Shadow financing forces the pace of Chinese interest-rate reforms

Standard & Poor's' KimEng Tan looks at how the emergence of "shadow financing" is being dealt with by Beijing and the implications for the banking industry.

The People’s Bank of China (PBoC) recently took another big step toward interest-rate liberalisation, removing the floor on interest rates that banks can charge borrowers. KimEng Tan, sovereign ratings analyst at Standard & Poor’s Ratings Services, explores the implications for banks and whether the surge in “shadow banking” or non-bank financing is behind this move.

What’s the upshot of the latest reforms?
The latest change leaves China’s central bank with commercial bank deposit rate controls as its main price-based policy instrument. Freeing deposit rates in the future could see the PBoC adopt a more conventional monetary policy framework by targeting a money-market interest rate. Such a move may create several policy challenges for the government. Bank profitability could suffer, especially at smaller institutions. Near-term economic growth could face more headwinds due to the associated uncertainty. Short-term international capital flows may also become more volatile.

The benefits of a monetary policy framework change may flow with time, however. We expect such a change to strengthen the government’s ability to sustain economic growth and attenuate economic or financial shocks. In our opinion, China’s current reliance on direct administrative measures impedes its ability to influence domestic financing conditions in important parts of the economy. The change could improve monetary support for the government’s creditworthiness.

Has the rise of “shadow banking” been a factor?
The faster pace of interest-rate liberalisation over the past year or so may be related to the rapid growth of off-balance-sheet and non-bank financing. This growth has reduced the central bank’s influence over credit conditions in the country. The PBoC’s current main policy tools are controls over the balance-sheet activities of banks. These tools have a weak direct impact on off-balance-sheet and non-bank financing markets, where strong credit growth appears to have raised regulators’ concerns.

The PBoC, which is responsible for financial stability, has no direct tool to slow non-bank activities. Unlike for banks, the regulator does not provide guidance for the growth of these non-bank businesses, nor the price of their products. The versatility and diversity of the various non-bank channels also make it difficult to quickly implement new restrictions.

While the interbank market volatility in mid-June 2013 had likely slowed the growth in “shadow financing”, the effects are likely to be temporary. The central bank may have to retool to exert a more sustained and less-disruptive control over broader credit conditions as nonbank credit activities become more important.

Can the government impose stricter controls on “shadow banking” activities?
The government may not want to. Despite the recent negative attention, shadow banking activities are likely to be here to stay. It is partly because policymakers have not viewed these activities as entirely undesirable.

While such activities are conducted less transparently than bank lending and subjected to less direct policy influence, they meet financing needs that regulated bank lending cannot. Private small- and mid-size enterprises (SMEs) have turned to this avenue when banks shut their doors in an effort to keep within their lending growth quota. Savers in the shadow banking system also get higher returns than what bank deposits offer, helping to relieve speculative pressure on asset prices to some extent.

Consequently, additional regulations on these activities on pricing and size could reduce the non-bank financial sector’s ability to ease some of the distortions that China’s rigid financial regulations create.

But has the growth been too fast?
Recent developments in non-bank and off-balance-sheet financing have indeed raised concern among regulators. The growth has been significantly faster than bank lending. In 2012, new non-bank credit creation was almost 51% more than that in 2011, even as new bank lending showed a 10% gain. Non-bank credit activities accounted for 42% of total new credit in the year, up from just 22% in 2008. In addition, much of this growth may be related to activities that the central government is trying to stem. For example, media reports suggest that real estate and local government financing platforms (companies set up to finance the infrastructure projects) have been big users of such financing.

So where do monetary reforms come into the picture?
Formally targeting an interest rate that will affect financing costs across all credit institutions allows policymakers influence over economy-wide credit conditions. Policymakers will then have continual control over the non-bank financial market and reduce the need for them to turn to unconventional measures as a policy tool. Over time, as other structural reforms proceed further, the more market-oriented framework for monetary policy could also help achieve the government’s stated aim of increasing the efficiency of credit allocation.

The foundation for this change has already been largely laid. For a few years, financial regulators have been helping to make the Shanghai interbank offered rate the key benchmark for domestic wholesale interest rates of up to one year. Early this year, the PBoC introduced the short-term liquidity operations and the standing lending facility, which should provide stability to wholesale funding markets. With the impending re-introduction of Chinese treasury bond futures, lenders can also hedge their longer-term interest rate risk. This should reduce the need for current official long-term interest rate guidance.

Do you expect more financial deregulation as well?
The numerous restrictions on banks are likely to remain for some time, even though we believe that the central bank may indeed move toward targeting wholesale market lending rates more swiftly.

A key obstacle to efficient credit allocation in China is the banks’ willingness to lend to government-related entities even when they show weak credit attributes. Without meaningful reforms on the local government front, lending to these entities could surge with the dismantling of direct controls on the financial sector.

At the same time, granting banks more price-setting powers could also lead to other policy consequences. Greater price competition is likely to narrow net interest margins further to reduce profitability, especially for the smaller banks. In the absence of a deposit insurance scheme, depositors could move their money to bigger and stronger banks if financial performances deteriorate among small banks in this scenario.

Capital flows could also become more volatile if the exchange rate fluctuations remain limited as interest rates are liberalised. Differentials between Chinese and US interest rates could increase and change more frequently. As savers move their funds in and out of the country in response, banks may find managing their liquidity positions more tricky.

 

KimEng Tan, the author of this article, is a Singapore-based senior director for Standard & Poor’s

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