China's recent eclipsing of Japan as the world's second-largest economy didn't come as a big surprise. But now that the country has reached that milestone, the government policies that spurred that impressive growth are in urgent need of reform, say finance and economics experts. That includes the country's interest rate regime on which the government keeps an iron grip.
At the moment, its one-year renminbi deposit rate is 2.25% and its one-year benchmark renminbi lending rate is 5.31%. But unlike in other major economies, those rates are set tightly controlled by the People's Bank of China (PBoC), the country's central bank, which “mandates a wide spread between bank lending and deposit rates -- probably around 1.5 to 2.5 percentage points more than the normal spread; that is, the spread that should be determined by market equilibrium,” says Michael Pettis, a finance professor at Peking University and a senior associate at Washington, D.C.-based Carnegie Endowment for International Peace.
The impact of the PBoC's interest rate regime can be felt in all corners of the country's economy. First, its state-owned banks -- several of which are now among the largest in the world in terms of market capitalization -- are using the rates to prop up their balance sheets as they creak under the weight of their record lending during the economic downturn. Second, the country's vast network of state-owned enterprises (SOEs) have benefited from years of access to cheap credit through the banks, at the expense of private small and midsized enterprises (SMEs). Finally, the nation's individual savers are also affected by the interest rates -- low deposit rates combined with escalating inflation rates have decimated their savings.
According to Charles Freeman of the Center for Strategic and International Studies, a Washington D.C.-based think tank, “The state-owned banks are 'subsidized' by the state governments as well as individual Chinese savers, who have had negative deposit rates for years.”
The challenges are not new, but with the massive expansion of government-directed lending during the economic downturn -- resulting in a record US$1.4 trillion of new bank loans in 2009, about double the previous year -- it was with good reason, then, that the PBoC pledged in May to “continue pushing the reform of China’s interest rate system and introducing more market-determined interest rates.” But what those reforms comprise, and when they will happen, are far from clear.
Boon for Some, Bane for Others
Because the PBoC sets rates on both loans and deposits, China's banks both win and lose -- but more the former than the latter. While banks have to lend to SOEs at low rates, the rate they pay depositors is even lower, says Gary Liu, deputy director of the CEIBS Lujiazui Finance Research Center in Shanghai. “The state-owned banks turn a super-normal profit through this spread, making them the biggest beneficiaries of the government’s unreasonable policy initiative,” he states.
Underpinning all that are the intertwined relationships between the banks, regulators and the Communist Party. Those relationships, says Liu, are deep rooted, thanks to the government appointing all high-ranking bank executives, who tend to hail from state-run institutions. China Construction Bank's chairman, Guo Shuqing, for instance, was parachuted in to his post from the State Administration of Foreign Exchange, after also having been a PBoC vice governor. The head of China Development Bank, Jiang Chaoliang, was transferred to his post following a chairmanship at Bank of Communications and also held various posts at the PBoC.
There are good reasons for the cozy state-bank-SOE relationship. For example, since many SOEs have had long relationships with their banks, there's a deep, mutual trust between the two. Also, China’s nascent credit evaluation system makes it hard for banks to scrutinize the creditworthiness of private companies. In contrast, a loan to an SOE generally implies that central and local governments will act as guarantors.
Nonetheless, there's no getting around the fact that the system gives SOEs an unfair advantage over their private-sector counterparts, according to Giovanni Ferri, head of economics and mathematics at the University of Bari in Italy. “If we take China's private sector as representing SMEs, SOEs have an interest rate subsidy of around 250 basis points (or 2.5 percentage points),” he says.
Such subsidies have created a startling imbalance. Although the contribution of SOEs to China's GDP is around 25%, they receive about 65% of total loans, according to research published in 2009 by Ferri and Li-Gang Liu, chief economist for greater China of BBVA's research unit. In analyzing a sample of Chinese enterprises, Ferri and Liu concluded that if the SOEs paid the same rates for their loans as private enterprises did, "their additional interest outlays would be larger than SOEs' profits on average.” In other words, without access to cheap capital, many SOEs would struggle to survive.
And although the large gap between lending and deposit rates essentially guarantees profitability, it does not encourage banks to conduct thorough risk analyses of loan applicants. According to the China Banking Regulatory Commission (CBRC), outstanding loans from Chinese banks to local governments as of the end of June reached a total of RMB 7.7 trillion (US$1.14 trillion). The regulators also have noted that nearly one-forth of those loans are at risk of defaulting.
“If banks do not (or cannot) differentiate lending rates in accordance with the perceived risks of borrowers, they may just keep lending to undeserving borrowers, feeding inefficiency in China's economy,” says Ferri.
Seth Weissman, an economics professor at the National Defense University in the U.S., agrees, noting, “China's state-owned banks are feeding wasteful investments since they are not lending to companies that make the wisest investment decisions. Instead, the investment goes to those SOEs that have nepotistic connections with local governmental officials.”
China's property sector for one is paying dearly for these inefficiencies. “Many real estate developers are state-owned enterprises," says Zheng Hui, a finance professor at Shanghai Fudan University. "The cost of acquiring capital for those SOEs is very low, sometimes close to zero. That boosts their eagerness to overinvest in China’s real estate sector and results in a huge asset bubble.”
