Commentary

Financial Repression

China’s large stimulus package and rapid credit expansion have kept the growth engine running, but at the expense of the non-state sector. Credit allocation via state-owned banks has favoured state-owned enterprises and local governments. Although the large banks are in no immediate danger, there are warning signs that the banking sector is more fragile than commonly understood.

Local politicians, under strong pressure to develop infrastructure, have used investment platforms to circumvent restrictions on direct borrowing from banks. If too many subprime projects are undertaken, bank loans may go sour and non-performing loans could mushroom Investment decisions are still heavily politicised and risk assessment is weak. Trying to serve two masters — the market and the state — is a tricky business. Lending to local governments accounts for about 20 per cent of total bank credit, and 20 per cent of those loans are now considered non-performing.

Credit expanded by 34 per cent last year. Although new bank loans have slowed to about 18 per cent this year, the use of off-balance sheet lending is spreading. In a recent report, Fitch noted that the use of informal securitisation is leading to a “pervasive understatement of credit growth and credit exposure”. As such, actual loan growth may have been understated by 28 per cent in the first half of this year.

State-owned banks now work closely with trust companies to package loans and resell them as “wealth management products”, which pay a higher rate of interest than bank deposits. Those products come with a guarantee so the demand for them is high, and supply is meeting demand. In May, banks in conjunction with trust companies issued about 615 billion yuan (HK$704 billion) of these products, nearly matching the amount of new bank loans.

Without transparent private ownership of banks and other financial institutions, China could face mounting non-performing loans as loans are made to local governments and state-owned firms for projects that wouldn’t float in the sea of private enterprise. Distortions will increase.

If the People’s Bank of China does not adequately slow the printing press, today’s inflation of 3 per cent could easily increase, resulting in wage and price controls, the loss of economic freedom, and a rise in unemployment and poverty.

“The ongoing clean-up of local government investment vehicles is critical to contain fiscal and banking sector risks over the medium term,” says UBS economist Tao Wang. China needs more capital freedom and less government intervention. Grafting securitisation onto a socialist market economy is a recipe for disaster: leverage is increased and risk is socialised.

China needs to take steps to allow real capital markets to develop and for funds to flow to the private sector on a commercial basis. Interest rates need to be further liberalised, and the capital account needs to be further opened. The recent lifting of restrictions on the free flow of yuan in Hong Kong is a step in the right direction, as is the announcement that the exchange rate will be more flexible.

Hu Xiaolian, the outspoken POBC deputy governor, has acknowledged the inflation risk inherent in the current system of financial repression. In her recent statement, posted on the bank’s website, she cited Milton Friedman’s market-liberal treatise Free to Choose, to emphasise that “inflation is a disease that if not checked in time can destroy society”.

Beijing needs to look at ideas that have worked and speed up the transition to a free capital market. The moral hazard problem arises when government is too big and the market too small.

China’s reform process since the late 1970s has transformed society and widened the range of choices open to people. Yet financial repression still constrains the choice of investments and favours state-owned firms and banks. The “too big to fail” problem and moral hazard are not limited to the West.

James A. Dorn is a China analyst at the Cato Institute and its vice-president for academic affairs.