What Form Should Financial Reforms Take?
China's financial reforms should improve capital allocation efficiency and long-term stability. Measures to improve liquidity are not real reforms. They merely cover up bad assets longer and increase the risk of a financial crisis down the road. Under a fixed monetary growth target, such measures decrease capital efficiency by allocating more money to supporting underperforming assets.
There are two fundamental flaws in the financial system: first, both borrowers and lenders are government entities; and second, the financial institutions are staffed by political appointees. Unless either or both change, financial reforms will just be propaganda or prolong the status quo under a different name.
Because the real economy is government-dominated, market terms for financial reforms are misleading. Breakthroughs in financial reforms are very difficult. The realistic goals in the short term are controlling monetary growth in line with the economic growth, which is the only effective way to manage aggregate financial risk, and limiting loans to local governments and state-owned enterprises (SOEs).
Winds of Change?
Financial reforms are being talked about more frequently nowadays. Some measures, like loan securitization and interest rate liberalization, are touted as possible major reforms. It appears that there is a misunderstanding of what fundamental financial reforms should be. China doesn't have a market-based financial system or capital formation process. Market instruments or price mechanisms play different roles in China than elsewhere. Without recognizing this, financial reforms could make things worse.
Excessive spending and investment by local governments are at the heart of the country's financial problems. Almost all financial institutions are government-owned. It is inevitable that such a system sacrifices the interests of the household sector. This is the most important factor in making the real interest rate so negative, property prices so high and the stock market so low. Technical changes to the financial system, no matter how well intentioned, will certainly lead to a worse deal for the households.
In theory, state ownership does not have to be so. China's unique system is that all the senior managers in state-owned enterprises and financial institutions are appointed through the same mechanism as government officials. They are each other's constituency in winning political support. Hence, they naturally support each other. The rising concentration of financial resources in the state sector is a natural result of the system. This is the main reason that independent measures to support the private sector or small and medium-sized enterprises end up as failures. Dancing around the dragon and creating some new mechanisms will not lead to meaningful changes.
Even though local governments have reported impressive revenue growth despite the economic slowdown, money tightness is apparent among most local governments. The revenue numbers are probably overstated. Some local governments are known for masquerading borrowed money as revenue.
The main complaint in that regard is that the monetary policy is too tight. China may achieve a 7.5 percent GDP growth rate, but the M2 or total credit is likely to grow by 15 percent. Domestic debt is already two times GDP. The numbers suggest a very loose liquidity environment. A negative real interest rate for depositors and high inflation support this conclusion. So why are so many complaints over liquidity?
The main reason is that local governments have been piling up poor-performing assets with little cash generation. As the GDP growth rate depends on such investment growth, liquidity needs far exceed the GDP growth rate. Let's say that the nominal GDP growth rate is 10 percent and investment is half of GDP. If the GDP depends 80 percent on investment, it needs to grow by 16 percent. Of course, there is payment pressure from the loans contracted in the past. Let's say government loan stock to investment flow is 100 percent, a low guesstimate. The interest payment alone is 8 percent of investment. Hence, to sustain the model, the money inflow needs to grow 24 percent just to maintain status quo.
Instead of complaining about liquidity, one needs to question the necessity and sustainability of the model. Building a city may pay off if competitive businesses take root there. But most cities do not have such businesses and have no credible plan to attract or develop them. Debt-financed investment has become an end in itself, not the means to something else. I don't see how the current investment could end up well. The sooner this model ends, the better the country's future would be. Hence, instead of complaining about insufficient liquidity, most local governments need to rein in their spending and let the private sector take the lead in growing the economy. If this does not occur, then there is no need for the city to grow.
Interest rate liberalization is touted as a major step forward in financial reforms. I suggest caution, especially regarding the deposit rate. The lending rate is more or less about dividing up the income between state-owned banks on the one side and local governments and SOEs on the other.
It is really about how money is booked within the state sector. Its economic significance is limited. The only private sector that receives significant bank loans is property. But, its loans go to local governments through land purchases or taxes. The property sector should be considered a quasi state-owned sector.
Deposit interest rate liberalization does have real meaning. Local banks that have small deposit bases will inevitably use a higher interest rate to attract deposits. On the surface this is a good thing for savers. But, local banks are probably in bad shape. Because they are beholden to local governments, they tend to finance the worst projects. Hence, more deposits flowing to local banks will decrease investment inefficiency further. And, when some local banks go bust, the central government has to bail them out. People ultimately bear the burden.
In that regard, the push for a deposit guarantee system makes the matter worse on the margin. Local banks have a hard time attracting deposits partly due to savers' doubts over their health. With the benefit of the hindsight, this concern is correct. If the central government introduces a deposit guarantee, this concern would be removed. They can attract deposits with a bit higher interest rate. It just means more financing for local governments. The ultimate question is if it makes sense.
Interest rate liberalization means something when both banks and borrowers are market creatures. While some interest rate liberalization can be beneficial on the margin, it should not be touted as a major step forward.
Asset securitization increases liquidity and, under the right conditions, enhances efficiency on the margin. The pressure for asset securitization usually comes from insufficient capital. By spinning some assets off its balance sheet, a financial institution can lend more. That sort of motivation is the reason that a boom of asset securitization is usually followed by a financial crisis, as its main effect is to increase leverage.
The push for loan securitization in China is motivated by the same thing. For example, local banks are very short of capital. They are under pressure to support local government projects. Loan securitization is viewed as a way out.
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