For those SOEs, the return on capital is higher than the cost of capital. According to Peking University’s Pettis, with easy access to capital, SOEs productivity is growing much faster than domestic consumption. This, he says, is one of the major reasons why consumption accounts for a declining portion of the country's GDP -- from 46% of GDP in 2000 to less than 36% in 2009. (In the U.S., it is around 70% of GDP.) He adds that up to the point where new investment does not create additional productive capacity but begins to destroy value, as long as production grows faster than household income, it will probably also grow faster than consumption. “The gap between the two of course is the savings rate,” notes Pettis, “Since the trade surplus is equal to the difference between the savings rate and the investment rate, as long as savings grow faster than investment, the trade surplus must rise. In this sense, China will continue to suffer many more years of worsening trade imbalances. ”
Picking Up the Tab
While state-owned banks and enterprises benefit from the interest-rates system, Chinese households suffer. According to Liu of CEIBS, while the one-year renminbi deposit rate is 2.25%, inflation has been around 3.3% in July, up from a near two-year high 2.9% in June. “With inflation deducted, the real interest rate of the deposits made by Chinese households is negative,” he says. “Under this system, China's depositors are being exploited.”
In addition, says Pettis, the low lending rate and the even lower deposit rate make it easier for struggling SOEs to roll over their debt to China's households indirectly via banks. He says the equivalent of 5% to 10% of the country's GDP is being transferred annually from households to the net capital users, the SOEs. "Not only are China's depositors 'taxed' by having to fund the very low lending rates [to SOEs], but they are taxed to guarantee the mandated spread and that the banks are sufficiently profitable to rebuild capital," says Pettis. "Households are forced to clean up China's banking system.”
But individual savers don't have many alternatives. “Without a solid social safety net, Chinese households have to save a lot to support their children’s education, their own health care and their future retirement,” says CEIBS’s Liu. Squirreling away money in local savings accounts is more or less the only choice households have for their extra income since under current regulations, they aren't able to invest in overseas capital markets while, as the country's numerous retail investors have found, the domestic capital market can be a rollercoaster ride.
“Reforming China’s interest rate system includes two initiatives," says CEIBS’s Liu. "The first is to allow the deposit as well as the lending rate to be more flexible; the second is to diminish the spread between the lending and deposit rates.”
Liu also says the PBoC should only set an upper and lower range for the rates. Within such a range, banks could determine their own lending and deposit rates based on the market and the circumstances of individual customers. “If the PBoC eliminated the spread and allowed banks to compete openly in the market, the deposit rate would increase while on average the lending rate might decline, because some small private banks would jump into the market and offer lower lending rates to attract customers,” says Liu. “The profits of some banks would definitely be squeezed. However, those banks should not rely on the spread to make profits. Instead, they should create profits through financial innovation, enhancing their expertise and providing better services.”
Still, initiating any reform in an economy the size of China's is easier said than done. One dilemma faced by the PBoC is that a surge in interest rate levels may attract speculative investors -- or so-called "hot money" -- from abroad, says Chun Chang, executive director and professor of finance of Shanghai Advanced Institute of Finance (SAIF) of Shanghai Jiao Tong University.
Another complexity is that the government is in the midst of slowly revaluing the renminbi, which has been pegged to the U.S. dollar for the past few years. “Interest rate reform and the exchange rate are actually closely connected,” says Zhang, who adds that in a globalized economy, China needs to make the exchange rate of its currency flexible before it makes the interest rate flexible. “Without the elasticity of China’s exchange rate, it is impossible for it to offer more flexibility to its interest rate system. China has to let its currency appreciate as soon as possible.”
But that, too, needs to be managed carefully. “Under China’s current fixed exchange rate regime, its macro-economic policy is actually determined by the U.S. Federal Reserve,” he says. “To maintain the stability of China’s exchange rate, the spread between China’s and the U.S.'s interest rates cannot be too large, otherwise there would be arbitrage capital pouring into China.”
Another consideration is the fact that the assets on the PBoC's balance sheet are mainly in foreign reserves, while its liabilities are in renminbi and its own bills. The PBoC is using foreign reserves to purchase mainly U.S. Treasury Notes with an annual return of between 3% and 4%. As Pettis says, if China does reform its interest rate system, the interest paid by the PBoC on its own bills would also surge. “If the renminbi appreciates, the value of the PBoC liabilities will appreciate relative to assets and net indebtedness will rise. Meanwhile, if renminbi interest rates rise, the PBOC's financing costs will rise without a commensurate increase in financing revenues [the interest earned on its foreign reserve assets] and any net losses will create an increase in the PBoC's net indebtedness,” says Pettis.
He also estimates that if the currency appreciates and interest rates increase, the PBoC’s net indebtedness would probably rise signficantly. “So far, the authorities do not seem to be seriously considering raising interest rates," notes Pettis. “And if the U.S. successfully pressures Chinese authorities to revalue its currency [faster], they might be even less likely to do so.”