China's rocky road to financial freedom

China's recent cash rate spike was a sign of an immature financial system, and as its economy rebalances financial reform will continue in an unpredictable fashion.

Lowy Interpreter

The spike in China's short-term interest rates over the past month sent a shiver through world financial markets, in the same way that Fed Chairman Bernanke's statements on quantitative easing startled financial markets a month earlier. In both cases the market overreacted, reflecting a misunderstanding of what was happening. But at the same time the liquidity glitch was a trigger for legitimate concerns about the wider Chinese financial sector.

The short-term interest rate in China, as in almost all countries, is under the control of the central bank (the People's Bank of China, or PBoC). In countries with mature financial sectors, this interest rate is the key instrument of monetary policy: when the central bank wants to tighten policy, it raises this short-term rate, discouraging borrowing.

In the case of China, this key interest rate, which has been around 2-4 per cent in recent times, rose to well over 20 per cent. What policy message was being sent by such a disconcertingly large shift? Or if, for some reason, it wasn't a reflection of policy intent, what had gone wrong? Was it China's Lehman moment, a sign that the pent-up imbalances in the financial sector had finally tripped, spilling out the suppressed problems of accumulated bad debts and an unregulated shadow banking sector?

In a fully-evolved financial system, a short-term interest spike like this would suggest a serious operational error on the part of the central bank. It is a primary responsibility of central banks to supply enough liquidity to allow banks to provide the public with whatever currency they want to hold and to leave the banks with a comfortable amount of liquidity to meet their reserve requirements and carry out inter-bank transactions. Operational hitches are no excuse: it is especially easy to adjust liquidity in the Chinese system, via a reduction in required reserve levels.

It looks like there were a few glitches in the PBoC's liquidity management.

Circumstances (a public holiday, foreign exchange transactions) left liquidity tight. The PBoC seems to have been ready to use this tightness as a signalling device for its desire to firm policy, in the face of rapid growth in bank credit. This would never be a preferred method of signalling an intentional tightening in most central banks as it leads to confusion and misinterpretation. If credit or economic activity is growing too fast, an announced interest rate rise is more effective. If, on the other hand, the underlying problem is excessive non-performing loans, or the shadow banking sector is expanding too quickly, this is a matter for the prudential authorities, not a case for an interest rate increase which could trigger bank failures.

Monetary policy control in China, however, is still evolving.

The PBoC is not independent, nor is there a well-defined decision process. The PBoC may have taken the opportunistic path to shift the effective stance of policy in the desired direction. But the messy signal delivered demonstrates the collateral cost of such opportunistic ad hocery.

Liquidity has now been rebalanced and the situation has returned more-or-less to normality. The residual messages are that the PBoC would like the policy stance to be tighter, with credit growing more slowly. More fundamentally, the PBoC would like to see banks' non-performing loans dealt with and the shadow banking sector brought under control.

While these structural issues are serious, the threat of a Lehman-like meltdown or a repeat of the 1997-8 Asian crisis seems remote, to say the least. The big five banks that dominate the financial sector are all predominantly government owned. China's macro position has no similarities with that of Asia in 1997: China is not vulnerable to the capital flow reversals that were central in the 1997 crisis.

The problem of the shadow banking sector reflects the stage of development of the financial sector. When banks are closely regulated, financial intermediation shifts outside the regulated sector, beyond the control of the authorities. As usual, politics impinges: regional governments exercise informal pressure to obtain unregulated funding, using some of this to build infrastructure, not all of which is viable.

The PBoC has signalled, however crudely, its intention to slow the growth of credit. It will be a bigger step to get on top of the shadow banking sector, and the resolution of bad debts will leave official debt higher. It's hard to be sure about Chinese financial data or to find relevant comparators. The ratio of credit to GDP is around twice that in the US, but this reflects the nature of the Chinese financial sector, where banks play a much larger role than in the US.

Clearing up the financial system might be expensive and a credit squeeze might crimp growth, but reform is underway and the degree of control which the authorities have over the economy makes a financial collapse unlikely. One of their instruments might provoke a pang of envy from Western central bankers: the PBoC has issued a directive to the domestic press to avoid malicious hype and to strengthen positive reporting.

All this is playing out in an economy undergoing structural change to reduce its dependence on capital expenditure, especially infrastructure, replacing this with faster consumption growth. The liquidity glitch is not important in itself, but is another reminder that the road of financial reform is bumpy and the pace of travel is not fully under control.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.

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