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Thursday, December 26, 2013 3:09 PM

China Cash Crunch Eases, For How Long? Three Things China Needs to Avoid; When can Beijing Truly move to Market-Determined Interest Rates?

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As noted on December 23, China Interest Rate Crisis Continues: China Bans Words "Cash Crunch", the 7-Day Interest Rate Doubled to 10%. The doubling of rates took about a week.

Then, on December 24, China injected 29 billion RMB (Yuan), about $4.8 billion.

For the size of China's RMB 130 trillion economy (about $2.14 trillion), that $4.8 billion is a trivial amount. Nonetheless, the 7-day repo rate crashed back down to about 5.33%.

Mission accomplished?

It's a lot more complicated than "mission accomplished" as the following discussion shows.

China's Move to Market-Set Rates

Let's step back to December 8 and look at China Relaxes Grip on Interest Rates

China is relaxing its grip on interest rates with the launch of a financial instrument that allows banks to trade deposits with each other at market-determined prices.

The certificates of deposits will push banks closer to an operating environment in which rates are deregulated and are also aimed at improving the circulation of cash in the country’s interbank market.

Beijing used to fix deposit and lending rates, limiting competition between banks and in effect transferring cash from savers to borrowers because of the artificially low rates. But over the past two years, the government has rolled back its controls, lifting all restrictions on lending rates and giving banks more freedom to determine deposit rates.

Under the changes – which come into effect on Monday – individual CDs will have to be at least Rmb50m ($8.2m) in size and issuers will have to inform the central bank in advance how much they plan to issue in a year. Banks, fund managers and other institutions in the interbank market will be able to trade the CDs, but non-financial companies and retail investors will be barred.

The liberalisation is seen as a necessary part of China’s efforts to reduce its reliance on investment and boost consumption as well as to integrate itself more fully in the global financial system with lighter capital controls.
China's Central Bank Discusses Deposit Insurance

On December 9, Caixin Online noted PBOC Said to Be Talking to Major Banks about Deposit Insurance.
The central bank has been consulting executives of major banks about creating a deposit insurance mechanism and may announce a draft plan early next year, a source close to the situation said.

Advocates have called for such a system for years, saying it is the cornerstone of further financial reform. Without it, they argue, the government will be held as hostage to banks who may act irresponsibly because they know the government will not let them fail and hurt tens of millions of depositors.

Based on current discussions, the insurance mechanism would mostly likely start with the creation of a special fund controlled by the central bank, the People's Bank of China, from which money would be drawn to cover depositor losses if a bank fails, the source said.

Both companies and individuals would be shielded from losses of 500,000 yuan per account. As the mechanism matures, an independent company would be established to take over the fund, the source said.
China's Quandary

George Magnus writing for the Financial Times says China cash crunch symbolises central bank policy quandary
China’s financial markets are in the crosshairs of much bigger issues – the credit cycle and economic reforms.

China’s credit boom is still in full swing. Total credit in the economy (total social financing) showed a 40 per cent rise in November over the prior month and is on course for growth this year of almost 20 per cent. It is continuing to expand at twice the rate of nominal, or money, gross domestic product, and according to official data has pushed the credit to GDP ratio up to 215 per cent in 2013, and most likely more. It is clear that banking institutions, state-owned enterprises and local government financing vehicles have remained relatively insensitive to, or been able to circumvent, higher interest rates and bond yields, central government curbs on the shadow banking sector, and the rampant real estate and infrastructure markets.

Financial reform, which lies at the heart of China’s reform wishlist, embraces the eventual liberalisation of deposit rates, and the determination of interest rate levels by markets. But it is hard not to conclude that the authorities remain conflicted. They are happy for the financial sector to experiment with new products on- and off-balance sheet, allowing the system gently to displace state allocation of capital through decreed interest rates, loan quotas, loan-to-deposit ratios and specific credit restrictions.

The major operational problem for the PBoC is how to deploy its tools between targeting interest rates, and bringing down the rate of credit expansion.

A hitherto strong focus on managing interest rates, even with the occasional liquidity squall, has meant that credit growth and leverage have continued to rise rapidly. This is prolonging economic growth at current levels, but could lead to a solvency crisis in which an even higher debt burden and non-performing loans would eventually threaten both economic growth and financial reform. If China switched its focus to controlling credit expansion, on the other hand, the consequences would be much higher and more volatile interest rates. It could turn into a full-blown liquidity crisis, if political nerves held, and inevitably a cost to economic growth and to balance sheets, But this might lead to a speedier and more effective economic adjustment. These are the big issues, hinted at by the current hiatus in China’s money markets.
Important Start

On December 16, (before the cash crunch started), Michael Pettis discussed the implications of market-determined rates in an email titled"When can Beijing Liberalize Chinese Interest Rates?"

