Finance in China
Big but brittle
China needs to free up its financial system, even if it hurts, says Simon Rabinovitch
THE HEAD OFFICE of Sheyang Rural Commercial Bank is a reassuringly solid building. Its grey stone façade and arched doorways convey a feeling of prosperity, a splash of high finance in this small county town in eastern China where grain fields nip at the edges of factories. But look a little closer, and you will still find a couple of scars from the bank’s near-collapse two years ago. One is a digital sign running in a loop over the entrance: “Treasure your hard-earned money, avoid the temptation of high returns, stay far from illegal financial schemes.” The second is a prize draw for cars, a pair of gleaming white Kias on a red platform outside the bank. “Deposit 100,000 yuan today and win the chance to drive a new car home,” blares the announcement. The bank is fighting to attract customers because it knows all too well what it is like to lose them.
Decades of heady growth had put money into the pockets of Sheyang’s residents. But China’s big banks had little time for the countryside. Farmers who wanted to buy homes or start companies struggled to get loans. Illegal lenders stepped into the gap; they collected cash from those with idle savings and lent it out, often at double-digit interest rates. Business boomed. As locals put it, the lenders sprouted up like bamboo shoots after a spring rain—until a few years ago, when a harsh wind uprooted them. The economy was slowing and investment plans relying on superfast growth fell apart. Borrowers could not pay back what they owed. The unregulated lenders started defaulting on their depositors. Panic spread. In March 2014 it was rumoured that even Sheyang Rural Commercial Bank, which is owned by the government, was low on cash.
This was enough to spark China’s first bank run in years. Crowds gathered outside its branches, waiting for hours in the drizzly chill to get their money out. Bank managers stacked up bricks of 100-yuan notes (China’s largest denomination) to show they had sufficient cash. Yet fear travelled like a virus, infecting another nearby bank. On the third day of the panic the China Banking Association, an industry group, entered the fray and declared the rural banks to be healthy—in effect, pledging to stand behind them. That ended the run. It had taken the full weight of the nation’s banks acting in concert to restore calm.
One county’s travails might not seem worth making a big fuss about. After all, the deposits at Sheyang Rural Commercial amount to just 13.5 billion yuan ($2.1 billion), barely 0.01% of the total in banks nationwide; and the problems were successfully contained. But the run raised troubling questions. How could the authorities have let so many illegal lenders operate? Why were they suddenly collapsing? If they were in such bad shape, were proper banks safe? Was China on the brink of a financial crisis?
Sheyang’s bank run is just one of a series of problems to reveal cracks in the Chinese financial system in recent years. Others include a cash crunch in 2013, a wave of shadow-banking defaults in 2014, a stockmarket collapse in 2015 and a surge of capital flight at the start of 2016. Underlying it all, China has seen a dramatic rise in debt, from 155% of GDP in 2008 to nearly 260% at the end of last year, according to an estimate by The Economist. Few countries have gone on borrowing binges of that magnitude without hitting a crisis.
The scope for potential trouble in China is immense. Its banking sector is the biggest in the world, with assets of $30 trillion, equivalent to 40% of global GDP. China’s four biggest banks are also the world’s four biggest. Its stockmarkets, even after the crash, together are worth $6 trillion, second only to America’s. And its bond market, at $7.5 trillion, is the world’s third-biggest and growing fast.
A cocoon of regulations limits direct foreign involvement in China’s financial system, but connections are deepening by the day. Given its economic heft, serious problems could easily dwarf the global consequences of any previous emerging-markets crisis. Even the mild yuan depreciation at the start of this year (1% against the dollar in one week) sent shock waves around the world, upsetting stocks, currencies and commodities. Just imagine the effects of a big one.
Still, it is worth recalling that predictions of financial doom in China have long been wrong. Because of the nature of the system—the state owns both the banks and their biggest borrowers—the government is in a much better position to dictate outcomes than those in most other countries. Until recently the financial system has been very conservative. Plain-vanilla bank lending is the dominant form of credit; exotic products such as securitised loans that caused havoc in rich economies barely exist in China. Moreover, liquidity buffers are strong: residents have historically had little choice but to stuff their cash in banks, and a semi-closed capital account has made it hard for them to send money abroad.
All these controls have allowed China systematically to gather up its people’s savings in its banks and use the money to build infrastructure, factories and homes, fuelling economic growth. When lending has gone badly wrong, as it did in the 1990s, the state has recapitalised its banks and fired up the lending machine again. Not best practice for an advanced economy—but, as Taiwan and South Korea have shown, it can be a supremely effective model for development.
Even so, China’s status quo cannot be sustained for ever. Returns on capital are declining. It now takes nearly four yuan of new credit to generate one yuan of additional GDP, up from just over one yuan of credit before the global financial crisis. As the population ages and the economy matures, growth is bound to slow further.
At the same time, bad debts from the past decade’s lending binge are catching up with banks. Given slower growth, it will be tougher to clean them up than it was 15 years ago, when the country was booming. Moreover, the edifice of control is getting shakier: shadow finance is eating away at the power of state-owned banks, and the capital account has sprung leaks that regulators are struggling to plug.
China has, in other words, reached a level of development where it needs a more sophisticated financial system, one that is better at allocating capital and better suited to the market pressures now bubbling up. The government pays lip service to this, and indeed some reforms point in the right direction: it is deregulating interest rates; the exchange rate, though still managed, is more flexible; defaults are chipping away at the notion that the state will guarantee every investment, no matter how foolish.
Yet the state has held the levers of finance so tightly for so long that the loosening of its grip generates new dangers. Coddled banks are being plunged into competition. People who once had few outlets for their savings have many choices, each riskier than the next. Companies probe for weakness in the mesh of regulations, with the government seemingly always one step behind. In the past year alone, it has spent nearly $200 billion to prop up the stockmarket; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country.
This report will argue that China is faced with two unpalatable options. One is that it moves more boldly to free up its financial system. That would be the right thing to do for the future but would release pent-up perils now; defaults would climb, banks would rack up losses and many shadow lenders would go bust. The other is that China eschews reform and instead tries to patch up its current system. That would be easier in the short term, but the inexorable accumulation of debt would sap the economy’s vigour and raise the spectre of a fearsome crash.
In practice, the government has wavered between the two options. In good times, when the economy behaves as it should, it plods ahead with reforms. But at the first whiff of trouble it tends to lose its nerve, building up much bigger problems a few years hence. China needs to move faster, even at the cost of greater turbulence today.
Some good at least came of the Sheyang bank panic. China introduced nationwide deposit insurance last year, trying to reassure savers that their money is safe, no matter what happens to their bank. Banks have also raised their game, as demonstrated by the car giveaway at Sheyang Rural Commercial Bank. People again line up at its doors, only this time to put their cash in the bank, not take it out. But financial fragility is surfacing nearby. Grass encroaches on the lot of a textile company that defaulted on a bond last year. And on the county’s outskirts, apartment blocks stand empty, totems to the debt that looms over China’s financial system.