetary policy, eventually resulting in a “full-blown banking crisis,” according to a 2009 paper by IMF researchers. The savings-and-loan crisis in the U.S. also stemmed from regulatory restraint after the government removed deposit-rate controls, the IMF study said.

In South Korea, a partial loosening of limits on interest rates in the 1990s was followed by reckless investment by large companies and a financial crisis, according to the “China 2030” report published in 2012 by the World Bank and the State Council’s Development Research Center in China.

“The problem is deposit rates,” the economist Green said. “If you go up too quickly, everyone competes to justify the rising costs” and banks chase higher-yielding, and riskier loans, he said. While China is likely to need to re-capitalize its banks within the next five years, PBOC leaders are well aware of other countries’ experiences with interest-rate liberalization, he added.

Trust Product

Industrial & Commercial Bank of China Ltd. and China Credit Trust Co. may together with the government bail out investors in a troubled trust that sparked concern of defaults on high-yield investment products, the Time-Weekly newspaper reported on its website today, citing a person it didn’t identify.

Investors in the trust product met today with the lender’s officials at a private-banking branch in Shanghai, demanding their money amid concern of a default.

One or two small Chinese banks may fail this year as they face pressure from their reliance on short-term borrowing, Fang Xinghai, a Communist Party economic official, said in November. Trusts and shadow banking will see defaults this year, which is a good thing, Zhang Ming, a researcher at the state-run Chinese Academy of Social Sciences, said this week.

“High and volatile interest rates and debt defaults are a sign of the stress that ails the financial system, but also a sign that the necessary medicine is being applied,” said David Loevinger, former U.S. Treasury Department senior coordinator for China affairs and now an analyst at TCW Group Inc. in Los Angeles. “Like a smoker trying to quit cigarettes, an economy addicted to cheap credit can’t avoid headaches as it deleverages.”

— With assistance by Kevin Hamlin

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