Here are a few key snips.
  • With the establishment of negotiable CDs not subject to the cap on deposit rates, Beijing continues to move forward on financial sector reform. I have been skeptical about previous reforms on the grounds that they are only significant to the extent that they liberalize the cap on deposit rates and address corporate governance distortions in the banking system. The latest reforms, however, and for this reason, may be the first truly significant ones.
  • As China’s nominal GDP growth rates continue to decline, the gap between China’s controlled interest rates and its “natural” rate is narrowing. In one or two years I expect the gap to be virtually eliminated, in which case the PBoC can deregulate interest rates without worrying about a surge in financial distress costs.
  • One impact of the shadow banking system is an implicit and hidden “reduction” in China’s real minimum reserve requirement. As the shadow banking system is forced back onto the balance sheets of Chinese banks –something that the PBoC seems to want – monetary conditions will tighten as if the minimum reserve requirement had been increased. Investors should be prepared for unexpected “tightening” as part of the reform of the financial sector.
  • Contrary to market consensus, if the reforms proposed in the Plenum are enforced, growth rates must decline. In fact we can judge the effectiveness of Beijing’s implementation of the reforms by how rapidly growth declines over the 2014 and 2015.
  • There are three reasons why implementation of the reforms must lower growth sharply. First, if the reforms are effective the extraordinary growth in credit will stop, or even reverse.
  • Second, if Chinese banks have funded wasted investment, the failure to write them down in the past means that past GDP growth has been overstated by that amount. As these bad loans are written down explicitly, or implicitly over the debt repayment period, the amount of GDP overstatement will be subtracted from future GDP growth.
  • Third, rebalancing means reversing the implicit growth subsidies, of which repressed interest rates are the most important. These subsidies turbo-charged growth in the past, and so their elimination must have the opposite effect on growth.
  • When analysts claim that implementation of the reforms will result in continued high growth rates, they are implicitly claiming that the reforms will cause enough of a surge in productivity to compensate for the three conditions listed above, and will do so immediately. Of course this is possible, but it is highly improbable and, if it came to pass, would be truly unprecedented in modern economic history.

Although these negotiable CDs are designed in principle as an alternative to ordinary retail or corporate deposits, in fact they are more likely to be arranged and priced against interbank borrowings. The first five issues of negotiable CDs however were all priced at yields substantially below collateralized borrowings in the interbank market (repos and reverse repos), which suggests that the pricing of the first issues may have been driven by considerations other than pricing efficiency. Chen Long, writing for the ShadowPBoC, puts it fairly bluntly: “it is doubtful whether the interest rates of the negotiable CDs are market-driven.

At any rate the new regulations certainly do represent another step in the slow process of dismantling interest rate controls. And there are more proposed financial sector reforms along the same lines.

Setting up an explicit deposit insurance scheme is important because for now it there is a great deal of confusion about which financial sector liabilities are guaranteed by the state and which are not. There are no explicit deposit guarantees, of course, but most analysts agree that Beijing would never let banks fail, and so the perception is that all deposits are effectively guaranteed

The problem, of course, is that because of the ambiguity and uncertainty in the market, the implicit guarantee of deposits creates a moral hazard problem for Beijing. Wealth management products, for example, are not supposed to be obligations of the arranging banks, and yet it is widely believed by investors that they are fully backed by the banks that arranged them, and that these banks, in turn, are fully backed by the Ministry of Finance. As a result, many investors believe that even with their much higher yields there is in effect little difference in the riskiness of wealth management products (WMP) relative to ordinary bank deposits.

This puts the country in the paradoxical position of encouraging WMP even as it attempts to dissuade investors from funding them.

By making deposit insurance explicit, it is widely believed, Beijing would simultaneously be signaling that financial instruments that are not explicitly guaranteed are, by definition, not guaranteed at all, in which case investors would be forced to monitor and evaluate the riskiness of the end borrowers. This should constrain their willingness to fund projects whose value to the economy is limited or even negative.

It remains to be seen whether investors in WMP actually believe that the government is withdrawing its implicit support for WMP products, but it certainly seems that Beijing is finally serious about interest rate reform. So when can we expect real liberalization of interest rates, which, in the end, is only meaningful if deposit rates – which directly or indirectly bank underlie nearly all credit pricing in China – are liberalized?

