China's massive Rmb4 trillion ($585 billion) fiscal stimulus package, unveiled in the fourth quarter of 2008, was at the time widely regarded as a sign that the government was playing safe by providing an ample cushion for the economy. Now the package seems barely enough to keep economic growth at a decent rate in 2009 and a second stimulus is reportedly at the planning stage. If not for the government's early and forceful push, it is unlikely that real GDP growth will reach anywhere near the 6.5% rate that Standard & Poor's expects this year.
As large as Rmb4 trillion seems, it is only 13.3% of China's economy in 2008 and it is to be spent over a few years. Enterprises and households will have to have the confidence to spend more. If the fiscal stimulus succeeds, it will only be because of the government's credibility. Much depends on the results of the fiscal, structural, and financial reforms it has launched over the past two decades.
Debt financing is an important issue for the stimulus package. The bulk of the Rmb4 trillion being mobilised will be borrowed by the central government, local governments, and government-related companies. The country's underdeveloped debt market means most of the borrowers will turn to bank financing. Between December 2008 and February 2009, the banking sector reportedly disbursed more than Rmb3.4 trillion of loans. The same period saw the issuance of less than Rmb300 billion worth of non-financial corporate debt issues (including medium-term notes and short-term bills) split on 108 deals.
The insignificant role of the domestic bond market reflects deep structural problems. The market is fragmented, accessible by only a few types of investors, and dominated by government paper. Of the Rmb15.1 trillion worth of bonds outstanding last year, non-financial corporate debt accounted for about 8%. This rises to only 35% even if financial institution bonds, many of which were issued by the policy banks, are included.
With less than Rmb4.8 trillion of corporate bonds outstanding in total, the market will have trouble financing even half of the Rmb4 trillion package, even if no other issuance comes to the market. Investors have become less receptive toward longer-term corporate papers in the expectation of a deluge of long-term government bonds in 2009. For most companies participating in the fiscal stimulus, banks will therefore remain the only source of financing.
This heavy reliance on bank lending forces borrowers to take on maturity and interest risks that they would prefer to do without. Banks finance themselves overwhelmingly with short-term deposits and also try to keep the average maturity of their loans short, in order to mitigate mismatch risks. At the end of 2008, less than 40% of loans to financial institutions were medium- or long-term lending. In contrast, more than 95% of bonds outstanding have a maturity of more than one year. Unlike bonds, which typically pay a fixed interest rate, bank loans are priced off the central bank's base lending rates. So companies face uncertainties associated with the impact of monetary policy changes.
SME disadvantage continues
For small and medium size enterprises (SMEs), longstanding difficulties in getting funds are unlikely to disappear overnight even though lending restrictions on banks have been lifted recently. With a favourable interest rate spread assured by banking regulations in China, domestic banks are chasing after the state and larger borrowers to maximise profits. SMEs, by contrast, will continue to be neglected, despite their importance to the economy at this time because of the large number of workers that they employ. SMEs are often seen as riskier clients than large corporations, especially state-owned enterprises, as they require more extensive and costly background research. Hence, loans to these companies are often granted only when collaterals or third-party guarantees exist.
A proven way to improve financing conditions for SMEs is to develop a vibrant domestic bond market. Where such a market exists, the lower cost of bond issuance vis-à-vis bank borrowing draws large companies toward direct financing and ensures a greater diversity of funding sources. When this happens, banks naturally seek out SMEs and other borrowers to grow their loan books. In Korea, for instance, close to 90% of bank lending to the corporate sector are to SMEs.
Free to lend now, Chinese banks are expected to grow their loan books substantially this year, with attendant risks. The current slowdown is the first major test for the large state-owned commercial banks, which were reformed and had their non-performing assets removed not too long ago. The fact that the banks have responded so enthusiastically to calls for increased lending could be viewed negatively. Should their credit assessment and risk-management reforms prove to be little more than skin deep, not only will a large part of their existing loans turn bad but the loans they are making now could also sour rapidly.
The dangers of this happening are high during a sustained period of strong credit growth in an economic slowdown, as we expect to see now. According to the People's Bank of China, paid-in capital of Chinese depository institutions now amounts to a little less than 6% of domestic credit. So if 6% of current loans turn bad, it could drag many banks into insolvency. Once that happens, the costs to the government and to the economy will far exceed the amount of bad loans.
Once again, the existence of a vibrant corporate bond market can mitigate these risks as it offers greater diversity of funding and reduced concentration of financial assets across institutions. Importantly, it provides companies with an alternative channel of financing when the banking system is under stress. These benefits are evident in the developed markets where highly rated companies continue to find demand for their bonds even as banks become risk-averse.
Bond market development moves up the policy agenda
Chinese policymakers have taken some steps to spur the development of the corporate bond market in recent years. Rules governing the corporate bond market have been liberalised to make issuance easier and to bring in more investors. Non-financial firms can now sell bonds in the interbank market without prior government approval and without guarantees. More recently, commercial banks have been allowed to trade bonds on the stock exchange, while foreign banks have also been promised access to the interbank bond market. Insurance companies may also soon be allowed to buy unsecured corporate bonds.
These small steps are unlikely to bring about a sufficiently vibrant bond market soon enough to play an important part in financing the stimulus package, but there are strong reasons for policy makers to accelerate its development. China's economic potential is limited by its still-developing financial services sector, which does not yet intermediate funds effectively and efficiently. As a result, private-sector firms and households are under-served, and play smaller roles in the economy than they could. More liberalisation measures and deeper reforms are needed if the bond market is to provide a real alternative to the banks.
This does not mean that the further reform of the banking sector should take a back seat. Banks will need to continue to improve their health because they play important roles that cannot be performed by other institutions or markets. A financial system can only be effective if all pillars -- banks as well as capital and money markets -- are able to play their respective roles well.
This article was contributed by Ping Chew, managing director and head of Greater China at Standard & Poor's.
