On October 10, the Chinese government announced that it will increase
its stakes in the four largest commercial banks, which are already largely
public-owned. The move is designed to ''support the healthy operations
and development of key state-owned financial institutions and stabilise
the share prices of state-owned commercial banks''.
But why was this move considered necessary at all? In the period just
before this, investors were dumping Chinese bank shares, anticipating
a slowing down not just of the economy as a whole, but in particular
the property market, which had experienced a bubble of massive proportions.
But the underlying concern about the health of Chinese banks reflects
a deeper concern, about the extent of entanglement of these commercial
banks with the growing ''shadow banking sector''.
What exactly is shadow banking? Basically, this refers to non-depository
banks and other financial entities like investment banks, mutual funds,
hedge funds, money market funds and insurers, who typically do not fall
under banking regulation. The growth of this sector has been explosive
in the last decade: in the United States, in the run-up to the financial
crisis, its size was estimated to be significantly bigger than that
of the formal banking sector. In the aftermath of the crisis, many of
these institutions, and banks that were exposed to them, had to be rescued.
UNCTAD's Trade
and Development Report 2011 noted that ''The shadow banking system
depends on wholesale funding, which is extremely unstable and renders
the system very fragile, as evidenced by the crisis'' (page 94). It
argued strongly in favour of bringing shadow banking under regulation;
not just money market mutual funds, but also the asset-backed securities
market financed with repos.
Even at the IMF, a
recent meeting of regulators held during the Autumn meetings called
for greater regulatory focus on shadow banking. Participants noted that
shadow banking operations, that firms doing these bank-like activities
outside the banking system can pose systemic threats, and to have some
effect regulators need more and different data to understand this fast-changing
sector.
But China was known to have a much more regulated banking sector. Indeed,
the ability of the Chinese authorities to control the four important
commercial banks (Bank of China, Agricultural Bank of China, China Construction
Bank and Industrial and Commercial Bank of China, which together were
earlier estimated to control more than three quarters of total domestic
credit) was seen as important macroeconomic tool in the hands of the
state as well as an instrument of ensuring directed credit, both of
which have been crucial to China's economic success.
Before the 1978 reform, the financial system of China was vastly different
from that in most countries. Starting from 1951, banks and other financial
institutions were taken over by the state and assimilated into a system
dominated by the People's Bank of China (PBC). Until 1984 this system
essentially implemented the cash and credit plans formulated by the
central authorities, which supported the physical plan for mobilisation,
allocation and utilisation of real resources. All public sector transactions,
including those between various levels of government and the state enterprises,
were through transfers on their accounts with the PBC. These account
transfers at the PBC accounted for an overwhelming share (of up to 95
per cent) of all transactions.
Moreover, cash (to serve the needs of households and non-state owned
enterprises) was printed and issued by the PBC on demand by the central
government and allocated according to instructions issued. The main
elements of money in circulation were wage payments to workers and staff,
the purchase of agricultural products by the government, other purchases
of goods in the rural sector, and the withdrawing of savings deposits
by individuals. The banking system was not responsible for provision
of resources for fixed asset investments by the state owned enterprises
(SOEs) and for much of their working capital requirements, which were
made available free of charge by the Ministry of Finance. The banking
system was merely responsible for providing additional working capital
and some loans, for accepting deposits from households and other non-government
entities and for settlement of transactions.
There was little role for monetary policy, since credit provision was
centralised and strictly controlled. Enterprises and other economic
entities received grants and loans directly from the PBC. Bank branches
had to merely meet credit targets. And lower level banking entities
had to hand over deposits that exceeded their credit provision targets
to higher-level units. If the government felt the need for restricting
economic activity, it did so directly through administrative means rather
than using levers of monetary policy. To manage the supply of cash and
its utilisation, the central authorities could adjust (administered)
prices relative to money wages (using a turnover tax if necessary).
However, since the objective was to keep prices mostly stable, excess
cash in circulation was absorbed through rationing, when commodity supplies
fell short of demand, and by encouraging savings.
Financial reform created a situation in which banks, financial institutions
and enterprises at provincial and local levels had more flexibility
in providing and accessing loans, so the ability of the government to
control sharp increases in investment and consumption was to an extent
reduced. So the government has increasingly relied more on countercyclical
fiscal policy to correct for recessionary or inflationary tendencies.
Meanwhile, price reform has meant that a growing number of commodities
have been removed from the administered price category, so that excess
demand can lead to inflation.
In the early phases of the economic reform, along with price reform,
certain significant changes were made in the financial field as well.