Can we allow interest rates to rise?

Not yet, clearly. If interest rates were liberalized today they would almost certainly rise very quickly. WMP, after all, are simply attempts by banks to disintermediate deposits as a way of getting around the deposit cap, and this wouldn’t be necessary if current deposit rates were anywhere close to where they ought to be. What’s more whenever the PBoC auctions MoF deposits, which are not subject to the cap, the winning bids are usually 200-300 basis points above the deposit cap, as are the negotiable CDs that have been issued since the new rules went into effect.

If deposit rates were liberalized, in other words, they would almost certainly jump by a couple of percentage points, and banks would be forced to raise their lending rates or else their profitability – urgently needed to handle the expected bad loans – would suffer. With so many borrowers in China just barely able to service their debt at current rates, any sharp increase in interest rates is likely to lead to an equally sharp increase in financial distress, and no one wants to see this in China just yet.

But if we wait another year or so, I would argue, conditions will be ripe for an elimination of interest rate caps. Why? Because in another year or so, if the PBoC is able to ignore pressure to lower them, interest rates in China will no longer be much below their “natural” rate. In that case eliminating the deposit cap (which, ultimately, is the basis of all interest rate controls in China) will not result in a surge in interest rates.

We can effectively think of the difference between where interests ought to be and where they actually are – the amount of “financial repression”, in other words – very broadly as the gap between the nominal GDP growth rate and the nominal risk-free lending rate. When the nominal lending rate is much below the nominal GDP growth rate, as has been the case for most of the past thirty years, there are two important consequences.

First, and most obviously, the benefits of investment are not shared equitably or efficiently between net savers and net borrowers, but rather are disproportionately retained by net borrowers at the expense of net savers. This represents a hidden transfer of wealth from savers to borrowers, which I have calculated as being in the order of 5-8% of GDP every year for most of this century until 2011-12. This transfer, of course, is at the heart of the current consumption imbalance in China.
Of course the near-infinite demand from preferred borrowers for sharply underpriced credit has left very little credit available for non-preferred borrowers, which include nearly the entire universe of small and medium businesses, who are widely acknowledged to be the most efficient and productive part of the Chinese economy.

Low interest rates, in other words, are at the heart both of China’s economic imbalances and China’s soaring debt, and the amount by which interest rates are too low is broadly equal to the gap between the nominal GDP growth rate and the nominal lending rate.

But, as I suggested last September in an OpEd piece for the Financial Times (China has a choice – short-term growth or sustainability), there has been good news on that front:

The hidden subsidy has declined dramatically since 2011. In the five years from 2006 to 2011, nominal GDP growth averaged about 18 per cent or more, while the official lending rate averaged around 7 per cent. In the past two years the nominal GDP growth rate has fallen to below 10 per cent while the lending rate rose to 7.5 per cent, bringing the gap down by an impressive three-quarters.

In addition to stable inflation, real GDP growth rates have also been declining, although the market consensus is that we have bottomed out in terms of GDP growth at around 7.5%. This consensus will almost certainly prove wrong, and if we don’t see growth dip below 7% in 2014 we will almost certainly see it drop substantially in 2015 and later as surging debt forces China to adjust.

The combination of low inflation and declining GDP growth means that the financial repression “tax” – the spread between the lending rate and the nominal GDP growth rate – is declining, and as it declines the upward pressure on interest rates will decline with it. Once nominal GDP growth is in the 8-9% region, which I expect to happen soon enough, the PBoC will probably be in a position to eliminate, or at least de-emphasize, the deposit cap without a surge in interest rates that could destabilize the banking system.
This was a quite the complicated explanation involving discussion from Michael Pettis at China Financial Markets, Financial Times, Caixin Online, and Shadow PBOC.

Wow. Thanks to all.

Three Things China Needs to Avoid

  1. Lowering rates to spur more growth or to appease the markets
  2. Setting growth rate targets that are too high
  3. Delaying financial liberalization to appease the beneficiaries of "financial repression", most notably State Owned Enterprises (SOEs), at the expense of savers. 
China has already wasted hundreds of billions of dollars in malinvestments such as empty cities, unused airports, little used rail systems, and wealth management programs where losses are glaring (but not yet realized).

Given those huge unrealized losses, China GDP has undoubtedly been overstated and must come down dramatically. For further discussion, please see Pettis on Debt, Malinvestments, Hidden Losses, and China's GDP.

Attempts to spur more growth will only lead to additional losses and an even more painful transition down the road.

Mike "Mish" Shedlock

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