China's two-speed market evolution

FT.com

China's financial regulators are beginning to look like tugboat captains on a speedboat. They have the right instincts for steering their vessel – the country's markets – in the desired direction, but the engine is proving more powerful than they at first thought.

Their objective is a smaller banking sector, one that is less dominant in China's financial system. At present, banks account for 80 per cent of corporate financing in China, according to official data, well above the norm of 50 per cent or less in other countries – be they developed or developing.

These regulators have a carefully charted plan to reach that destination. But powerful market forces are now propelling China along this course far more quickly than intended and creating new, dangerous risks in their wake.

Beijing wants to bring change to the financial sector in a careful, step-by-step way and it has nudged this agenda forward in recent months. Most notably, with its two interest rate cuts since the start of June, the government has given banks more freedom to set deposit and lending rates. It still guarantees them a tidy interest margin, but the margin is smaller than before – forcing bankers to get used to a world where funding costs actually matter.

The government has also made progress in the corporate bond market, which was long hobbled by an onerous approval process for issuers. Regulators have recently lightened their touch, fast-tracking approvals and encouraging more bond issuance.

Beijing deserves credit for its accomplishments. After all, many observers had thought 2012 would be a quiet year for government initiatives. With the Communist Party consumed by a once-in-a-decade leadership transition, there was supposed to be little appetite for policy experiments.

But Beijing's progress looks slow when set against the rapid pace of change in Chinese financial markets, which is occurring beyond the confines of the official reform agenda.

The wealth management products that banks are selling are an example of real interest rate liberalisation. These products, which are typically loans repackaged as short-term investment products, barely existed a few years ago. By the end of the first quarter of this year, they were worth about Rmb10.4 trillion ($1.59 trillion) – equal to 12 per cent of total bank deposits.

Banks use these wealth products to fight for customers, luring them with higher yields than they can offer on capped deposit rates. But customers are a picky bunch. Many products expire after as little as one month, at which time investors can switch to another bank. The competition is fierce, leaving banks with the slimmest of interest margins.

To measure the boom in fixed income products, forget the formal bond market and look to the trust sector. Chinese trusts are companies that extend loans or make equity investments, then combine them into fixed-income products for customers.

Barely a blip on the radar a decade ago, these trust companies manage more than Rmb5.3 trillion today – putting them on track to eclipse the insurance sector in asset size this year. The comparison with bonds is even more striking. Trust products are worth about 20 times more than the total amount of corporate debt traded on China's exchanges.

Understanding the success of trusts and wealth management products is easy enough. There is pent-up appetite in China for any investments promising reasonably good, seemingly safe returns. Savers have grown tired of storing their money in bank accounts with low interest rates. The stock market is seen as a bastion of insider trading and property prices are falling. Investors were hungry for something new.

But the rise of trusts and wealth products also presents serious risks. The government has encouraged a belief that debt defaults are almost impossible by ordering banks to bail out companies on the brink of trouble, such as rayon maker Shandong Helon earlier this year. Many wealth and trust products have been sold with implicit guarantees that debtors will not default. Investors could be in for a nasty surprise.

There is also the systemic risk of market reforms getting ahead of themselves. Beijing has been deliberate for a reason. Just a decade ago, China's banks were in effect insolvent. A huge injection of capital from the state was needed to nurse them back to health and the government wanted to give them time to find their feet as profit-focused institutions.

For years, China's regulators have been supremely cautious about steering the country's financial system into the stormy waters of competition. The regulators are finally heading toward that destination, but the financial system is in a much bigger hurry to get there.

Simon Rabinovitch is the FT's Beijing correspondent. Copyright The Financial Times Limited 2012.