In 1979, the government declared its intention to reduce the share of
investment funds for enterprises granted exclusively from the cost-free
state budget, and to gradually replace budgetary grants with bank loans
which were subject to interest charges. This did result in major changes
in the financing of investment. The share of budgetary appropriations
in financing capital construction declined dramatically and that of
loans and self-raised funds increased quite significantly.
A two-tiered banking system was established in 1984 by converting the
PBC into the country's central bank and getting the specialised banks
to undertake the commercial banking business. Further in 1986, reform
of the non-bank financial sector resulted in the creation of a number
of trust and investment companies, and financial intermediaries such
as leasing companies, pension funds and insurance companies. Subsequently,
foreign banks were allowed to begin business for the first time.
However, even under the new arrangement it was in principle possible
for the PBC to rein in overdrafts being run by these banks and prevent
them from exceeding loan limits or quotas. Further, now the PBC could
control the terms of its lending by charging lower rates of interest
for loans within the credit plan and penalize unauthorised borrowing.
Thus the ability of the PBC to realize its credit plan was strengthened
by the reform.
However, with a greater degree of decentralisation of financial activity
and the ability of local officials to influence provincial and local
appointments in the banks, it was possible for provincial and local
governments to easily obtain finance for special projects adding another
element to the investment hunger determined by soft budget constraints
in the SOE sector. Over time this problem has only increased with an
increase in the number of financial entities, a change in property rights
in the financial sector and a far greater degree of functional autonomy.
In the process, the capacity of the central bank to use monetary levers
to control investment expenditures is weakened.
The changes accelerated after 2008, when the urge to provide more stimulus
meant that the government allowed or encouraged more ''informal'' credit
flows that went through new shadow banking intermediaries. As a result,
the government's control over actual flows of domestic liquidity is
weaker than it has been for more than half a century. In addition to
trust companies and private banks, which are not regulated but at least
are registered businesses with established offices, there has been a
proliferation of underground operators, usually no better than loan
sharks operating in a world of largely unsecured loans. Such has been
the profitability of these operations that even large local state-owned
firms whose main business was not finance are now expanding into operating
guarantee companies, pawnshops and trusts, arbitraging their own access
to cheap loans to lend out at many multiples of the official interest
rates.
On the face of it, China's household sector appears to be not excessively
leveraged at all - rather, they are substantial net financial savers,
as Chart 1 indicates. Unfortunately, however, China's official financial
statistics still do not cover shadow banking entities, though there
are plans to reform the statistical system to being these under the
purview of the data collection. But even without these, the data indicate
that the ratio of liabilities to assets has been rising quite rapidly.
The growing but opaque interlinkages between the formal credit system
and the world of shadow banking are cause for concern. This is because
the formal banks are also more attracted to indirect lending that generates
at least double or triple the official 6.5 per cent one-year lending
rate, and can even go up to 30-70 per cent in underground banks. The
most profitable activity of state-owned banks in the first half of 2011
was not lending to businesses, but funding trusts and underground banks.
Much of that went into the overheated housing market, associated not
just with a construction boom but with urban real estate prices that
are now the highest in the world for cities like Shanghai and Beijing.
Chart 2 shows that even formally, direct loans from Chinese banks for
real estate and housing increased significantly in the previous two
years.
But these relate only to the direct lending by banks. Increasingly, commercial banks find it more profitable to lend to other agencies, which then redirect the funds in this parallel or shadow banking activity that demands much higher interest rates. Chart 3 shows how this became a significant and even increasing share of banking assets especially for the small and medium sized Chinese banks. The chart takes claims on ''other depository corporations'', ''other financial corporations'' and ''other resident sectors'' (excluding non-financial corporations, government and central bank) as shares of total assets of banks according to size. This is only an approximate estimation of the shadow banking sector, since these categories also include other lending. But some analysts have already estimated that the value of China's shadow banking sector could amount to as much as RMB 14 to 15 trillion.
Since official curbs on lending to this sector were tightened in early
2011, this parallel market expanded even further. However, the tighter
interest rate policies and credit curbs have finally affected the real
estate market. Recently the market has wobbled and real estate prices
have finally started falling.
The bursting of this bubble could be painful. In an attempt to provide
some protection, the government has encouraged the growth of credit
guarantee companies - but many of these are also highly leveraged and
themselves far from creditworthy.
For a very long time, China's ability to control finance was an important
(some would say essential) ingredient of its macroeconomic success.
Now that this control looks more tenuous, the future of the overall
growth strategy also looks that much less rosy.