Could China be heading for a crisis in its shadow banking system? That’s the real risk highlighted by the International Monetary Fund in its latest review of the Chinese economy.
The IMF report notes that China’s central bank, the People’s Bank of China, uses both interest rates and reserve requirements (the amount of money that the banks are required to hold on deposit with the central bank) to slow the growth of credit in the system. In addition, the bank imposes direct administrative limits on how much the banks can lend.
But this approach, it notes, only limits the supply of bank credit. It has little impact on either the cost of credit or the demand for new loans. What’s more, banks have a strong incentive to find ways to keep lending, because they earn a guaranteed margin on their loans.
As a result, the IMF report says, there’s been a surge in the amount of borrowing, and lending, that’s being conducted outside the banking system. According to the IMF, “there has been a significant rise in off-balance sheet provision of loans (eg. through trust funds, leasing, bankers’ acceptances, inter-corporate lending, and other means) and a growing intermediation of credit through non-banks and fixed income markets.”
In addition, the report notes that “over the past several months, there have been large loan inflows from offshore entities recorded in the balance of payments (as Chinese companies go abroad to offset credit restrictions at home).”
This growth of the non-bank financial sector is now clearly reducing the effectiveness of Chinese monetary policy at a time when the country is battling rising inflationary pressures. China’s consumer price inflation index in June surged by 6.4% from a year earlier, its fastest rate in three years.
At the same time, China’s determination to stop its exchange rate from appreciating means that its central bank is struggling to mop up the flood of liquidity flowing into the country. In the three months to June, China accumulated a further $153 billion of foreign exchange reserves, bringing its total reserves to $3.2 trillion. To prevent China’s exchange rate from rising, China’s central bank prints new yuan and buys all the foreign exchange that comes streaming into the country.
However, this adds to China’s money supply, further stoking inflationary pressures. In order to remove this increased liquidity, the central bank either has to sell bills or order banks to set aside an even higher chunk of their deposits as required reserves.
Last month, China lifted the reserve ratio requirement by a further half a percentage point to a record 21.5% for the country’s biggest banks. But banks only earn an interest rate of 1% on the deposits they’re forced to hold with the central bank, and so the reserve requirement acts as a hefty tax on the banking system.
This creates a further incentive for savers and borrowers to find ways to transact business outside the formal banking system. Savers are attracted to this “shadow” banking system because they can earn higher interest rates on their deposits than the puny returns offered by the banks.
At the same time, private companies, starved of funds by the banks, can raise much-needed cash in the non-bank arena, although often at a significantly higher cost.
But this rampant growth in China’s shadow banking system poses grave risks for the Chinese – and global – economies. The IMF report urges the Chinese Government to start deregulating its financial markets, by allowing the exchange rate to rise and allowing the market to determine both deposit and lending rates. Instead of imposing limits on bank lending, the IMF says the Chinese central bank should allow credit to be allocated by price-based means.
The IMF report warns that continuing to delay financial liberalisation “could mean that the financial system, instead, evolves in an uncoordinated and disorderly fashion, outpacing supervisory capabilities and revealing regulatory gaps.”
It says there is now a high risk that “developments proceed on a timetable driven not by careful, pre-emptive and concerted policy planning but rather by the pace of market disintermediation and innovation.”
But with China’s financial system now much more complex, the IMF warns that “an ad-hoc or poorly configured approach would be especially risky, for both China and the global economy.”
This article first appeared on Business Spectator.